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FRM Part II · FRM Exam Part II · Liquidity and Reserves Management: Strategies and Policies

A bank's contingency policy assumes it can sell a $500 million corporate bond portfolio within one week at a 2% discount. In a market-wide stress, which adjustment to this assumption is most consistent with sound liquidity management?

Sound practice is to assume larger haircuts and longer sale times in stress, because market liquidity and funding liquidity deteriorate together when many institutions sell at once. Using normal-time discounts would overstate the liquidity the bank can actually raise.

  1. AKeep the 2% discount, since historical averages are reliable
  2. BAssume larger haircuts and longer sale times, because asset market liquidity and funding liquidity worsen togetherCorrect
  3. CAssume smaller haircuts, since other banks will buy the bonds
  4. DRemove the portfolio from the plan and ignore it

Explanation

In stress, market and funding liquidity interact: many institutions sell at once, widening discounts and lengthening time to sell. Using normal-time averages overstates the buffer. Assuming smaller haircuts is opposite to this effect. Ignoring the portfolio entirely is overly extreme and not required.

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