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FRM Part II · FRM Exam Part II · Liquidity and Leverage

A bank's repo desk observes that haircuts on a given asset class rise sharply whenever market volatility increases. Which consequence best describes the effect of this procyclicality on leverage?

Rising haircuts shrink borrowing capacity per unit of collateral, so leveraged institutions must deleverage by selling assets. Those sales can depress prices and raise volatility, which pushes haircuts higher again, creating a destabilising procyclical spiral.

  1. ALeverage must be cut as haircuts rise, forcing asset sales that can further depress pricesCorrect
  2. BLeverage can increase because higher haircuts mean more borrowing capacity
  3. CLeverage is unaffected because haircuts apply only to unsecured funding
  4. DLeverage rises because the collateral value is marked up

Explanation

Higher haircuts reduce the amount borrowable against each unit of collateral, so maximum leverage falls. Investors with fixed equity must deleverage by selling assets, pushing prices down and potentially raising volatility and haircuts further, a spiral.

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