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FRM Part II · FRM Exam Part II · Repurchase Agreements and Financing

A bank's treasurer notes that during market stress, repo lenders against lower-quality collateral raised haircuts sharply while those against government bonds changed little. Which interpretation best fits the run dynamics described in the repo literature?

Haircuts rise most on volatile, information-sensitive collateral because lenders need protection against liquidation losses. This concentrates runs on less liquid assets, forcing borrowers to deleverage and sell, which depresses prices further and sets off a self-reinforcing spiral.

  1. AHaircut increases are uniform across collateral types because they depend solely on lender liquidity
  2. BRepo runs are confined to unsecured funding, so collateral quality is irrelevant
  3. CHaircuts rose because the central bank guarantees all repo
  4. DLenders respond to collateral price volatility and information-sensitivity, so runs concentrate on less liquid collateral, forcing borrowers to deleverage and sell assetsCorrect

Explanation

Haircuts are set to cover potential price falls over liquidation; riskier, more information-sensitive collateral sees larger haircut jumps, creating deleveraging spirals. Uniform haircuts, irrelevance of collateral, and a central bank guarantee are inconsistent with observed behaviour.

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