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

A dealer bank funds a portfolio with short-term repo and is subject to a haircut. In a stress event, lenders raise haircuts on the collateral from 5% to 15%, while the bank holds a fixed pool of equity and cannot raise new capital. Which is the most likely systemic consequence?

Higher haircuts reduce the leverage a fixed equity base can support, since maximum leverage is roughly the inverse of the haircut. The bank must sell assets, and such forced sales across institutions depress prices, spreading stress to other holders of similar assets.

  1. AThe bank can hold a larger asset portfolio because the higher haircut raises its effective capital
  2. BThe maximum leverage the bank can support falls, forcing asset sales that can depress prices for other holdersCorrect
  3. CFunding liquidity risk falls because secured funding becomes safer for lenders, so the bank's borrowing capacity rises
  4. DMarket liquidity improves because fewer assets are financed with leverage, which stabilizes prices at once

Explanation

Haircut is the equity the bank must put up per unit of asset. Leverage capacity is about 1/haircut, so moving from 5% to 15% cuts maximum assets per unit of equity from about 20x to about 6.7x. With equity fixed, the bank must shrink, selling assets and creating price pressure on similar holders. The disorderly sales are the systemic channel, not an immediate stabilization.

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