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

A regulator observes that a bank's leverage ratio is procyclical: leverage rises in booms and falls in busts as measured by market-value balance sheets. Which implication for systemic risk is most consistent with this observation?

Procyclical leverage means banks expand balance sheets and lending when prices are rising and system-wide risk is building. When prices reverse, forced deleveraging contracts credit sharply and amplifies the downturn, so systemic vulnerability is greatest after the boom.

  1. ABanks supply the most credit at the point when system-wide risk is highest, increasing the risk of a sharp later contractionCorrect
  2. BBanks reduce risk exposures during booms, building a buffer against later stress
  3. CAggregate balance sheet size is unrelated to asset price changes
  4. DFunding liquidity becomes less important because leverage falls during busts

Explanation

Procyclical leverage means balance sheets expand as asset prices and measured equity rise, financing more risk taking during booms. When prices reverse, deleveraging is abrupt and amplifies the downturn. The other options contradict the observed pattern.

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