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FRM Part II · FRM Exam Part II · Monetary and Fiscal Policy: Safeguarding Stability and Trust

A risk manager at a bank holding large domestic government bonds worries about the sovereign-bank nexus. Which development most directly strengthens the adverse feedback loop between sovereign stress and bank solvency?

The loop is strengthened when higher sovereign yields cut the market value of banks' government bonds, eroding capital. Weaker banks raise expected bailout costs for the state, which further stresses the sovereign. The other options reduce, not amplify, the linkage.

  1. ABanks diversify holdings across many sovereigns with low correlation
  2. BHigher sovereign yields reduce the value of banks' government bond holdings, weakening bank capital and raising the implicit contingent liability of the sovereignCorrect
  3. CThe central bank provides liquidity against high-quality collateral
  4. DDeposit insurance is funded by a pre-funded industry fund

Explanation

The loop works as follows: sovereign stress lowers bond prices, which erodes bank capital; weaker banks raise expected bailout costs for the government, worsening its credit standing. Diversification, liquidity support and pre-funded insurance dampen rather than strengthen the loop.

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