FRM Part II · FRM Exam Part II · Monetary and Fiscal Policy: Safeguarding Stability and Trust
A risk manager at a bank with large holdings of domestic government bonds is assessing the sovereign-bank 'doom loop'. Which sequence best describes this mechanism?
The doom loop runs in both directions: sovereign stress lowers the value of government bonds held by banks and weakens their funding, and the resulting bank fragility raises contingent liabilities for the government, which further damages sovereign credit quality, reinforcing the cycle.
- AHigher sovereign yields cut bank bond values and funding strength, weakening banks, raising the likelihood of government support and further worsening sovereign creditworthinessCorrect
- BLower sovereign yields raise bank capital, which prompts banks to sell government bonds and lowers sovereign debt
- CRising inflation reduces the real value of bank deposits, which forces the central bank to buy government bonds
- DCentral bank rate cuts reduce bank margins, which lowers tax revenue and causes sovereign downgrades
Explanation
The doom loop is a two-way feedback: sovereign stress hits banks through bond losses and lower ratings, and bank weakness feeds back to the sovereign via expected bailout costs and weaker economy. The other options describe no mutually reinforcing sovereign-bank link.
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