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FRM Part I · FRM Exam Part I · Anatomy of the Great Financial Crisis of 2007-2009

Before the crisis, large banks used off-balance-sheet conduits and structured investment vehicles (SIVs) funded by asset-backed commercial paper, supported by liquidity backstops from the sponsoring banks. Why did these structures contribute to systemic risk when the commercial paper market froze in 2007?

Sponsoring banks had provided liquidity backstops and faced reputational pressure, so when commercial paper stopped rolling they had to fund or take back the conduits' assets. This brought hidden leverage and losses back onto bank balance sheets, straining capital and spreading stress through the system.

  1. ASponsors had to bring assets back onto their balance sheets or fund the conduits, so hidden leverage returned to the banksCorrect
  2. BThe conduits' assets were fully hedged, so losses transferred to government regulators automatically
  3. CInvestors in the conduits held the credit risk with no recourse to sponsors, so banks were unaffected
  4. DConduits were subject to higher capital requirements than banks, which restricted lending

Explanation

The liquidity support and reputational pressure meant sponsors effectively retained the risk. When rollover failed, banks funded or consolidated the vehicles, which increased their balance sheets and capital needs. The idea that sponsors were unaffected contradicts this, and conduits typically enjoyed lighter, not higher, capital treatment.

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