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

During a market downturn, many leveraged financial institutions are forced to sell assets at the same time to meet margin calls and maintain target leverage ratios. Which systemic mechanism does this behavior most directly describe?

This is a loss spiral. Falling prices reduce capital and collateral values, tightening margins and leverage limits, which forces more selling and pushes prices lower again. Simultaneous forced sales increase volatility and correlation rather than reduce them, amplifying systemic stress.

  1. AA loss spiral in which falling asset prices tighten funding constraints and trigger further forced salesCorrect
  2. BA reduction in aggregate volatility because forced sellers add liquidity to the market
  3. CA diversification benefit that lowers correlations across institutions
  4. DA transfer of credit risk to central banks that stabilizes asset prices

Explanation

Forced selling lowers prices, which erodes capital and collateral values, tightening margin and leverage constraints and prompting further sales. This is the loss spiral (with the margin spiral) in the liquidity-leverage literature. Forced selling raises volatility and correlations, so the other options are wrong.

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