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

During a market downturn, several leveraged financial institutions that hold similar assets are hit by falling prices. Each sells assets to restore its target leverage ratio, which pushes prices down further and triggers more sales. Which description best characterizes this systemic dynamic?

This is a leverage spiral. Falling asset prices erode capital and tighten funding limits, forcing leveraged institutions to sell, which pushes prices lower still. The self-reinforcing loop amplifies the initial shock and makes leverage procyclical, rather than reducing risk or providing diversification.

  1. AA leverage spiral in which asset price declines and tighter balance sheet constraints reinforce each otherCorrect
  2. BA flight-to-quality episode that reduces volatility and relaxes funding constraints
  3. CA diversification benefit that lowers correlation among institutions
  4. DA reduction in procyclicality because deleveraging lowers aggregate risk

Explanation

When institutions with similar positions delever by selling into falling markets, prices drop further, tightening margin and capital constraints and forcing more sales. This feedback loop is the leverage (or loss) spiral. The other options describe effects that would dampen, not amplify, stress.

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