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FRM Part II · FRM Exam Part II · Managing Nondeposit Liabilities

During market stress, a bank that relies heavily on overnight repo funding of lower-quality collateral faces sharply higher haircuts from its lenders. What is the primary liquidity risk this creates?

The main risk is rollover and funding risk. Higher haircuts cut the cash raised against the same collateral, so the bank must replace the shortfall with other funding or asset sales, while overnight maturities force it to refinance every day under stress.

  1. ARollover and funding risk, since higher haircuts reduce cash raised per unit of collateral and require additional fundingCorrect
  2. BReduced interest rate risk, because haircuts hedge repricing exposure
  3. CLower credit risk, because lenders hold more collateral
  4. DA reduction in the bank's encumbered assets

Explanation

Higher haircuts mean the same collateral yields less cash, so the bank must find extra funding or sell assets, and short tenors force frequent rollover. This increases encumbrance rather than reducing it. Haircuts do not hedge repricing risk, and lender credit protection does not remove the borrower's funding gap.

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