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

During the 2007-2009 crisis, many financial institutions funded long-term, illiquid assets with short-term wholesale borrowing such as repo and commercial paper. When asset prices fell and lenders refused to roll over funding, institutions had to sell assets quickly. Which description best captures the amplification mechanism at work?

The mechanism is a liquidity spiral. Funding withdrawal forces fire sales, falling prices cut collateral values and capital, and tighter funding then forces further sales. This self-reinforcing loop between market liquidity and funding liquidity amplified the initial losses during the crisis.

  1. AA liquidity spiral, in which forced asset sales depress prices, which erodes capital and tightens funding furtherCorrect
  2. BA diversification effect, in which asset sales across institutions reduce overall portfolio risk
  3. CA moral hazard effect, in which deposit insurance reduces depositors' incentive to run
  4. DA regulatory arbitrage effect, in which assets are moved to lower-capital jurisdictions

Explanation

Funding withdrawal forced fire sales. Lower prices reduced collateral values and capital, which increased margin and haircut demands and led to still more sales. This feedback loop is a liquidity spiral. The other options describe different concepts that do not explain a self-reinforcing price-funding loop.

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