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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. Which feature of this arrangement most directly made the system vulnerable to a self-reinforcing run?

Short-term wholesale funding must be rolled over often, so when lenders lose confidence they stop lending or raise haircuts. Borrowers then must sell illiquid assets at falling prices, which deepens losses and further erodes confidence, creating a self-reinforcing run.

  1. AShort-term funding had to be rolled over frequently, so a loss of lender confidence forced rapid asset salesCorrect
  2. BLong-term assets carried fixed coupons that always exceeded funding costs
  3. CShort-term funding was fully insured by governments before the crisis
  4. DWholesale lenders were required to hold the borrowers' equity

Explanation

Reliance on short-term funding creates rollover risk. When lenders withdrew or raised haircuts, borrowers had to sell illiquid assets at depressed prices, which lowered prices further and fed the run. Wholesale funding was generally not insured, and fixed coupons do not remove funding risk.

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