Skip to content

IAI Actuarial Core Principles · Business Economics · Role, structure and stability of the financial system

Rumours about a mid-sized Indian non-bank lender lead many depositors and short-term creditors to withdraw funds at once, even though the lender was solvent. Which feature of financial intermediaries chiefly explains why this can force the lender into distress?

The lender borrows short and lends long, so its illiquid assets cannot be turned into cash quickly enough to meet simultaneous withdrawals. A confidence-driven run can therefore push even a solvent institution into distress through forced fire-sales.

  1. AIt lends long-term and illiquid assets while funding itself with short-term liabilities, so it cannot meet all demands simultaneouslyCorrect
  2. BIt holds too much equity capital relative to its loans
  3. CIt is prevented by law from selling any assets
  4. DIt earns interest on deposits instead of paying it
  5. It operates under perfect competition with zero profit

Explanation

Maturity transformation means assets are long-dated and illiquid while liabilities can be withdrawn quickly. If many creditors demand repayment together, forced asset sales at low prices can create insolvency from a liquidity problem. Excess equity would make a run less likely.

Did you get it right without looking?

One question tells you little. A timed set on Role, structure and stability of the financial system shows your real accuracy, how long you take and where you lose marks.

Practise Role, structure and stability of the financial systemFree diagnostic mock

More Role, structure and stability of the financial system questions