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FRM Part II · FRM Exam Part II · Global Financial Stability Report, April 2025, Chapter 2 (Geopolitical Risk)

Which feature of the interaction between sovereign and bank balance sheets can amplify geopolitical stress on a domestic bank?

A sovereign-bank feedback loop amplifies stress. Sovereign downgrades reduce the value of government bonds held by banks and raise their funding costs, eroding capital. Weaker banks then increase the government's contingent liabilities, further pressuring the sovereign and reinforcing the cycle.

  1. ABanks hold no government bonds, so sovereign stress is irrelevant
  2. BSovereign downgrades raise banks' funding costs and cut the value of government bonds they hold, weakening capital and further pressuring the sovereignCorrect
  3. CSovereign stress always raises the value of bank-held government bonds
  4. DSovereign stress affects only foreign-currency deposits

Explanation

Banks often hold large domestic sovereign debt, so sovereign stress lowers bond values and raises funding costs, weakening bank capital. Weaker banks add contingent liabilities for the sovereign, creating a feedback loop. The other options deny or reverse this link.

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