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FRM Part II · FRM Exam Part II · Liquidity and Leverage

Which situation best illustrates a liquidity spiral between market liquidity and funding liquidity?

A liquidity spiral occurs when price declines lead lenders to raise margins or haircuts, forcing leveraged holders to sell, which depresses prices further and tightens funding again. This feedback between funding and market liquidity amplifies losses, unlike hedging or diversification.

  1. AA bank with stable retail deposits holds high-quality government bonds to meet regulatory ratios
  2. BFalling asset prices cause lenders to raise margins, forcing leveraged traders to sell assets, which pushes prices lower and triggers further margin increasesCorrect
  3. CA corporate treasurer swaps floating-rate debt into fixed-rate debt to reduce interest-rate uncertainty
  4. DA fund manager diversifies across uncorrelated strategies to reduce portfolio volatility

Explanation

A liquidity spiral is a feedback loop: losses tighten funding through margins and haircuts, forced sales depress prices, and lower prices tighten funding again. The other options describe stable funding, hedging and diversification, none of which involve a self-reinforcing loop.

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