Skip to content

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

Which statement best describes why a bank's response to a funding shock can create externalities for the wider financial system?

Fire sales by one institution lower prices for everyone holding similar assets, tightening others' margin and capital constraints. Because individual banks do not bear or consider this cost when choosing leverage, the system ends up with excessive leverage and liquidity risk.

  1. AEach institution's fire sales lower prices for all holders of similar assets, a cost that individual banks do not internalize when choosing leverageCorrect
  2. BBanks that sell assets quickly always recover their full value, so there is no cost to other institutions
  3. CLeverage limits imposed by regulators have no impact on the likelihood of fire sales
  4. DSystemic risk arises only when a bank becomes insolvent, not when it is merely illiquid

Explanation

Fire sales impose a pecuniary externality: price declines mark down other institutions' holdings and tighten their constraints. An individual bank sets its leverage without accounting for this cost, so private choices produce excessive leverage and liquidity risk from a system perspective. This underlies macroprudential tools.

Did you get it right without looking?

One question tells you little. A timed set on Liquidity and Leverage shows your real accuracy, how long you take and where you lose marks.

Practise Liquidity and LeverageFree diagnostic mock

More Liquidity and Leverage questions