Module: | MODULE B: RISK MANAGEMENT
Q426: Scenario: XYZ Bank heavily relies on 30-day wholesale deposits to fund its 5-year infrastructure loan portfolio. Suddenly, the wholesale market tightens, and depositors refuse to roll over their funds. Based on liquidity risk principles, consider the following statements regarding the correct regulatory actions and risk profile:
1. The bank is experiencing severe funding liquidity risk due to its aggressive strategy of borrowing short and lending long.
2. To immediately rectify the cash outflow, the bank can forcefully recall the 5-year infrastructure loans without any penalty.
3. The bank must utilize its stock of High Quality Liquid Assets to meet the immediate 30-day obligation shortfall.
Which of the statements given above is/are correct?
2. To immediately rectify the cash outflow, the bank can forcefully recall the 5-year infrastructure loans without any penalty.
3. The bank must utilize its stock of High Quality Liquid Assets to meet the immediate 30-day obligation shortfall.
Which of the statements given above is/are correct?
✅ Correct Answer: B
The correct answer is B. Statement 1 is correct: The core driver of funding liquidity risk is maturity mismatch.
By relying on short-term 30-day volatile liabilities (wholesale deposits) to fund long-term 5-year illiquid assets (infrastructure loans), XYZ Bank has created a classic "borrowing short to lend long" vulnerability.
Statement 2 is incorrect: A bank cannot forcefully recall standard term loans before their contracted maturity date simply because the bank is facing a liquidity crunch.
The borrower is protected by the loan agreement.
Statement 3 is correct: When short-term liabilities fall due and cannot be rolled over, the primary regulatory defense mechanism is the liquidation or pledging of the bank's unencumbered High Quality Liquid Assets (HQLA) to generate immediate cash flows.
By relying on short-term 30-day volatile liabilities (wholesale deposits) to fund long-term 5-year illiquid assets (infrastructure loans), XYZ Bank has created a classic "borrowing short to lend long" vulnerability.
Statement 2 is incorrect: A bank cannot forcefully recall standard term loans before their contracted maturity date simply because the bank is facing a liquidity crunch.
The borrower is protected by the loan agreement.
Statement 3 is correct: When short-term liabilities fall due and cannot be rolled over, the primary regulatory defense mechanism is the liquidation or pledging of the bank's unencumbered High Quality Liquid Assets (HQLA) to generate immediate cash flows.