CRA Liquidity Risk Management 1 — Questions and Answers
Question 1: What is the primary purpose of the Liquidity Coverage Ratio (LCR) under Basel III?
- To measure long-term structural funding stability over a one-year horizon
- To ensure banks hold sufficient high-quality liquid assets to survive a 30-day stress scenario (Correct answer)
- To limit the concentration of short-term wholesale funding sources
- To quantify credit risk exposure in the trading book
Correct answer: To ensure banks hold sufficient high-quality liquid assets to survive a 30-day stress scenario
The LCR requires banks to maintain enough HQLA to cover net cash outflows over a 30-day stressed liquidity scenario.
Question 2: Which of the following best describes funding liquidity risk?
- The risk that an asset cannot be sold quickly without a significant price discount
- The risk that a firm cannot meet its cash obligations as they come due without incurring unacceptable losses (Correct answer)
- The risk that rising interest rates reduce the market value of fixed-income assets
- The risk that a counterparty defaults on a contractual payment obligation
Correct answer: The risk that a firm cannot meet its cash obligations as they come due without incurring unacceptable losses
Funding liquidity risk is the inability to meet cash payment obligations when due without incurring excessive cost or material losses.
Question 3: The Net Stable Funding Ratio (NSFR) was introduced under Basel III primarily to:
- Measure daily intraday payment obligations within the settlement system
- Ensure short-term liquidity adequacy over a 30-day acute stress period
- Promote stable medium- and long-term funding structures over a one-year horizon (Correct answer)
- Limit bank exposure to sovereign debt instruments
Correct answer: Promote stable medium- and long-term funding structures over a one-year horizon
The NSFR requires banks to maintain a stable funding profile over a one-year horizon, reducing reliance on volatile short-term wholesale funding.
Question 4: During a liquidity stress event, which action is most likely to amplify systemic risk across the financial system?
- Drawing down pre-established committed credit lines
- Selling illiquid assets at fire-sale prices to generate immediate cash (Correct answer)
- Activating a pre-approved contingency funding plan
- Pledging additional collateral to access central bank facilities
Correct answer: Selling illiquid assets at fire-sale prices to generate immediate cash
Fire-sale disposals depress market prices and create feedback loops that spread stress to other institutions holding similar assets.
Question 5: A bank's liquidity buffer is best described as:
- The maximum amount the bank is authorized to borrow from the central bank overnight
- A reserve of unencumbered liquid assets held to cover unexpected cash outflows under stress (Correct answer)
- The difference between the book value of long-term assets and long-term liabilities
- The total collateral currently pledged in outstanding repo agreements
Correct answer: A reserve of unencumbered liquid assets held to cover unexpected cash outflows under stress
A liquidity buffer consists of unencumbered HQLA that can be readily monetized to meet unexpected outflows without market access.
Question 6: Which of the following is an example of market liquidity risk rather than funding liquidity risk?
- A bank's inability to roll over its short-term commercial paper at maturity
- A firm's failure to meet margin calls due to an unexpected cash shortfall
- An inability to sell a large position in a thinly traded bond without significantly moving the market price (Correct answer)
- Increased funding costs resulting from a credit rating downgrade
Correct answer: An inability to sell a large position in a thinly traded bond without significantly moving the market price
Market liquidity risk arises when a large position cannot be liquidated without materially impacting its market price due to insufficient market depth.
Question 7: Under Basel III, Level 1 High-Quality Liquid Assets (HQLA) are best characterized by which of the following?
- They carry a 15% haircut and are capped at 40% of the total HQLA buffer
- They are primarily composed of corporate bonds rated AA- or above with a 15% haircut
- They include cash, central bank reserves, and qualifying sovereign securities with 0% risk weight and no haircut (Correct answer)
- They are capped at 60% of the total buffer and include investment-grade covered bonds
Correct answer: They include cash, central bank reserves, and qualifying sovereign securities with 0% risk weight and no haircut
Level 1 assets include cash, central bank reserves, and qualifying sovereign/central bank securities with 0% risk weight, and carry no haircut or buffer cap.
CRA Liquidity Risk Management 1
What is the primary purpose of the Liquidity Coverage Ratio (LCR) under Basel III?