A rapid expansion of leveraged assets accompanied by significant utilization of short-term repos serves as an early warning sign for a potential liquidity problem. The leverage ratio measures the level of debt relative to the bank’s capital and indicates the potential strain on its liquidity position. Additionally, relying on short-term repo funding means the bank has a dependence on short-term borrowing to finance its activities, which can pose liquidity risks if the availability of funding becomes limited or costly.

B, C and D are incorrect. Decreased collateral haircuts, a credit rating upgrade, and increased asset diversification are generally positive developments and do not typically indicate an early warning of a potential liquidity problem.

Things to Remember

• Leverage ratio: Measures the level of debt relative to the bank’s capital and indicates potential strain on liquidity position.
• Short-term repo funding: Indicates a dependence on short-term borrowing which can pose liquidity risks.
• Collateral haircuts: Reduction in collateral haircuts may not indicate liquidity issues but can affect risk management.
• Credit rating: Upward revision in credit rating is a positive development but may not serve as an early warning indicator for liquidity issues.
• Asset diversification: While important for risk management, increased diversification of assets may not signal liquidity problems.