Book 4. Liquidity and Treasury Risk

FRM Part 2

LTR 8. The Failure Mechanics of Dealer Banks

Presented by: Sudhanshu

Module 1. Functions of Dealer Banks

Module 2. Liquidity Concerns for Dealer Banks and Risk Policy Measures

Module 1. Functions of Dealer Banks

Topic 1. Compare the major lines of business in dealer banks operate 

Topic 2. Dealer Bank Markets

Topic 3. Diseconomies of Scope

Topic 1. Compare the major lines of business in dealer banks operate 

• Dealer banks operate across diverse financial sectors, creating complexity and commingled risks.

1. OTC Derivatives Dealing

• Function: Act as an intermediary to transfer risk (e.g., interest rate swaps, CDSs).

• Key Risk: Counterparty Risk. The risk that a counterparty will default on contractual obligations, leading to distress costs and rapidly increasing systemic risk across the financial system.

2. Repurchase (Repo) Market Activities

• Function: Provide and obtain short-term, often overnight, cash loans collateralized by high-quality securities.

• Key Risk: Accelerated Solvency Risk. High leverage combined with reliance on continuous renewal of overnight repos. If solvency is questioned, creditors refuse to renew, forcing immediate collateral sales and a liquidity crisis.

3. Prime Brokerage

• Function: Offer services to large investors (hedge funds), including custody, clearing, and securities lending.

• Key Risk: Liquidity Drain/Collateral Shortage. When a prime broker's solvency is questioned, clients flee, demanding cash margin loans and removing their cash and securities from the bank’s liquidity pool.

4. Investment Banking & Underwriting

• Function: Manage and underwrite securities issuances (IPO/bonds), M&A advising, and merchant banking.

• Key Risk: Strain on Cash Inflows. Issuers pull business if the bank's solvency is questioned, halting cash inflows and threatening the bank's own liquidity.

Practice Questions: Q1

Q1. A dealer bank’s liquidity crisis is least likely to be accelerated by:
A. the refusal of repurchase agreement creditors to renew their positions.
B. the flight of prime brokerage clients.
C. a counterparty’s request for a novation through another dealer bank.
D. depositors removing their savings from the dealer bank.

Practice Questions: Q1 Answer

Explanation: D is correct.

A liquidity crisis for a dealer bank is accelerated if counterparties try to reduce their exposure by restructuring existing OTC derivatives with the dealer or by requesting a novation. The flight of repo creditors and prime brokerage clients can also accelerate a liquidity crisis. Lastly, the loss of cash settlement privileges is the final collapse of a dealer bank’s liquidity.

Topic 2. Dealer Bank Markets

• Large dealer banks operate in markets outside the scope of traditional bank-failure resolution (e.g., conservatorship).
• Securities Markets

  • Primary Market: Dealer banks are the security underwriter, buying issues from corporations/governments and selling them to investors.

  • Secondary Market: They play a major role in providing liquidity, particularly in the OTC securities market (private negotiations).

• The Repo Market

  • Mechanism: Short-term cash loans collateralized by securities (e.g., Treasuries, corporate bonds).

  • Key Feature: The majority of repos are overnight and are often continuously renewed as long as the dealer bank's solvency is unquestioned. A clearing bank frequently acts as a third party to hold collateral and reduce counterparty risk.

• ​OTC Derivatives Market

  • Operation: Dealer banks are typically the counterparty in contracts like interest rate swaps and Credit Default Swaps (CDSs).

  • Risk Transfer: They perform a "matched book" operation, transferring risk by creating new, offsetting contracts with other counterparties (often other dealer banks), resulting in large mutual derivatives exposures.

• Off-Balance Sheet Financing (SPEs/SIVs)

  • Function: Dealer banks sponsor Special Purpose Entities (SPEs), such as Structured Investment Vehicles (SIVs), which purchase assets (like mortgages) from the bank and finance them by issuing debt (CDOs, CMOs) to third-party investors.

  • Pre-Crisis Risk: These activities were often excluded from minimum capital requirements, allowing banks to become highly leveraged.

Topic 3. Diseconomies of Scope

• While large bank holding companies may benefit from economies of scope in areas like technology and marketing, the 2007-2009 financial crisis exposed major disadvantages.

• The Core Problem

  • The large, complex holding company structure created diseconomies of scope in:

    1. Risk Management

    2. Corporate Governance

• Management Failure: Executive management and the board of directors did not fully comprehend or control the sheer volume and complexity of risk-taking activities across their many divisions and off-balance sheet entities.

• ​The Outcome of Excessive Leverage

  • Example: Prior to insolvency, firms like Bear Stearns and Lehman relied heavily on overnight repos with leverage ratios exceeding 30.

  • They held substantial assets on their balance sheets with very little incremental capital, failing to properly manage both on- and off-balance sheet risks.

  • Result: This over-leveraged position made it impossible to absorb losses when asset values (like those backed by subprime mortgages) were questioned, resulting in rapid, catastrophic liquidity failure and insolvency.

Practice Questions: Q2

Q2. Banks are most likely to diversify their exposure to a specific asset class such as mortgages by grouping these assets together and selling them to:
A. hedge funds.
B. government agencies.
C. the U.S. Federal Reserve.
D. special purpose entities.

Practice Questions: Q2 Answer

Explanation: D is correct.

Banks can diversify their exposure to a specific asset class, such as mortgages, by grouping these assets together and selling them to special purpose entities.

Practice Questions: Q3

Q3. The formation of large bank holding companies results in diseconomies of scope with respect to:
A. risk management.
B. technology.
C. marketing.

D. financial innovation.

Practice Questions: Q3 Answer

Explanation: A is correct.

Some argue that information technology, marketing, and financial innovation result in economies of scope for large bank holding companies. Conversely, the 2007– 2009 financial crisis raised the concern that the size of bank holding companies creates diseconomies of scope with respect to risk management.

Module 2. Liquidity Concerns for Dealer Banks and Risk Policy Measures

Topic 1. Liquidity Concerns for Dealer Banks

Topic 2. Policies to Alleviate Dealer Bank Risks

Topic 1. Liquidity Concerns for Dealer Banks

• A liquidity crisis in a dealer bank is accelerated by three major movements, all triggered when counterparties and clients question the bank's solvency:

1. Flight of OTC Derivatives Counterparties

• Restructuring/Novation: Counterparties immediately reduce exposure by restructuring existing contracts, entering new offsetting contracts, or requesting a novation (transferring the contract to another, solvent dealer).

• Cash Demands: They may request that in-the-money options be revised to at-the-money, requiring the dealer to pay out cash and deplete its liquidity.

• Reputation Damage: Refusing novation requests (as Bear Stearns did) signals deeper distress and further accelerates the loss of franchise value and cash collateral.​

2. Run by Repo Creditors (Short-Term Financing)

• Refusal to Renew: Money market funds, securities lenders, and other dealer banks (repo creditors) refuse to renew overnight or short-term repurchase agreements.

• Forced Collateral Sale: Creditors may be legally required to sell the collateral immediately. If the proceeds are less than the cash loan, the dealer faces litigation and a liquidity shortfall.

• Mitigation by Bank: The dealer can try to mitigate this risk by establishing lines of credit, holding liquid securities, and laddering the maturities of its liabilities (spreading refinancing needs over time).

3. Flight of Prime Brokerage Clients

• Margin Demands: Hedge funds demand cash margin loans backed by securities held in their account, forcing the dealer to use its own cash.

• Loss of Liquidity Pool: The client's cash and securities are removed from the prime broker's pool of funds, which is otherwise used to meet the liquidity needs of other clients.

• The Final Collapse: The ultimate sign of failure is the loss of cash settlement privileges, such as when a clearing bank (like JPMorgan Chase during Lehman's collapse) invokes its "full right of offset" and refuses to process underfunded transactions.

Topic 2. Policies to Alleviate Dealer Bank Risks

• Policy measures implemented after the 2007-2009 crisis aim to address structural flaws in markets and regulation.

1. Addressing "Toxic" Assets (Adverse Selection)

• Public Private Investment Partnership (PPIP): Instituted via the TARP program to address adverse selection in illiquid asset markets (e.g., CDOs). * Mechanism: PPIP subsidized bidders of "toxic assets" by offering below-market financing and absorbing losses beyond a pre-determined level, creating demand and helping banks clear their balance sheets.

2. Bolstering Liquidity and Central Bank Access

• Primary Dealer Credit Facility (PDCF): Created by the Federal Reserve to finance securities for investment banks (dealers).

• Bank Holding Company Conversion: Post-Lehman failure, Morgan Stanley and Goldman Sachs became regulated bank holding companies, granting them direct access to the Discount Window (central bank borrowing) and FDIC deposit insurance.

3. Structural Market Reforms

• Central Clearing: Policy mandates that standardized OTC derivatives must be novated or "cleared" to a Central Clearing Counterparty (CCP).

  • Goal: The CCP stands between the original counterparties, significantly reducing the systemic risk of bilateral exposures and limiting the liquidity effect when one dealer fails.

• Increased Capital Requirements: Regulations were tightened to increase capital requirements and, critically, ensure that off-balance sheet positions are included in leverage calculations.

• Tri-Party Repo Reform (Proposed): Proposals included creating a tri-party repo utility or "emergency bank" to manage the orderly unwinds of repo positions and insulate critical clearing banks from losses.

4. Resolution Planning ("Too-Big-to-Fail")

• For institutions deemed "too-big-to-fail" due to their systemic risk, the proposed resolution mechanism is to provide bridge banks, similar to the approach used for traditional commercial bank failures, ensuring critical functions can continue.

Practice Questions: Q1

Q1. One potential solution for mitigating the liquidity risk caused by derivatives counterparties exiting their large dealer bank exposures is most likely the:
A. use of central clearing.
B. use of a novation through another dealer bank.
C. requirement of dealer banks to pay out cash to reduce counterparty exposure.

D. creation of new contracts by counterparties.

Practice Questions: Q1 Answer

Explanation: A is correct.

One potential solution for mitigating the liquidity risk caused by derivatives counterparties exiting their large dealer bank exposures is the use of central clearing through a counterparty. However, central clearing is only effective when the underlying securities have standardized terms. The reduction of a counterparty’s exposure through novation, entering new offsetting contracts, or requiring a dealer bank to cash out of a position will all reduce the liquidity of the dealer bank.

Practice Questions: Q2

Q2. Which of the following items is not a policy objective of the U.S. Treasury Department’s 2008 Troubled Asset Relief Program to help dealer banks recover from the subprime market crisis?
A. Provide below-market financing rates for bidders of “toxic” assets.
B. Absorb losses beyond a pre-specified level.
C. Force the sale of illiquid assets in order to better determine the “true” value.
D. Mitigate the effect of adverse selection.

Practice Questions: Q2 Answer

Explanation: C is correct.

The U.S. Treasury Department’s 2008 Troubled Asset Relief Program was designed to create policies to help dealer banks recover from the subprime market crisis by mitigating the effect of adverse selection, by providing below-market financing rates for bidders of “toxic” assets, and by absorbing losses beyond a pre-specified level. Forcing the sale of illiquid assets would worsen the liquidity position of the
troubled dealer bank.