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. Core Functions of Large Dealer Banks

Topic 2. Counterparty Risk and Systemic Vulnerabilities

Topic 3. Systemic Risk Amplification Mechanisms

Topic 4. Dealer Bank Structure and Core Activities

Topic 5. Dealer Bank Structure and Core Activities

Topic 6. OTC Derivatives and Off-Balance Sheet Financing

Topic 7. Diseconomies of Scope

Topic 1. Core Functions of Large Dealer Banks 

• OTC Derivatives Market Intermediation: Dealer banks transfer risk by creating derivatives contracts between counterparties, including interest rate swaps, CDOs, CMOs, and credit default swaps
• Repurchase Agreement (Repo) Market: Dealer banks finance significant portions of other dealer banks' assets through repos, using overnight repos to finance agency securities, corporate bonds, Treasuries, mortgages, and CDOs
• Prime Brokerage Services: Provide custody of securities, clearing, securities lending, cash management, and reporting services to large investors such as hedge funds
• Investment Banking Functions: Manage and underwrite securities issuances, advise on mergers and acquisitions, and conduct merchant banking activities including commodities trading
• Asset Management: Provide asset management services for wealthy individuals and institutions, operating internal hedge funds and private equity partnerships
• Traditional Commercial Banking: Gather deposits and provide corporate and consumer lending, though historically without access to central bank discount windows or federal insurance

• Counterparty Default Risk: Risk that one or more counterparties will default on contractual obligations, creating frictional bankruptcy costs and distress for other counterparties in the derivatives chain
• Interconnected Exposure: Dealer banks often act as counterparties to other dealer banks and large market players, creating concentrated systemic risk where one bank's failure rapidly spreads
• Lehman Brothers Case Study: The September 2008 default disrupted not only OTC derivatives markets but caused widespread repercussions across financial markets and institutions
• High Leverage Through Repos: Prior to the financial crisis, dealer banks maintained very high leverage due to lack of capital requirements for repos, creating significant solvency risk
• Collateral Quality Concerns: When subprime mortgages used as collateral were questioned, it triggered rapid deterioration in dealer bank solvency and market confidence
• Liquidity-Solvency Link: Without liquidity to function, dealer banks become insolvent; if counterparties question solvency, they exit positions, creating a self-reinforcing liquidity crisis

Topic 2. Counterparty Risk and Systemic Vulnerabilities

• Repo Market Freeze: When solvency is questioned, counterparties refuse to renew repos and creditors may be legally required to sell collateral immediately, eliminating funding sources
• Prime Brokerage Client Flight: Hedge funds demand cash margin loans or exit positions when questioning prime broker solvency, reducing available collateral pool and weakening liquidity
• Investment Banking Revenue Loss: Issuers take business elsewhere when questioning dealer bank solvency, halting cash inflows and creating liquidity strain with few institutions able to fill the void
• Lack of Client Diversification: Prior to the financial crisis, hedge funds concentrated positions with few dealer banks, amplifying systemic risk when one dealer faced distress
• Off-Balance Sheet Exposure: Dealer banks voluntarily support struggling internal hedge funds, structured investment vehicles, and money market funds to protect reputation and franchise value
• Credit Market Contagion: Increased concerns about dealer bank solvency threatened credit availability across the entire industry, potentially causing severe market slowdowns for all borrowers

Topic 3. Systemic Risk Amplification Mechanisms

Topic 4. Dealer Bank Structure and Core Activities

• Dealer banks operate outside traditional bank failure resolution mechanisms like conservatorship or receivership
• Organized under holding company umbrellas to provide diverse services: commercial banking, merchant banking, investment banking, brokerage, and off-balance sheet partnerships
• Asset-management divisions offer custody of securities, cash management, brokerage, and alternative investment vehicles
• Often serve as general partners with limited partner clients in various investment structures
• Complex organizational structure enables comprehensive financial services across multiple market segments
• Regulatory framework differs significantly from traditional commercial banks due to diverse market participation

• Primary Securities Market: Act as underwriters, purchasing equity and bond securities from issuers and distributing them to institutions and investors over time
• Secondary Securities Market: Provide critical market liquidity as primary intermediaries in OTC markets
• Facilitate private negotiations between investors and corporations, municipalities, national governments, and securitized credit products
• Active in publicly traded equity markets as brokers, custodians, securities lenders, and facilitators of large block trades
• Repo Market Role: Major participants in repurchase agreements (repos) - short-term cash loans collateralized by securities
• Most repos are very short-term (often overnight) and collateralized by government bonds, corporate bonds, mortgages, agency securities, or CDOs; clearing banks often act as third parties to reduce counterparty risk

Topic 5. Dealer Bank Structure and Core Activities

Topic 6. OTC Derivatives and Off-Balance Sheet Financing

• OTC Derivatives: Serve as counterparties in over-the-counter derivatives, particularly interest rate swaps exchanging variable rates (linked to SOFR) for fixed rates
• Operate "matched book" dealer operations, transferring risk by creating offsetting derivatives contracts with other counterparties (often other dealer banks)
• Maintain large OTC derivatives exposures with other dealer banks; also act as counterparties in credit default swaps (CDSs) to transfer default risk
• Off-Balance Sheet Financing: Sell residential mortgages or loans to special purpose entities (SPEs) that issue debt to third-party investors or hedge funds
• SPEs historically not included in minimum capital requirements, allowing some banks to become highly leveraged before the 2008 crisis
• 2007-2008 Crisis Example: Structured Investment Vehicles (SIVs) financed mortgages with short-term debt (CDOs/CMOs); housing value decline led to mortgage defaults, creditor concerns, liquidity issues, requiring sponsor bank support to protect reputation

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.

Topic 7. Diseconomies of Scope

• The 2007-2009 financial crisis raised serious questions about dealer banks' ability to manage risks properly within their complex holding company structures
• Economies vs. Diseconomies of Scope: While large bank holding companies achieve economies in IT, marketing, and financial innovation, the crisis revealed significant diseconomies in risk management and corporate governance
• Executive management and boards of directors failed to fully understand or control risk-taking activities within their organizations
• Bear Stearns and Lehman Brothers Example: Prior to insolvency, both relied heavily on overnight repos with leverage ratios exceeding 30
• These banks held assets on balance sheets with minimal incremental capital; management failed to properly assess off-balance sheet risk exposure
• Over-leveraged positions made it impossible to overcome liquidity and solvency issues when asset values were questioned
• Increased risk awareness and more appropriate risk models may have prevented the insolvency of these dealer banks

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 Crisis Mechanism for Dealer Banks

Topic 2. Mitigation Strategies and Central Clearing

Topic 3. Systemic Risk and Institutional Differences

Topic 4. Crisis Response and Market Stabilization Measures

Topic 5. Regulatory Reforms and Systemic Risk Mitigation

Topic 1. Liquidity Crisis Mechanism for Dealer Banks

• Counterparty exposure reduction: When OTC derivatives counterparties question a dealer bank's solvency, they attempt to reduce exposures by restructuring existing derivatives, entering offsetting contracts, or borrowing from the dealer
• Novation requests: Counterparties may request novations to transfer their positions to another dealer bank, removing cash collateral from the original dealer and damaging reputation capital (as seen with Bear Stearns' denied requests)
• Option restructuring: Counterparties can reduce exposure by requesting in-the-money options be revised to at-the-money strike prices, forcing the dealer to pay out cash and further straining liquidity
• Repo creditor flight: Money market funds, securities lenders, and other dealer banks finance significant fractions of dealer bank assets through short-term repos; non-renewal of repos creates immediate liquidity pressure
• Prime brokerage withdrawals: When clients remove cash and securities from prime brokerage accounts, the dealer loses a critical pool of liquidity that was used to meet other clients' needs
• Loss of settlement privileges: The final collapse occurs when clearing banks refuse to process insufficiently funded transactions, invoking rights to offset exposures and discontinuing daylight overdraft privileges

Practice Questions: Q1 (Module 1)

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 (Module 1)

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. Mitigation Strategies and Central Clearing

• Central clearing benefits: Central clearing counterparties stand between original counterparties, mitigating liquidity risk when counterparties exit large dealer bank exposures and reducing systemic risk in financial markets
• Central clearing limitations: Effective only for derivatives with relatively standard terms; not suitable for customized products like the infamous AIG credit derivatives that contributed to the financial crisis
• Liquidity risk mitigation tools: Dealer banks can establish lines of bank credit, hold cash and liquid securities, and ladder liability maturities to spread refinancing needs over time rather than concentrating them overnight
• Post-2008 regulatory changes: Creation of the Primary Dealer Credit Facility by the New York Federal Reserve Bank to finance securities of investment banks during crisis periods
• Bank holding company conversion: Following Lehman's failure, remaining dealer banks (Morgan Stanley and Goldman Sachs) became regulated bank holding companies, gaining access to the discount window, FDIC insurance, and loan guarantees
• Prime brokerage diversification: Future hedge funds are likely to mitigate exposure by diversifying prime brokerage sources with custodian banks rather than concentrating with a few dealer banks

Topic 3. Systemic Risk and Institutional Differences

• Collateral disposition issues: When repo counterparties question dealer solvency and don't renew repos, they may be incentivized or legally required to sell collateral immediately, potentially facing litigation if sale proceeds are insufficient
• Prime brokerage margin demands: Hedge funds can demand cash margin loans backed by securities held with the prime broker, but the broker may be unable to use those securities as collateral with other lenders who question their solvency
• Cash settlement privilege loss: When clearing banks refuse to process transactions (as JPMorgan Chase did with Lehman), invoking "full right of offset" and discontinuing daylight payments forces the dealer into bankruptcy
• Systemic destructiveness: Unlike traditional retail bank runs, dealer banks play essential roles in OTC derivatives and securities markets; their potential failure creates cascading effects across multiple counterparties and markets
• Dealer-to-dealer interconnectedness: The fact that dealer banks are often counterparties to other dealer banks significantly increases systemic risk in financial markets where these institutions perform critical functions
• Repo market vulnerability: Highly leveraged dealer banks face severe liquidity threats in repo markets when counterparties question solvency and refuse to renew overnight positions, exposing them to pressures that traditional retail banks don't face

Practice Questions: Q1 (Module 2)

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 (Module 2)

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.

Topic 4. Crisis Response and Market Stabilization Measures

• Public Private Investment Partnership (PPIP) 2009: Established by U.S. Treasury under Troubled Asset Relief Program (TARP) to help dealer banks and the financial industry recover from the crisis
• Addressing Adverse Selection: Program aimed to mitigate effects of information asymmetries in the market for "toxic" assets like CDOs backed by subprime mortgages, where buyers only purchase at deep discounts due to uncertainty about true asset value
• PPIP Subsidies: Government provided below-market financing rates and absorbed losses beyond predetermined levels to incentivize bidding on toxic assets
• Emergency Lending Facilities: Federal Reserve and Bank of England created new secured lending facilities for large dealer banks unable to obtain credit from traditional counterparties or repo markets
• Tri-Party Repo Utility Proposal: Alternative clearing mechanism designed with fewer conflicting incentives and less discretion in rolling over dealer repo positions when dealer bank solvency is questioned
• New Repo Standards: Proposed standardization of transaction documentation, margin requirements, and daily collateral substitution to be incorporated through new repo utility or traditional tri-party clearing approaches
• Emergency Bank Concept: Creation of specialized institution to manage orderly unwinding of repo positions for dealer banks facing liquidity difficulties, with central bank discount window access to protect critical clearing banks

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.

• Enhanced Capital Requirements: Increased capital standards including off-balance sheet positions to reduce leverage positions of dealer banks and strengthen financial stability
• Separation of Clearing Functions: Isolating tri-party repo clearing from other clearing account functions to reduce dealer bank leverage by tightening cash-management flexibility
• Central Clearing for OTC Derivatives: Implementation reduces threat of counterparties fleeing questionable dealer banks, though liquidity effects from reduced exposure would still occur but with more manageable total exposure levels
• Too-Big-To-Fail Problem: Recognition that some large dealer banks and financial institutions pose systemic risk to financial markets if they become insolvent
• Bridge Bank Resolution: Proposed approach for large dealer banks with questionable solvency deemed too-big-to-fail, similar to methodology used for traditional commercial banks
• Comprehensive Risk Management: Combined regulatory measures aim to prevent future crises by reducing leverage, improving transparency, and creating orderly resolution mechanisms for troubled institutions
• Market Confidence Restoration: Overall framework designed to stabilize financial markets, reduce contagion risk, and restore confidence in the banking system during periods of stress

Topic 5. Regulatory Reforms and Systemic Risk Mitigation