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FRM Part II · FRM Exam Part II

The Failure Mechanics of Dealer Banks for FRM Part II

Dealer banks fail when short-term secured funding disappears faster than they can sell or finance assets. They hold large, leveraged trading books funded by repo and prime brokerage balances. When lenders raise haircuts or pull funding, the bank faces a run. You solve questions by tracing the funding channel, then the policy response.

What this chapter covers

This chapter explains how broker-dealers, the investment banks that make markets, are built and why they break. A dealer bank holds large inventories of securities, finances them mostly with short-term secured borrowing, and runs on thin equity. That mix works in calm markets. It fails fast when confidence drops.

You study the balance sheet first, then the sources of fragility: leverage, maturity mismatch, collateral dependence and reliance on counterparties. Next comes the run mechanism in repo and prime brokerage. Clients and lenders withdraw cash or raise haircuts, and the dealer must sell assets or find new funding. The case studies of Bear Stearns and Lehman Brothers show the same mechanism in real events. The chapter ends with resolution, bankruptcy treatment and the reforms that followed.

The chapter links closely to the rest of Part II. It draws on liquidity and treasury risk (funding liquidity, haircuts, contingency funding), credit risk (counterparty exposure and collateral) and market risk (fire sales and mark-to-market losses). It also helps with Current Issues, where non-bank leverage and private credit raise similar run questions.

Questions on this chapter are applied. You are given a funding scenario and asked what happens next, which channel matters, or which reform addresses the problem. Candidates who only memorise the case histories lose marks, because the exam tests the mechanism. If you can trace how a haircut increase forces asset sales and then losses and then further funding loss, you can answer many liquidity and counterparty questions across the paper. The chapter is also conceptual, so it rewards clear understanding more than heavy calculation.

The Failure Mechanics of Dealer Banks: topics in the order to study them

  1. 1Dealer Bank Business Model and Balance SheetYou need to know what dealers hold, how they fund it and how they earn before you can see what breaks.
  2. 2Sources of Dealer Bank FragilityThis names the weak points, such as leverage, short-term funding and collateral dependence, that the run exploits.
  3. 3Runs on Repo and Prime Brokerage FundingThis is the core mechanism, and it builds directly on the fragility sources you just learned.
  4. 4Case Studies: Bear Stearns and Lehman BrothersThe cases are easier once you can map each event onto the run mechanism.
  5. 5Resolution, Bankruptcy and Policy ReformsReforms make sense only when you know which failure each one targets, so this comes last.

How to prepare The Failure Mechanics of Dealer Banks

Aim to understand one chain of cause and effect, then attach the details to it. Short, repeated sessions work well on a phone.

  1. Draw a simple dealer balance sheet from memory: trading assets, reverse repo, and liabilities of repo, prime brokerage balances, unsecured debt and thin equity.
  2. List each fragility source and write one sentence on how it speeds up a run. Keep leverage, maturity mismatch and collateral reliance separate.
  3. Write the run sequence as steps: loss of confidence, higher haircuts or withdrawals, asset sales, price falls, further losses, more withdrawals. Practise explaining it aloud.
  4. For Bear Stearns and Lehman, note what triggered the loss of confidence, which funding channel failed and how authorities responded. Focus on the contrast between the two outcomes.
  5. Match each reform to the problem it addresses, for example liquidity requirements to funding runs and resolution regimes to disorderly failure.
  6. Finish with scenario questions. For each, name the channel first, then the effect, then the policy answer, and explain why the wrong options fail.

Common mistakes in The Failure Mechanics of Dealer Banks

  • Treating the failures as pure solvency problems

    Fix: Separate solvency from liquidity. A dealer can fail because funding vanishes, and the loss of funding can itself cause the insolvency.

  • Memorising case timelines instead of mechanisms

    Fix: For each case, record the trigger, the funding channel that failed and the outcome. Exam options test the mechanism, not dates.

  • Confusing haircuts with interest rates on repo

    Fix: A haircut is the gap between collateral value and cash lent. It limits how much the dealer can borrow against the assets. A rate is the price of that borrowing.

  • Assuming good collateral prevents a run

    Fix: Lenders can raise haircuts, shorten terms or refuse to roll over. Collateral protects lenders, but it does not guarantee the dealer's funding.

  • Matching reforms to the wrong problem

    Fix: Link each reform to the failure it fixes: capital for loss absorption, liquidity rules for funding runs, resolution tools for orderly failure.

  • Ignoring the spillover to other firms

    Fix: Include the counterparties, clients with assets held at the dealer, and fire-sale effects on market prices when you answer scenario questions.

Last-day revision: The Failure Mechanics of Dealer Banks

  • Dealers hold large trading inventories funded mostly by short-term secured borrowing and thin equity.
  • High leverage means a small fall in asset value causes a large loss relative to equity.
  • Maturity mismatch: assets may be hard to sell quickly, while funding rolls over daily or in days.
  • A repo is a secured loan; a higher haircut means the dealer must put up more of its own funding for the same assets.
  • Rising haircuts force asset sales, which push prices down and cause more losses and more haircut increases.
  • Prime brokerage clients can withdraw cash balances and free credits quickly when they worry about the dealer.
  • A run can happen even when the collateral is good, because lenders only need to doubt the dealer's survival.
  • Bear Stearns lost secured funding access quickly and was sold with central bank support.
  • Lehman Brothers filed for bankruptcy and its failure spread stress through counterparties and funding markets.
  • Dealer failure creates fire sales, counterparty losses and frozen collateral for other firms.
  • Reforms target the failure points: higher capital, liquidity rules, stronger resolution tools and better repo practices.
  • In an exam scenario, identify the funding channel first, then the feedback loop, then the policy remedy.

The Failure Mechanics of Dealer Banks practice questions

The Failure Mechanics of Dealer Banks: frequently asked questions

Is this chapter calculation-heavy in FRM Part II?

No. It is mostly conceptual and scenario-based. You may need simple reasoning on haircuts, leverage or funding gaps, but the main skill is explaining the mechanism.

How much should I know about Bear Stearns and Lehman?

Know the trigger, the funding channel that failed, and how the outcome differed. Do not spend time on precise dates or minor events unless your reading material stresses them.

Why does a repo run happen if repo is secured?

Lenders can raise haircuts, shorten maturities or stop rolling over. If they doubt the dealer's survival, they cut funding even against good collateral, which forces the dealer to sell assets.

How does this chapter connect to Current Issues?

Current Issues readings on private credit and non-bank leverage involve similar themes of funding fragility and run risk. The dealer mechanics give you a framework for those questions.