FRM Exam Part II · The Failure Mechanics of Dealer Banks

Dealer Bank Business Model and Balance Sheet Explained

Updated 11 October 2026 · Fact-checked

A dealer bank holds large inventories of securities to make markets and serve clients. It funds most of them with short-term secured financing, mainly repo. Because the debt matures daily or weekly while assets are longer-lived, the bank depends on lenders rolling funding and on collateral values holding up.

Understand Dealer Bank Business Model and Balance Sheet

A dealer bank buys and sells securities for clients and holds an inventory to do it. When a client wants to sell, the dealer buys and holds the position until it finds a buyer. The inventory can be very large. It also includes assets used to serve hedge funds and other clients, such as securities lent or posted as collateral.

The dealer does not fund this inventory mainly with long-term equity or deposits. It uses short-term secured financing. The main tool is the repurchase agreement (repo): the dealer sells a security and agrees to buy it back later, often overnight, at a slightly higher price. Economically it is a collateralised loan. The lender holds the security. The difference between the security's value and the cash lent is the haircut, which the dealer must fund with its own capital.

This creates a maturity mismatch. Assets may be illiquid or long-dated. Liabilities must be rolled over every day or week. The balance sheet is also highly leveraged: assets are many times equity. A small fall in asset value is a large fall in equity. Leverage = total assets ÷ equity.

The model works only while lenders are confident. If lenders doubt the collateral or the dealer, they can raise haircuts, demand better collateral, or refuse to roll. A higher haircut means the dealer needs more cash at once. To raise it, the dealer sells assets into a weak market. Prices fall, collateral is worth less, and haircuts may rise again. This is a run on repo.

So the dealer's fragility has two linked parts: funding liquidity (can it roll its debt?) and market liquidity (can it sell assets at fair prices?). Confidence and collateral value link them. In the FRM, you must be able to trace this chain from the balance sheet to failure.

Key formulas to remember

Leverage ratio (balance sheet): Leverage = Total assets ÷ Equity; Higher leverage means a smaller asset price fall wipes out equity.
Equity loss from asset decline: Equity loss % = Asset fall % × Leverage; Valid before any new capital raised or assets sold; wipe-out occurs when asset fall % = 1 ÷ Leverage.
Repo haircut: Haircut = (Collateral value − Cash lent) ÷ Collateral value; The haircut is the dealer's own funding per unit of collateral.
Cash raised in repo: Cash lent = Collateral value × (1 − Haircut); A rise in haircut cuts cash raised from the same collateral.
Funding gap from haircut increase: Gap = Collateral value × (New haircut − Old haircut); Dealer must fund this gap from other sources or by selling assets.

How to solve Dealer Bank Business Model and Balance Sheet questions

Use this sequence for any question on the dealer bank model, balance sheet or funding fragility.

1Identify the assets: trading inventory, collateral posted, and how liquid each is.
2Identify the funding: repo, other secured financing, unsecured debt, and equity. Note maturities, especially overnight.
3Compute leverage as assets ÷ equity if figures are given.
4Find the trigger: a price fall, a haircut rise, a lender refusing to roll, or a credit concern.
5Calculate the effect: equity loss, cash raised, or funding gap, using the formulas.
6Trace the feedback loop: forced sales, lower prices, lower collateral values, higher haircuts, more sales.
7Match the answer to the concept asked: funding liquidity, market liquidity, leverage or confidence.
8Check the units and direction, then choose the option that fits the mechanism.

Quickest way: Leverage and haircut shortcut

When to use it: Use when a question gives balance sheet figures or a haircut change and asks for a loss, a gap or a threshold.

Write assets, equity and haircut in one line.
Wipe-out fall = 1 ÷ leverage.
Funding gap = collateral × change in haircut.
Eliminate options that treat repo as unsecured or that ignore the need to fund the haircut.
For concept questions, choose the answer that links short-term funding to confidence and collateral value.

Common mistakes in Dealer Bank Business Model and Balance Sheet

Treating repo as unsecured borrowing
The word 'borrowing' hides that a security is pledged.
Fix: Remember repo is a collateralised loan. Lender risk depends on collateral value and haircut, not only on dealer credit.
Confusing haircut with the interest rate
Both are price terms of the repo.
Fix: The haircut is the equity-funded part of the collateral. The repo rate is the cost on the cash lent.
Computing funding gap using total assets instead of the collateral financed
Students apply the haircut change to the whole balance sheet.
Fix: Apply the change only to assets actually financed in repo.
Using leverage as debt ÷ equity when asked for assets ÷ equity
The two ratios differ by exactly 1.
Fix: Read the definition in the question. Assets ÷ equity = 1 + debt ÷ equity.
Blaming only market liquidity or only funding liquidity
The two are treated as separate topics.
Fix: Show the loop: funding stress forces sales, sales depress prices, lower prices tighten funding.
Assuming overnight funding is safe because it is secured
Security gives comfort about repayment.
Fix: Secured does not mean stable. Lenders can refuse to roll or raise haircuts, so rollover risk remains.

Worked examples

Example 1

A dealer bank has total assets of $200 billion and equity of $5 billion. By what percentage must asset values fall to wipe out its equity, and what is the equity loss if assets fall 1%? Choices for the first part: A) 1.0% B) 2.5% C) 4.0% D) 5.0%

Show the solution

Leverage = 200 ÷ 5 = 40.
Wipe-out fall = 1 ÷ 40 = 2.5%.
Check: 2.5% of $200 billion = $5 billion, equal to equity.
For a 1% fall, asset loss = $2 billion.
Equity loss = 2 ÷ 5 = 40%, or 1% × 40.

Answer: B) 2.5%. A 1% asset fall wipes out 40% of equity.

Example 2

A dealer finances $80 billion of government bonds in repo at a 2% haircut. Lenders raise the haircut to 5%. How much extra funding must the dealer find, and what is the cash raised after the change? Choices for the extra funding: A) $1.6 billion B) $2.4 billion C) $3.0 billion D) $4.0 billion

Show the solution

Old cash = 80 × (1 − 0.02) = $78.4 billion.
New cash = 80 × (1 − 0.05) = $76.0 billion.
Gap = 78.4 − 76.0 = $2.4 billion.
Check: 80 × (0.05 − 0.02) = 80 × 0.03 = $2.4 billion.
The dealer must fund this from cash reserves, other sources or asset sales.

Answer: B) $2.4 billion extra funding; cash raised falls to $76.0 billion.

Exam tips

Expect short case vignettes that give assets, equity and a haircut. Do the arithmetic first, then interpret.
Know the loop: haircut rise, forced sale, price fall, further haircut rise. Questions often ask which step amplifies the run.
Distinguish funding liquidity risk from market liquidity risk, and say how they reinforce each other.
Read options carefully. Wrong options often describe repo as unsecured or ignore the haircut.
Link the topic to Bear Stearns and Lehman: both relied on short-term secured funding that lenders stopped rolling.

Practice questions from The Failure Mechanics of Dealer Banks

Dealer Bank Business Model and Balance Sheet: frequently asked questions

How do dealer banks finance trading inventory with repo?

They sell securities to lenders for cash and agree to repurchase them later, usually overnight or for a short term. The securities act as collateral. The haircut is the part the dealer funds with its own capital.

Why is dealer bank leverage a liquidity risk, not only a solvency risk?

High leverage means small price falls cut equity sharply, which worries lenders. They may raise haircuts or stop rolling funding. That creates an immediate cash need, so solvency worries become a liquidity crisis.

What is a run on repo?

It is when repo lenders raise haircuts, shorten terms or refuse to roll funding because they doubt the dealer or its collateral. The dealer must sell assets or find cash quickly. This can force failure even if the assets are worth more than the debt.

Is this topic in the FRM Part II syllabus?

Yes. It sits under Liquidity and Treasury Risk Measurement and Management, in the material on the failure mechanics of dealer banks. Expect applied questions on funding structure, haircuts and run dynamics.