Skip to content

FRM Exam Part II · The Failure Mechanics of Dealer Banks

Dealer Bank Resolution, Bankruptcy and Policy Reforms

Updated 11 October 2026 · Fact-checked

Ordinary bankruptcy is disorderly for a dealer bank because counterparties can terminate and seize collateral at once, forcing fire sales and freezing funding. Reforms aim to stop this: orderly resolution (single point of entry), TLAC loss-absorbing debt, liquidity rules (LCR, NSFR) and central clearing of derivatives.

Understand Resolution, Bankruptcy and Policy Reforms

A dealer bank funds a large, liquid-looking trading book with short-term secured borrowing, mainly repo, and sells services such as prime brokerage and OTC derivatives. Its counterparties are also its creditors. That mix makes it fragile. When doubt appears, funding disappears fast.

The problem with bankruptcy is what happens on the filing day. Normal bankruptcy law freezes creditor claims (an automatic stay). But repos, derivatives and many other financial contracts are usually exempt from the stay. Counterparties can terminate, close out and sell collateral immediately. Many sell the same assets together, so prices fall, which hurts the dealer's remaining assets. Clients with prime brokerage balances may find assets frozen. The dealer loses its funding and trading franchise within days, and the loss spreads to other firms. Lehman Brothers in September 2008 is the standard example, and the lesson is that value is destroyed because the firm cannot keep operating while claims are sorted out.

Orderly resolution tries to keep the critical operating parts alive while shareholders and creditors absorb losses. Under single point of entry (SPOE), authorities take control only of the top parent holding company. Losses are pushed up to the parent's equity and long-term debt. Operating subsidiaries, which hold the trading, repo and derivative contracts, stay open and solvent. Counterparties of those subsidiaries then have little reason to run. In the US, the Orderly Liquidation Authority in the Dodd-Frank Act gives authorities this power for failing systemic firms, as an alternative to bankruptcy.

TLAC (total loss-absorbing capacity) supports resolution. It is the FSB standard requiring global systemically important banks to hold enough equity and long-term, bail-in-able debt that can be written down or converted to equity. The idea is that a failing bank can be recapitalised from its own creditors, not taxpayers. Debt is issued by the parent so SPOE can work.

Other reforms reduce the chance of failure. The LCR requires enough high-quality liquid assets to cover net cash outflows over a 30-day stress. The NSFR requires stable funding to match the liquidity profile of assets over one year, which limits reliance on short-term wholesale funding. Central clearing moves standard OTC derivatives to a CCP, which nets exposures and takes margin, so a dealer's default is less likely to cascade. Duffie also argues for reforms of the bankruptcy treatment of repo and derivatives, such as limiting the exemption from the stay, and for better prime brokerage client asset protection.

Key formulas to remember

Liquidity Coverage Ratio (LCR)
LCR = Stock of high-quality liquid assets ÷ Total net cash outflows over the next 30 days ≥ 100%
Short-term resilience under a 30-day stress. Net outflows = outflows − min(inflows, 75% of outflows).
Net Stable Funding Ratio (NSFR)
NSFR = Available stable funding ÷ Required stable funding ≥ 100%
Structural, one-year horizon. Targets reliance on short-term wholesale funding.
Loss absorption order in resolution
Equity first → then TLAC-eligible long-term debt (written down or converted) → operating liabilities protected
Under SPOE, losses at subsidiaries are passed up to the parent's equity and debt holders.
Key rule: why bankruptcy is disorderly
Safe harbours for repo and derivatives → immediate termination and collateral sale → fire sales and funding freeze
Contrast with the automatic stay, which normally delays creditor action.

How to solve Resolution, Bankruptcy and Policy Reforms questions

Use this sequence for any question on dealer bank failure, resolution or reform.

  1. 1Identify the failure channel: run on short-term repo or prime brokerage funding, derivative close-out, or loss of confidence.
  2. 2Check whether the question is about bankruptcy or resolution. Bankruptcy means safe harbours and no continuity. Resolution means authorities control the failure.
  3. 3If resolution, ask which entity is resolved. SPOE means only the parent; subsidiaries keep operating.
  4. 4Match the reform to the problem: loss absorption is TLAC; 30-day liquidity is LCR; structural funding is NSFR; counterparty cascades are central clearing.
  5. 5Check the time horizon and ratio definition (30 days versus one year; HQLA versus stable funding).
  6. 6Eliminate options that confuse who bears losses: under resolution it is shareholders and creditors, not taxpayers.
  7. 7Pick the option that names the mechanism, not just the goal.

Quickest way: Problem-to-reform matching

When to use it: For short conceptual MCQs asking which reform addresses a stated weakness.

  1. Underline the weakness in the stem: funding run, no loss buffer, counterparty chain, or disorderly close-out.
  2. Funding run over 30 days: LCR. Mismatch over a year: NSFR.
  3. Loss buffer for recapitalising without public money: TLAC.
  4. Counterparty chain or OTC exposures: central clearing and margin.
  5. Disorderly close-out on failure: resolution regime with SPOE or limits on the stay exemption.

Common mistakes in Resolution, Bankruptcy and Policy Reforms

  • Saying bankruptcy is disorderly because creditors are paid too slowly.

    Students think of ordinary firms, where the stay delays claims.

    Fix: For dealers the problem is the opposite: repo and derivative counterparties can act immediately, causing fire sales.

  • Treating LCR and NSFR as the same rule.

    Both are liquidity ratios with a 100% minimum.

    Fix: LCR is a 30-day stress ratio on liquid assets. NSFR is a one-year structural funding ratio.

  • Thinking SPOE resolves every subsidiary.

    The word resolution suggests the whole group fails.

    Fix: Only the parent is put into resolution. Operating subsidiaries continue and are recapitalised from the parent.

  • Believing TLAC is extra equity only.

    It is described as capital-like.

    Fix: TLAC includes equity and eligible long-term debt that can be written down or converted to equity.

  • Assuming central clearing removes counterparty risk.

    CCPs are presented as safe.

    Fix: It concentrates and mutualises risk in the CCP and relies on margin and a default waterfall.

Worked examples

Example 1

A dealer bank files for ordinary bankruptcy. Its repo lenders hold Treasury and corporate bond collateral. Which outcome best explains why the failure is disorderly?

Show the solution
  1. Repo contracts are usually exempt from the automatic stay.
  2. Lenders can terminate and keep or sell collateral immediately.
  3. Many lenders sell similar assets at the same time, depressing prices.
  4. Lower prices hurt the dealer's other positions and other holders of the same assets, and funding to the dealer freezes.

Answer: Repo lenders can close out and sell collateral at once, causing fire sales and loss of funding, which destroys the firm's value.

Example 2

A G-SIB has USD 80 billion of high-quality liquid assets and expects total outflows of USD 120 billion and inflows of USD 60 billion over 30 days. Compute the LCR, and say whether it meets the minimum.

Show the solution
  1. Inflows are capped at 75% of outflows: 0.75 × 120 = USD 90 billion.
  2. Actual inflows of 60 are below the cap, so use 60.
  3. Net outflows = 120 − 60 = USD 60 billion.
  4. LCR = 80 ÷ 60 = 1.333, or 133.3%.
  5. Compare with the 100% minimum.

Answer: LCR = 133.3%, which meets the 100% minimum.

Exam tips

  • Link each reform to its specific failure channel; MCQs often test this match.
  • Remember SPOE puts only the parent into resolution.
  • For LCR questions, apply the 75% inflow cap before dividing.
  • Watch for options saying taxpayers bear losses first; this contradicts the bail-in logic.
  • Do not assume central clearing eliminates risk.

Practice questions from The Failure Mechanics of Dealer Banks

Resolution, Bankruptcy and Policy Reforms: frequently asked questions

Why was Lehman's bankruptcy so disorderly?

Its repo and derivative counterparties could terminate and seize collateral, and funding vanished quickly. Its cross-border structure also made coordination hard. Value was lost as assets were sold in a hurry.

What is single point of entry resolution?

Authorities resolve only the top parent holding company. Losses go to its equity and long-term debt holders. Operating subsidiaries stay open, so counterparties have little reason to run.

What is the difference between LCR and NSFR?

LCR covers a 30-day stress with high-quality liquid assets against net outflows. NSFR compares available stable funding with required stable funding over one year. Both must be at least 100%.

What does Duffie propose for dealer resolution?

The main ideas are an orderly resolution process that keeps operations running, and curbing the bankruptcy exemptions that allow immediate close-out of repo and derivatives. Better protection of prime brokerage client assets is also part of the discussion. Know the logic more than the detail.