FRM Exam Part II · The Failure Mechanics of Dealer Banks

Runs on Repo and Prime Brokerage Funding Explained

Updated 11 October 2026 · Fact-checked

A run on a dealer bank happens when secured lenders, prime brokerage clients and derivative counterparties stop rolling funding or demand more collateral because they doubt the bank's solvency. Higher haircuts, cut credit lines and collateral calls drain liquidity fast. To solve questions, identify who withdraws, what they withdraw, and the liquidity amount lost.

Understand Runs on Repo and Prime Brokerage Funding

A dealer bank holds large inventories of securities and funds them mostly with short-term secured borrowing, especially repo. In a repo, the bank sells securities and agrees to buy them back, usually overnight, at a slightly higher price. The lender gives less cash than the securities are worth. That gap is the haircut. The bank must fund the haircut with its own money.

Because repo is short term, it must be rolled over every day. This is the weak point. If lenders doubt the bank, they can simply refuse to roll. They are secured, so they do not need to wait for a default. They take the collateral and leave. If the collateral is hard to value or sell, they raise the haircut instead. A higher haircut means the bank must find more cash on the same securities. This is a margin spiral: losses and falling prices lead to higher haircuts, forced sales and lower prices again.

The run is not only in repo. Prime brokerage clients, such as hedge funds, keep cash and securities at the dealer. The dealer may rehypothecate client securities, meaning it re-uses them as its own collateral for funding. When confidence falls, clients withdraw free credit balances and move assets to other prime brokers. The dealer loses a cheap funding source and the collateral it was re-using. If rehypothecated client assets cannot be returned, the client has only an unsecured claim for them, as happened to clients of Lehman Brothers International (Europe). Assets that were properly segregated are generally protected, but the treatment depends on the jurisdiction.

Derivative counterparties add a third channel. They can demand extra collateral, refuse to novate or trade, or close out positions. A ratings downgrade can trigger contractual collateral calls. Each channel is separate, but they feed one another. A fall in confidence in one produces a fall in the others.

Bear Stearns (March 2008) and Lehman Brothers (September 2008) are the standard cases. Bear's secured funding and prime brokerage balances drained within days, even though much of its funding was secured. Lehman faced rising collateral demands from clearing banks and counterparties, falling liquidity pool value and withdrawals by clients. Exam questions test the mechanism, not just the story.

Key formulas to remember

Haircut: Haircut = (Market value of collateral − Cash lent) ÷ Market value of collateral; The haircut is the borrower's equity in the trade. A rise in haircut is a loss of funding even if the repo rolls.
Cash raised in repo: Cash = Collateral market value × (1 − haircut); Use the same collateral value and the new haircut to find funding lost.
Funding shortfall from a haircut rise: Shortfall = Collateral value × (new haircut − old haircut); Assumes the repo rolls and collateral value is unchanged. If prices also fall, recompute cash raised from scratch.
Leverage from haircut: Maximum asset-to-equity multiple on repo-funded assets = 1 ÷ haircut; This applies to a position funded entirely by repo at that haircut, with the haircut portion funded by equity. A 2% haircut allows 50 times; at 10% it falls to 10 times. This is why haircut shocks force deleveraging.
Liquidity survival check: Liquidity buffer − (repo not rolled + extra haircuts + client withdrawals + collateral calls) ≥ 0; A negative result means the bank cannot survive the stress horizon without outside help.

How to solve Runs on Repo and Prime Brokerage Funding questions

Use this order for any question on runs on repo and prime brokerage funding.

1Identify the funding channel: repo lenders, prime brokerage clients, derivative counterparties, or a combination.
2Identify the trigger: loss of confidence, downgrade, collateral price fall, or rumour about solvency.
3State what is withdrawn: non-rollover of repo, higher haircut, free credit balances, rehypothecated assets, or extra margin.
4Check collateral quality. Less liquid or harder-to-value collateral (such as structured products) faces larger haircuts and earlier withdrawal than Treasuries.
5Do the arithmetic: recompute cash raised after a haircut or price change, then take the difference from the old amount.
6Add all channels and compare with the liquidity pool to find the shortfall or the survival horizon.
7Explain the feedback loop in a sentence: forced sales lower prices, which raise haircuts and margin calls again.
8Choose the option that names the right mechanism, not one that blames only solvency or only liquidity.

Quickest way: Haircut shock in four lines

When to use it: Use when a question gives collateral value, an old haircut and a new haircut, and asks for the funding lost.

Compute old cash = original value × (1 − old haircut).
Compute the new collateral value = original value × (1 − price fall). If there is no price fall, the value is unchanged.
Compute new cash = new value × (1 − new haircut).
Subtract: old cash − new cash. The difference is the funding the bank must replace.

Common mistakes in Runs on Repo and Prime Brokerage Funding

Treating the haircut as the amount the lender loses.
The word sounds like a loss on the collateral.
Fix: The haircut is the borrower's own funding in the trade. The lender is protected by it.
Assuming secured funding cannot run.
Collateral looks like safety for the lender.
Fix: Secured lenders run by not rolling or by raising haircuts. They do not need to wait for default.
Computing the shortfall only from the haircut change and ignoring a collateral price fall.
Students focus on the headline haircut number.
Fix: Recalculate cash raised from the new collateral value and the new haircut, then subtract from the old cash.
Confusing rehypothecation with a repo.
Both involve re-using securities for funding.
Fix: Rehypothecation is the dealer re-using a prime brokerage client's pledged securities. A repo is the dealer's own sale-and-repurchase transaction.
Calling every dealer failure a pure solvency failure.
Case studies are remembered as loss stories.
Fix: Funding liquidity and solvency interact. A run can make a solvent but fragile bank fail because assets cannot be funded or sold quickly.
Forgetting derivative counterparties as a run channel.
Repo and prime brokerage get most of the attention.
Fix: Add collateral calls, downgrade triggers and close-outs by derivative counterparties to the outflow list.

Worked examples

Example 1

A dealer funds ₹200 crore of securities in overnight repo at a 4% haircut. Confidence falls and lenders raise the haircut to 12% on the same securities, with no price change. How much extra funding must the dealer find?

Show the solution

Old cash raised = 200 × (1 − 0.04) = ₹192 crore.
New cash raised = 200 × (1 − 0.12) = ₹176 crore.
Funding lost = 192 − 176 = ₹16 crore.
Check: 200 × (0.12 − 0.04) = ₹16 crore.

Answer: ₹16 crore of extra funding is needed, even though every repo rolled.

Example 2

A dealer holds $500 million of collateral in repo at a 5% haircut. Collateral prices fall 10% and lenders raise the haircut to 15%. How much funding must the dealer replace?

Show the solution

Old cash raised = 500 × (1 − 0.05) = $475 million.
New collateral value = 500 × 0.90 = $450 million.
New cash raised = 450 × (1 − 0.15) = $382.5 million.
Funding lost = 475 − 382.5 = $92.5 million.

Answer: $92.5 million. Using only the haircut change on the original value would give $50 million and understate the shortfall.

Exam tips

Expect case-style stems that ask which channel caused the cash drain. Match the channel to the wording: non-rollover, haircut, client withdrawal or collateral call.
In arithmetic questions, always check whether the collateral price also moved.
Know that Treasuries have low haircuts and complex structured assets have high ones, so stress hits weaker collateral first.
Link the topic to liquidity buffers, survival horizon and the reforms that followed, such as LCR and NSFR.

Practice questions from The Failure Mechanics of Dealer Banks

Runs on Repo and Prime Brokerage Funding: frequently asked questions

How does a run on a dealer bank happen?

Confidence in the bank falls, so repo lenders stop rolling, prime brokerage clients withdraw assets and derivative counterparties demand collateral. The bank must sell assets or borrow from the central bank. Forced sales lower prices and make the run worse.

Why can a repo lender run if it holds collateral?

The loan is short term, so the lender can refuse to roll it the next day. It can also raise the haircut. It does not need a default to withdraw.

What is rehypothecation in prime brokerage?

It is the dealer re-using a client's pledged securities as collateral for its own borrowing. It lowers the dealer's funding cost, but if the dealer fails the client may be stuck behind other creditors for those assets.

What is a margin spiral?

It is a loop where falling asset prices lead lenders to raise haircuts or margins. Borrowers sell assets to raise cash, which pushes prices down further and triggers more increases.