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FRM Part II · FRM Exam Part II · The Failure Mechanics of Dealer Banks

A dealer bank has $200 billion of assets, financed by $10 billion of equity and $190 billion of liabilities. Before failure, $60 billion of repo liabilities are secured by collateral with a 5% haircut; counterparties run, and $30 billion of that collateral is fire-sold at a 12% discount to its pre-run value, with no other changes. If the market value of the collateral sold was $30 billion before the discount, what is the loss of asset value from the fire sale, and what is it as a percent of equity?

The fire sale loss is 12% of $30 billion, or $3.6 billion. Relative to $10 billion of equity this is 36%. Using the 5% haircut gives $1.5 billion, and dividing by total assets gives 1.8%, both of which use the wrong rate or base.

  1. A$3.6 billion; 36% of equityCorrect
  2. B$1.5 billion; 15% of equity
  3. C$0.9 billion; 9% of equity
  4. D$3.6 billion; 1.8% of equity

Explanation

Loss = 12% x $30 billion = $3.6 billion. As a share of equity: 3.6/10 = 36%. The $1.5 billion option applies the 5% haircut instead of the 12% discount. The 1.8% option divides by total assets ($200 billion) instead of equity.

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