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

A dealer bank has a liquidity pool of $20 billion. Under stress, repo lenders apply increased haircuts on $100 billion of securities financed at a 5% haircut, raising the haircut to 10%. Assuming the dealer must fund the extra haircut from its own cash, by how much does the liquidity pool fall, and what remains?

The extra haircut is five percentage points of $100 billion, so the dealer must fund $5 billion more. The liquidity pool drops from $20 billion to $15 billion. Counting the full 10% haircut would overstate the drain because 5% was already funded.

  1. A$5 billion fall; $15 billion remainsCorrect
  2. B$10 billion fall; $10 billion remains
  3. C$15 billion fall; $5 billion remains
  4. D$2 billion fall; $18 billion remains

Explanation

The haircut increase is 10% - 5% = 5 percentage points on $100 billion of securities, so the dealer must supply $5 billion more cash. The pool falls from $20 billion to $15 billion. Using 10% of the amount ($10 billion) mistakenly counts the whole new haircut instead of the increment.

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