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

A dealer bank has total assets of USD 200 billion and equity of USD 5 billion. Its assets fall in value by 2% with no change in liabilities. What is the resulting equity and what does it illustrate?

Equity falls to USD 1 billion. Assets of USD 200 billion lose 2%, or USD 4 billion, which is absorbed entirely by USD 5 billion of equity. With leverage of 40 times, a small asset decline wipes out most of the capital.

  1. AUSD 1 billion; leverage of 40x magnifies asset losses into large equity lossesCorrect
  2. BUSD 3 billion; losses are limited to the asset decline
  3. CUSD 1 billion; leverage is 20x
  4. DUSD 4 billion; losses are shared with creditors proportionally

Explanation

Leverage is 200/5 = 40x. A 2% fall in assets is a loss of USD 4 billion, leaving equity of USD 1 billion, an 80% decline. Option C uses the correct equity but a wrong leverage figure.

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