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

A dealer bank holds a large inventory of securities funded mainly by short-term secured borrowing, which is rolled over daily. Which feature of this business model most directly makes the dealer vulnerable to a sudden loss of confidence?

The key vulnerability is the maturity mismatch from funding inventory with short-term wholesale borrowing, mostly repo, that must be rolled over continually. If lenders lose confidence and stop rolling, the dealer must raise cash quickly, often by fire-selling assets.

  1. AIts reliance on short-term wholesale funding that must be continually rolled over against long-lived or less liquid assetsCorrect
  2. BIts holding of large amounts of insured retail deposits
  3. CIts use of long-term subordinated debt to fund trading inventory
  4. DIts low reliance on repo because it funds only with equity

Explanation

Dealer banks fund inventory with short-term wholesale funding, mainly repo, that matures far sooner than the assets can be sold without loss. If lenders refuse to roll, the dealer must sell assets quickly or find replacement funding. Retail deposits and long-term debt would reduce, not create, this vulnerability.

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