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

A dealer bank in distress is expected to be placed into a resolution regime that imposes a short temporary stay on early termination of derivative contracts by counterparties. According to the reasoning on failure mechanics, what is the main intended benefit of such a stay?

A temporary stay on early termination slows the simultaneous counterparty run, so collateral is not dumped in fire sales and authorities have time to transfer or wind down positions in an orderly way. It does not guarantee creditor repayment or remove the need for liquidity buffers.

  1. AIt guarantees that unsecured creditors are repaid in full
  2. BIt removes the need for the dealer to hold any high-quality liquid assets
  3. CIt slows the simultaneous run by counterparties, reducing fire sales and giving authorities time to transfer or wind down positions in an orderly wayCorrect
  4. DIt converts all derivative exposures into equity of the dealer

Explanation

A short stay prevents a rush of terminations and collateral seizures that would force fire sales and deplete liquidity. This gives authorities time to transfer positions to a bridge institution. It neither guarantees repayment nor eliminates liquidity buffers.

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