FRM Part II · FRM Exam Part II · The Failure Mechanics of Dealer Banks
A dealer bank is downgraded and its OTC derivatives counterparties exercise rating-trigger clauses. Which combined effect most increases the bank's liquidity demand?
A downgrade triggering rating clauses forces the dealer to post extra collateral and, where counterparties terminate contracts, to pay close-out amounts. Both create immediate cash and collateral demands just when funding is scarce, which worsens fragility and can accelerate failure.
- ACounterparties demand additional collateral and some terminate and close out contracts, requiring settlement paymentsCorrect
- BCounterparties lower their margin requirements to retain the business
- CThe bank's variation margin received automatically increases
- DNetting agreements are voided, reducing gross exposure
Explanation
Rating triggers require extra collateral posting or allow early termination, so the dealer must deliver cash or securities immediately. Counterparties do not reduce margin, and variation margin received does not rise because of a downgrade. Netting is not voided by a downgrade; it typically helps limit exposure.
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