FRM Part II · FRM Exam Part II · The Failure Mechanics of Dealer Banks
A dealer bank's assets include reverse repos and securities received as collateral that it can rehypothecate. In a stress event, several counterparties demand return of excess collateral and stop allowing reuse. Which is the most direct effect on the dealer's liquidity?
The dealer loses funding that it had obtained by reusing clients' collateral and must replace it with other sources. Withdrawal of excess collateral or rehypothecation rights creates an immediate liquidity drain, which can accelerate failure in stress.
- AThe dealer loses a source of funding obtained by reusing client collateral, and must replace it with other fundingCorrect
- BThe dealer's capital ratio rises because collateral exits the balance sheet
- CThe dealer's haircut on its own repo declines
- DThe dealer's trading book duration becomes shorter
Explanation
Rehypothecation lets dealers use client collateral to raise funding. When clients withdraw excess collateral or reuse rights, the dealer must find replacement funding, creating a liquidity drain. Capital ratios are not directly improved.
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