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

A dealer bank's balance sheet shows $120 billion of securities, financed by $90 billion of overnight repo, $20 billion of other liabilities and $10 billion of equity. Which statement best describes how a funding run would unfold for this dealer?

A run forces the dealer to fund the shortfall from its own liquidity or sell securities, shrinking the balance sheet. Overnight repo must be rolled daily, and lenders can refuse or raise haircuts, so collateral does not protect the dealer from funding stress.

  1. AEquity would automatically be converted into repo funding, preserving the balance sheet
  2. BRepo lenders would be unaffected because collateral is posted
  3. CRising haircuts and refusals to roll would force the dealer to replace funding with its own liquidity or to sell assets, shrinking the balance sheetCorrect
  4. DThe dealer could simply reduce its liabilities without selling any assets

Explanation

Overnight repo of $90 billion must be refinanced daily. If lenders raise haircuts or refuse to roll, the dealer must supply cash from its liquidity pool or sell securities. Collateral does not make the funding immune, since lender willingness and haircuts change. Reducing liabilities without asset sales requires cash from somewhere.

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