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

A dealer bank's creditworthiness is downgraded by three notches. Which combination of effects most accurately describes how this can accelerate its failure?

A downgrade raises repo haircuts and triggers contractual collateral calls on derivatives, so liquidity needs increase just as funding becomes scarcer. This procyclical feedback between falling confidence and rising liquidity demands is a key mechanism driving dealer bank failure.

  1. AHigher haircuts on repo are applied, and derivatives counterparties call additional collateral under downgrade triggers, increasing liquidity needs when funding is least availableCorrect
  2. BLower repo haircuts are demanded as lenders prefer the dealer's higher yield, easing liquidity
  3. CDerivatives counterparties return collateral because of lower expected exposure, increasing liquidity
  4. DClearing members reduce initial margin because the dealer has become less risky

Explanation

A downgrade tends to raise repo haircuts or shorten tenors and triggers contractual collateral calls on derivatives, increasing liquidity demand while funding sources shrink. The other options reverse the direction of these effects.

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