FRM Part II · FRM Exam Part II · The Failure Mechanics of Dealer Banks
A dealer bank's prime brokerage unit holds hedge fund client cash balances and has rehypothecated client securities. After rumors of losses, hedge fund clients move their free credit balances and securities to other prime brokers. Which fragility source does this best illustrate?
The scenario shows loss of client-related funding. Prime brokerage free credit balances and rehypothecated securities finance dealer inventories, so when hedge fund clients withdraw them on rumors of losses, the dealer suffers a sudden liquidity drain, a key source of dealer bank fragility.
- ALoss of liquidity through withdrawal of client-related funding that was effectively a source of cheap financingCorrect
- BCounterparty credit risk from long-dated OTC derivatives
- CInterest rate risk in the banking book
- DFire-sale losses on a held-to-maturity portfolio
Explanation
Prime brokerage client balances and rehypothecable securities act as funding for the dealer. When clients withdraw them, the dealer loses that funding quickly, as in the Lehman and Bear Stearns episodes. The other options describe different risks not triggered by client withdrawals.
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