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

A dealer bank's prime brokerage unit holds hedge fund clients' cash balances and rehypothecable securities. Rumours of losses spread. Which mechanism best explains why this business accelerates the dealer bank's failure?

Prime brokerage clients can quickly withdraw cash balances and move securities to rival prime brokers. This removes funding and rehypothecable collateral the dealer relied on, draining liquidity just when confidence is weakest and accelerating failure.

  1. AClients' margin requirements automatically fall, reducing the bank's collateral needs
  2. BClients withdraw free credit balances and move assets to other prime brokers, draining the dealer's liquidity quicklyCorrect
  3. CRegulators require the bank to rehypothecate more client assets
  4. DClients' hedge funds must buy more of the bank's equity

Explanation

Prime brokerage clients can quickly pull cash and securities, which removes funding that the dealer had been using for its own financing. The loss of rehypothecable assets and free credit balances cuts liquidity at the moment confidence is falling. The other options describe effects that do not occur or run opposite to the mechanism.

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