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

In Duffie's analysis of how dealer banks fail, which feature of a dealer bank's secured funding most directly explains why a loss of lender confidence can cause a rapid liquidity collapse?

Overnight tri-party repo lenders can simply decline to roll their loans, so a dealer must replace large amounts of funding almost immediately. This short maturity makes confidence losses translate into a fast liquidity collapse, because no contractual obligation forces lenders to keep financing the dealer.

  1. ATri-party repo lenders can decline to roll over overnight cash loans, so funding must be replaced almost immediatelyCorrect
  2. BRepo borrowing is always unsecured and priced at a fixed spread to the policy rate
  3. CRepo contracts have fixed five-year terms that cannot be adjusted when collateral values fall
  4. DRepo lenders are legally required to roll maturing trades when haircuts are unchanged

Explanation

A large share of dealer financing is short-term, often overnight, secured funding. Lenders can simply refuse to roll, or demand higher haircuts, so the funding must be replaced quickly. Repo is secured, not unsecured, and there is no obligation to roll.

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