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

In Duffie's analysis of the failure mechanics of dealer banks, which feature of the U.S. Bankruptcy Code did he highlight as contributing to the rapid run on a dealer bank's liquidity once it is in distress?

Safe-harbor treatment lets repo and derivative counterparties terminate contracts and seize or sell collateral immediately on a dealer's bankruptcy, outside the automatic stay. This speeds the loss of liquidity and can trigger fire sales, so the claim that the stay freezes these claims is incorrect.

  1. AThe automatic stay freezes all repo and derivative counterparties' claims against the dealer
  2. BSafe-harbor exemptions let repo and derivative counterparties terminate contracts and seize collateral immediatelyCorrect
  3. CSecured creditors are paid only after unsecured creditors in bankruptcy
  4. DBankruptcy judges must approve every collateral sale before it occurs

Explanation

Repo, derivatives and certain other contracts are exempt from the automatic stay. Counterparties can close out and liquidate collateral immediately, which accelerates the loss of funding. The automatic stay does not apply to these contracts, so the first option is wrong.

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