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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 is most associated with accelerating a dealer bank's collapse once its creditworthiness is in doubt?

Safe-harbor treatment lets repo and derivative counterparties terminate contracts and sell collateral immediately, outside the automatic stay. This encourages runs by such counterparties and speeds a dealer bank's failure, because the usual bankruptcy pause on creditor actions does not protect the troubled dealer.

  1. AAn automatic stay that freezes all repo and derivative counterparties' claims indefinitely
  2. BSafe-harbor treatment allowing repo and derivative counterparties to terminate and seize collateral immediatelyCorrect
  3. CA requirement that secured creditors wait for court approval before selling collateral
  4. DMandatory conversion of unsecured debt into equity on filing

Explanation

Safe harbors exempt repo and derivative contracts from the automatic stay, so counterparties can close out and liquidate collateral at once. This encourages a run by those counterparties and removes the stabilizing pause. The automatic stay does not apply to them, so option A is wrong.

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