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

Which development best describes why a run on a dealer's tri-party repo funding may be more damaging when the dealer relies on lower-quality collateral?

Lower-quality collateral makes repo funding fragile because lenders may sharply raise haircuts or stop financing it in stress. The dealer then has to replace the lost cash with unsecured or other funding, or sell assets at a discount, which accelerates the liquidity spiral.

  1. ALenders accept lower-quality collateral at lower haircuts, reducing the dealer's funding needs
  2. BHaircuts on lower-quality collateral can rise sharply or financing can be withdrawn, forcing the dealer to fund the gap with other sourcesCorrect
  3. CLower-quality collateral is automatically replaced by central bank reserves
  4. DRepo lenders must absorb the losses on lower-quality collateral under standard documentation

Explanation

Lower-quality collateral is more sensitive to lender concerns, so haircuts can jump or funding can be refused altogether. The dealer must then fund the gap from unsecured or other sources. Lenders do not bear collateral losses ahead of the borrower and no automatic replacement occurs.

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