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

Why does the failure of a dealer bank tend to be more disorderly than that of a commercial bank resolved through deposit insurance, according to the failure mechanics literature?

Because repo and derivatives counterparties can immediately terminate contracts and sell seized collateral, and client assets and cash can become entangled, a dealer's failure triggers fire sales and rapid liquidity loss. This makes it far more disorderly than a deposit-insured bank resolution.

  1. ADealer banks have no derivatives exposures, so counterparties are indifferent to failure
  2. BDerivative and repo counterparties can terminate and close out immediately, seizing collateral and triggering fire sales, while clients' assets and cash may be tied up, which accelerates the collapseCorrect
  3. CDealer banks are always funded by long-term debt that cannot be accelerated
  4. DRegulators are prohibited from imposing stays on counterparties' close-out rights in any jurisdiction

Explanation

Exemptions from automatic stays let repo and derivatives counterparties close out and liquidate collateral on default, causing fire sales and further losses, while client positions complicate resolution. The other options misstate the facts: dealers have large derivatives books and mostly short-term funding.

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