Learning objectives: Describe the major lines of business in which dealer banks operate and the risk factors they face in each line of business. Identify situations that can cause a liquidity crisis at a dealer bank and explain responses that can mitigate these risks. Describe policy measures that can alleviate firm-specific and systemic risks related to large dealer banks.
Questions:
809.1. Duffie explains that the main business lines of large dealer banks are: (1) securities dealing, underwriting, and trading; (2) over-the-counter derivatives; and (3) prime brokerage and asset management. About these main business lines, each of the following statements is true EXCEPT which is false?
a. A tri-party repo agreement (between the dealer, the investor and a clearing bank) is used to mitigate counterparty risk and/or reduce burden of collateral management
b. For most over-the-counter (OTC) derivatives, one of the counterparties is a dealer who typically lays off much (or all) of the risk of its client-initiated trades by running a matched book
c. With respect to over-the-counter (OTC) derivatives, the best measure of their systemic risk is the total market value of all outstanding contracts; further, master swap agreements do not reduce their actual risks (although they do lower the administrative burden of OTC derivative contracts)
d. Some large dealers are Prime Brokers who provide clients a range of services including management of securities holdings, clearing, cash-management, securities lending, financing, reporting (e.g., risk measurement), and tax accounting
809.2. Duffie explains the similarities between a classic depositor run at a commercial bank and the failure mechanisms for dealer banks: "The relationships between a dealer bank and its derivatives counterparties, prime-brokerage clients, potential debt and equity investors, clearing bank, and other clients can change rapidly if the solvency of the dealer bank is threatened. The concepts at play are similar to those of a depositor run at a commercial bank. That is, fears over the solvency of the bank lead others to act so as to reduce their potential losses in the event of the bank’s default. Unlike insured depositors at a commercial bank, many of those with exposures to dealer banks have no default insurance, or do not wish to bear the frictional costs of involvement in the bank’s failure procedures even if they do have insurance. The key mechanisms that lead to the failure of a dealer bank are the flight of short-term creditors, the departures of prime-brokerage clients, various cash-draining actions by derivatives counterparties that are designed to lower their exposures to the dealer bank, and finally and most decisively, the loss of clearing-bank privileges."
In regard to these failure mechanisms, which of the following statements is TRUE?
a. The contractual "right to offset" guarantees that a dealer bank will retain cash settlement privileges
b. During the financial crisis, the flight (aka, exit) of prime brokerage clients paradoxically reduced the stress on major dealer banks like Morgan Stanley by reducing their balance sheets and therefore their exposure
c. A dealer bank who finances long-term assets with overnight repos (e.g., where the counterparties are money-market funds, securities borrowers, and other dealers) can experience funding liquidity problems if haircuts suddenly decrease
d. In the case of Lehman, over-the-counter (OTC) derivative contracts were exempted by law as “qualifying financial contracts” from the automatic stay at bankruptcy that holds up other creditors of a dealer, which resulted in a large post-bankruptcy drain on the defaulting dealer
809.3. Duffie examines several policy measures that might alleviate firm-specific and systemic risks related to large dealer banks. He would tend to agree with each of the following EXCEPT to which statement would he most DISAGREE?
a. The threat posed by the flight of over-the-counter derivatives counterparties can be lowered by central clearing
b. Distress-contingent convertible debt is an innovation that is likely to be destabilizing during periods of financial distress, and regulators should consider curtailing their usage
c. Short-term tri-party repos are a particularly unstable source of financing; potential remedies to their risk include a tri-party repo utility, central-bank insurance of tri-party repo transactions, or an emergency bank to be financed by repo market participants
d. The most important source of systemic risk is the potential impact of dealer-bank fire sales on market prices and investor portfolio; during the financial crisis, the risk of fire sales was significantly mitigated by lender-of-last resort financing by central banks and by capital injections into dealer banks
Answers here:
Questions:
809.1. Duffie explains that the main business lines of large dealer banks are: (1) securities dealing, underwriting, and trading; (2) over-the-counter derivatives; and (3) prime brokerage and asset management. About these main business lines, each of the following statements is true EXCEPT which is false?
a. A tri-party repo agreement (between the dealer, the investor and a clearing bank) is used to mitigate counterparty risk and/or reduce burden of collateral management
b. For most over-the-counter (OTC) derivatives, one of the counterparties is a dealer who typically lays off much (or all) of the risk of its client-initiated trades by running a matched book
c. With respect to over-the-counter (OTC) derivatives, the best measure of their systemic risk is the total market value of all outstanding contracts; further, master swap agreements do not reduce their actual risks (although they do lower the administrative burden of OTC derivative contracts)
d. Some large dealers are Prime Brokers who provide clients a range of services including management of securities holdings, clearing, cash-management, securities lending, financing, reporting (e.g., risk measurement), and tax accounting
809.2. Duffie explains the similarities between a classic depositor run at a commercial bank and the failure mechanisms for dealer banks: "The relationships between a dealer bank and its derivatives counterparties, prime-brokerage clients, potential debt and equity investors, clearing bank, and other clients can change rapidly if the solvency of the dealer bank is threatened. The concepts at play are similar to those of a depositor run at a commercial bank. That is, fears over the solvency of the bank lead others to act so as to reduce their potential losses in the event of the bank’s default. Unlike insured depositors at a commercial bank, many of those with exposures to dealer banks have no default insurance, or do not wish to bear the frictional costs of involvement in the bank’s failure procedures even if they do have insurance. The key mechanisms that lead to the failure of a dealer bank are the flight of short-term creditors, the departures of prime-brokerage clients, various cash-draining actions by derivatives counterparties that are designed to lower their exposures to the dealer bank, and finally and most decisively, the loss of clearing-bank privileges."
In regard to these failure mechanisms, which of the following statements is TRUE?
a. The contractual "right to offset" guarantees that a dealer bank will retain cash settlement privileges
b. During the financial crisis, the flight (aka, exit) of prime brokerage clients paradoxically reduced the stress on major dealer banks like Morgan Stanley by reducing their balance sheets and therefore their exposure
c. A dealer bank who finances long-term assets with overnight repos (e.g., where the counterparties are money-market funds, securities borrowers, and other dealers) can experience funding liquidity problems if haircuts suddenly decrease
d. In the case of Lehman, over-the-counter (OTC) derivative contracts were exempted by law as “qualifying financial contracts” from the automatic stay at bankruptcy that holds up other creditors of a dealer, which resulted in a large post-bankruptcy drain on the defaulting dealer
809.3. Duffie examines several policy measures that might alleviate firm-specific and systemic risks related to large dealer banks. He would tend to agree with each of the following EXCEPT to which statement would he most DISAGREE?
a. The threat posed by the flight of over-the-counter derivatives counterparties can be lowered by central clearing
b. Distress-contingent convertible debt is an innovation that is likely to be destabilizing during periods of financial distress, and regulators should consider curtailing their usage
c. Short-term tri-party repos are a particularly unstable source of financing; potential remedies to their risk include a tri-party repo utility, central-bank insurance of tri-party repo transactions, or an emergency bank to be financed by repo market participants
d. The most important source of systemic risk is the potential impact of dealer-bank fire sales on market prices and investor portfolio; during the financial crisis, the risk of fire sales was significantly mitigated by lender-of-last resort financing by central banks and by capital injections into dealer banks
Answers here:
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