LO 55.1: Describe the major lines of business in which dealer banks operate and

LO 55.1: Describe the major lines of business in which dealer banks operate and the risk factors they face in each line of business.
Large dealer banks provide a variety of intermediary functions in the markets for over-the- counter (OTC) derivatives, repurchase agreements, and securities. In addition, large dealer banks act as a prime broker for hedge funds and provide asset management for wealthy individuals and institutions.
Large dealer banks play an important function in the OTC derivatives market. Dealer banks transfer the risk of the derivatives positions requested by counterparties by creating new derivatives contracts with other counterparties. Examples of types of OTC derivatives are interest rate swaps, collateralized debt obligations (CDOs), collateralized mortgage obligations (CMOs), and credit default swaps (CDSs).
Counterparty risk in the OTC market refers to the risk that one or more of the counterparties will default on their contractual obligations. The total amount of wealth does not change as derivatives transfer wealth from one counterparty to another as contingencies are realized over time. However, if a counterparty incurs large losses, their derivatives contracts incur frictional bankruptcy costs that result in distress costs for their counterparties. Dealer banks are often counterparties to other dealer banks and large market players. Therefore, the solvency and liquidity problems of one large dealer bank can quickly result in increased systemic risk and a potential liquidity crisis.
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If the dealer bank does not have the liquidity to function, they will become insolvent. The failure of a large dealer bank would result in increased systemic risk for the OTC market. When counterparties question the solvency of a dealer bank, they will take actions to reduce their exposure and exit their positions. For example, the default of Lehman Brothers in September of 2008 not only disrupted the OTC derivatives markets, but the repercussions were also felt by other financial markets and institutions.
.Another important function of large dealer banks is in the short-term repurchase or repo market. Large dealer banks finance significant fractions of another dealer banks assets through repos. Prior to the recent crisis, dealer banks used overnight repos to finance holdings of agency securities, corporate bonds, Treasuries, mortgages, and collateralized debt obligations (CDOs) with little incremental capital. Some large dealer banks had very high leverage due to the lack of capital requirements for these repos. The high leverage caused significant solvency risk when the use of subprime mortgages as collateral was questioned.
The systemic and firm specific risk is significantly increased if a repo counterparty questions the solvency of a dealer bank. Counterparties are unlikely to renew repos, and the repo creditors may be legally required to sell collateral immediately. Without a government or central bank stepping in as a lender of last resort, dealer banks have no place to turn when repos are not renewed. As many dealer banks act as counterparties for other positions, the solvency of one dealer bank is likely to have a ripple effect and greatly increase the systemic risk of these markets.
Dealer banks provide investment banking functions through the management and underwriting of securities issuances. These investment banking functions also include advising corporations regarding mergers and acquisitions and merchant banking functions, such as the buying and selling of oil, metals, and other commodities. These functions provide an important source of revenue for dealer banks. An additional strain on liquidity is caused by the lack of cash inflows when issuers question the solvency of the dealer bank and take their business elsewhere. This can lead to systemic risk as new issues and the liquidity of existing issues are halted, as few institutions are able or willing to fill the void when a large dealer banks solvency or liquidity are questioned.
Large dealer banks act as a prime broker to large investors such as hedge funds. In this context, the services provided by the dealer banks include custody of securities, clearing, securities lending, cash management, and reporting. When the solvency of a prime broker is questionable, a hedge fund could demand cash margin loans from the dealer that are backed by securities. The prime broker may not be able to use those same securities as collateral with other lenders who may also question their solvency. Thus, the dealer banks liquidity position is weakened if large clients reduce their exposure by exiting their positions or entering new positions to offset their risk.
In addition, if prime broker clients leave, then their cash and securities are no longer in the pool of funds to meet the dealer banks liquidity needs for other clients. A systemic shortage of collateral and a liquidity crisis can result from the reduction of collateral securities caused by the flight of prime brokerage clients. Systemic risk is even greater when hedge funds do not mitigate their exposure through diversification. Prior to the recent financial crisis, hedge funds had significant positions with only a few dealer banks.
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Dealer banks also provide an important function as a counterparty for derivatives for brokerage clients. Dealer banks sometimes operate internal hedge funds and private equity partnerships. Off-balance sheet entity functions such as internal hedge funds, structured investment vehicles, and money market funds can have substantial losses. The dealer banks have an incentive to voluntarily support these entities to protect their reputation and franchise value. When a dealer bank shows signs of distress, counterparties and others may begin to exit their relationships, which severely increases the dealer banks liquidity risk.
In addition, large dealer banks provide traditional commercial banking functions, such as gathering deposits for corporate and consumer lending. The risks for a dealer bank are similar to a traditional bank with respect to these functions. However, prior to the recent financial crisis, dealer banks did not have access to the discount window (borrowing money from the central bank), and their accounts were not federally insured. For these reasons, a run on the banks deposits was more likely to lead to a liquidity crisis. With increased concerns of the solvency of large dealer banks, the availability of credit across the industry was threatened. This had the potential to lead to severe market slowdowns if borrowers were unable to obtain credit.
D e a l e r B a n k M a r k e t s
Large dealer banks operate in markets that are outside the scope of traditional bank-failure resolution mechanisms, such as conservatorship or receivership. The dealer banks are organized under the umbrella of holding companies in order to provide the wide variety of commercial banking, merchant banking, investment banking, brokerage, and off-balance sheet partnership activities. In addition, dealer banks often have large asset-management divisions that provide custody of securities, cash management, brokerage, and alternative investments vehicles. Dealer banks are also typically the general partner with limited partner clients.
In the primary securities market, dealer banks are the security underwriter. They buy equity and bond securities from issuers and sell them to institutions and investors over a period of time. Dealer banks also play a major role in the secondary securities market in providing liquidity to the market. They are the primary intermediary in the OTC securities markets by assisting in the private negotiation between investors and corporations, municipalities, certain national governments, and securitized credit products. Dealer banks are also actively involved in publicly traded equity markets by acting as brokers, custodians, securities lenders, and facilitating large block trades.
A major market in which dealer banks operate is the repurchase agreements, or repos, market. Repos are short-term cash loans collateralized by securities. In the repo market, one counterparty borrows cash from another counterparty. The majority of repos are for a very short period of time, such as overnight. The loans are collateralized by government bonds, corporate bonds, mortgages, agency securities, or other securities such as CDOs. In order to reduce counterparty risk, a clearing bank often acts as a third party and holds the collateral. The clearing bank facilitates the trade and somewhat reduces the risk of default for the lender. It is common for counterparties to renew these positions on a continuous basis as long as the solvency of the dealer bank is not questioned. It is not uncommon for these counterparties to be another dealer bank.
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Dealer banks are usually counterparties in the OTC derivatives market. The most prominent OTC derivatives are interest rate swaps where variable rate commitments often linked to the London Interbank Offering Rate (LIBOR) are exchanged for a fixed rate for a specific time period. Dealer banks typically perform what is known as a matched book dealer operation. They transfer the risk of the derivatives positions requested by counterparties by creating new derivatives contracts with other counterparties, who are oftentimes other dealer banks. Thus, dealer banks have large OTC derivatives exposures with other dealer banks. In addition to dealing with interest rate swaps, dealers are often counterparties in CDSs. In these contracts, the dealer bank transfers the default risk rather than the interest rate risk for the counterparties involved in the contracts.
Some large dealer banks are very active in off-balance sheet financing. In these markets, a bank can sell residential mortgages or other loans to a special purpose entity (SPE). The SPE compensates the sponsoring bank for the assets with the proceeds of debt that it issues to third-party investors or hedge funds. The SPE pays for the principal and interest of the debt issued with the cash flows from the mortgages or other assets that were purchased from the sponsoring bank. Thus, the SPE holds the collateralized pool of assets and provides an innovative product for hedge funds and other investors to purchase. These SPEs also provide a means for financial institutions to diversify their exposure by transferring risk to other investors who are either in or outside the financial industry.
For example, prior to the recent financial crisis, dealer banks were actively participating as sponsor banks for structured investment vehicles (SIVs), which are a form of a special purpose entity. The SIV finances residential mortgages or other debt obligations with short term debt sold to other investors in the form of CDOs and CMOs.
Before the recent crisis, banks were not required to include the off-balance sheet assets and debt obligations in minimum capital requirement and accounting reports. Thus, some dealer banks became highly leveraged as they were allowed to operate much larger loan purchases and origination businesses with a limited amount of capital. The fall in residential housing values in the summer of 2007 led to the rise of mortgage defaults, which threatened the ability of the SIV to make payments. As short-term creditors became concerned with the solvency of the SIVs, they refused to renew loans, and this created a liquidity and solvency issue for SIVs. Dealer banks had to provide support to SIVs to protect its reputation and franchise value.
D i s e c o n o m i e s o f S c o p e
As mentioned, dealer banks act as holding companies in order to provide a wide variety of commercial banking, prime brokerage, investment banking, asset management, and off-balance sheet activities. The recent financial crisis caused many to question the ability of dealer banks to manage risks properly. It is sometimes argued that forming large bank holding companies results in economies of scope with respect to information technology, marketing, and financial innovation. However, the recent financial crisis clearly identified diseconomies of scope in risk management and corporate governance. The executive management and board of directors did not fully understand or control the risk taking activities within their organizations.
For example, prior to their insolvency, Bear Stearns and Lehman relied heavily on overnight repos with leverage ratios above 30. These dealer banks held these assets on their balance
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sheets with little incremental capital. Management did not properly manage the amount of off-balance sheet risk the bank was exposed to. Thus, the over-leveraged positions made it impossible to overcome the liquidity and solvency issues that quickly arose when the values of the banks assets were questioned. Increased awareness or more appropriate risk models may have prevented the insolvency of these dealer banks.
L i q u i d i t y C o n c e r n s f o r D e a l e r B a n k s

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