LO 55.2: Identify situations that can cause a liquidity crisis at a dealer bank and

LO 55.2: Identify situations that can cause a liquidity crisis at a dealer bank and explain responses that can mitigate these risks.
A liquidity crisis for a dealer bank is accelerated if counterparties try to reduce their exposure by restructuring existing OTC derivatives with the dealer or by requesting a novation (as discussed in the following). The flight of repo creditors and prime brokerage clients can also accelerate a liquidity crisis. Lastly, the loss of cash settlement privileges is the final collapse of a dealer banks liquidity.
As mentioned previously, when OTC derivatives counterparties question the solvency of a dealer bank, they will begin to reduce their exposures to the dealer. A counterparty could reduce their exposure by borrowing from the dealer or by entering into new offsetting derivatives contracts with the dealer. A counterparty may also request to have in-the-money options revised to at-the-money strike prices and, thus, reduce their exposure to the dealer by receiving cash from the option position.
Another means that a counterparty has of reducing their exposure to a dealer is through a novation to another dealer. For example, a hedge fund may use a credit default swap from a dealer to protect themselves from a loss on a borrower. If the hedge fund was concerned about the solvency of the dealer bank, they could request a novation from another dealer bank to protect themselves from default arising from the original dealer bank. Although these novations are often granted by dealer banks, in the case of Bear Stearns, the request was denied, which raised additional concerns regarding the solvency of Bear Stearns. In addition to decreasing the reputation capital and franchise value of this dealer bank, the liquidity position was also under increased stress. A novation could result in the removal of the cash collateral of the original dealer bank and transfer of this collateral to the second dealer bank.
Central clearing mitigates the liquidity risk caused by derivatives counterparties exiting their large dealer bank exposures. OTC derivatives are novated or cleared to a central clearing counterparty that stands between the original counterparties. The use of a central clearing counterparty also mitigates the systemic risk of financial markets and institutions when the solvency of a large dealer bank is questioned. However, the use of central clearing counterparties is only effective with derivatives that contain relatively standard terms. Thus, this was not an effective means of dealing with the infamous customized MG credit derivatives.
Further liquidity pressure can arise if derivative counterparties desire to reduce their exposure by entering new contracts that require the dealer bank to pay out cash. For example, a dealer bank may try to signal their strength to the market by quoting competitive bid-ask spreads on an OTC option. If the bid price is then accepted, the dealer
2018 Kaplan, Inc.
Page 241
Topic 55 Cross Reference to GARP Assigned Reading – Duffie
must settle with a cash payment to the counterparty which reduces their liquidity. If the dealer refuses to quote competitive bid prices, it may further signal their liquidity concerns to the market.
Money market funds, securities lenders, and other dealer banks finance significant fractions of a dealer banks assets through short-term repurchase agreements. As mentioned previously, if the repo counterparty questions the solvency of a dealer bank, they are unlikely to renew repos. In this event, the repo creditors may have an incentive, or be legally required, to sell the collateral immediately. If the sale of the collateral is less than the cash position, then the dealer counterparty may face litigation for the improper disposal of assets. 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. They could reinvest their cash in new repos, but other counterparties are unlikely to take these positions if the dealer banks solvency is questioned.
The dealer bank can mitigate the liquidity risk caused by a run of short-term creditors by establishing lines of bank credit, holding cash and liquid securities, and by laddering the maturities of its liabilities. When a dealer bank ladders its liabilities, the maturities are spread out over time so that only a small fraction of its debt needs to be refinanced overnight. In 2008, the New York Federal Reserve Bank created the Primary Dealer Credit Facility to finance securities of investment banks. Immediately following the failure of Lehman, the remaining two dealer banks, Morgan Stanley and Goldman Sachs, became regulated bank holding companies. As a bank holding company, the firms gained access to the discount window and could turn to the government for financial support, including FDIC deposit insurance and loan guarantees.
Prime brokerage accounts are a source of cash inflows for large dealer banks. In normal circumstances, the cash and securities of prime brokerage clients are a source of liquidity for the bank. In the United Kingdom, assets from client prime brokerage accounts are commingled with the banks own assets. Flowever, in the United States, dealer banks are allowed to pool the money together into a separate account from the banks own funds. Thus, the prime broker is able to use the cash from one client to help meet the liquidity needs of another client.
As mentioned previously, when the solvency of a prime broker is questionable, a hedge fund could demand cash margin loans from the dealer that are backed by the securities held in their account with the prime broker. The prime broker may not be able to use those same securities as collateral with other lenders who may question their solvency. Lenders may not find any incentive to lend to the questionable dealer bank. Thus, even without a run by prime brokerage accounts, considerable strain could be placed on the dealer banks liquidity position.
In addition, if prime broker clients do leave on short notice, then their cash and securities are no longer in the pool of funds to meet the needs of other clients. In this case, the dealer bank must use its own cash to meet liquidity needs. The reduction of collateral securities caused by the flight of prime brokerage clients can lead to a systemic shortage of collateral and a liquidity crisis. In the future, hedge funds are likely to mitigate their exposure to a few dealer banks by diversifying their sources of prime brokerage with custodian banks.
Page 242
2018 Kaplan, Inc.
Topic 55 Cross Reference to GARP Assigned Reading – Duffie
Under normal conditions, a clearing bank may extend daylight overdraft privileges to clearing customers who are creditworthy. However, when the solvency of a dealer bank is questioned, the clearing bank may refuse to process transactions that are insufficiently funded by the dealer banks cash fund account. For example, in the case of Lehmans default, J.P. Morgan Chase was the clearing bank that invoked its full right of offset. Under this legal right, J.P. Morgan Chase was able to offset their exposures using Lehmans cash, and at the same time, discontinued to make cash payments during the day on Lehman transactions that would bring Lehmans account below zero. The failure to meet its transactions obligations on that day forced Lehman into bankruptcy. To mitigate this risk in the future, emergency banks are proposed to act as either a clearing bank or a tri-party repo utility.
The basic economic principles causing a liquidity crisis, and potentially the insolvency of a large dealer bank, are not that different from the traditional retail bank run. Banks may finance illiquid assets with short-term deposits. However, an unexpected liquidity demand from depositors or the inability of borrowers to repay their loans may lead to concerns about the solvency of the bank. If the concern persists, a bank run could lead to liquidity problems, and the concern about the banks failure could end up as a self-fulfilling prophecy.
While the basic economic principles of a bank run are similar for large dealer banks and retail banks, the institutional mechanisms and the systemic destructiveness are very different. For example, dealer banks play an essential role in providing liquidity in the OTC derivatives and securities markets. When the solvency of a dealer bank is questioned, counterparties of these markets and prime brokerage clients begin to reduce their exposure to the dealer. The OTC derivatives counterparty may reduce their exposure by borrowing from the dealer, entering new offsetting derivatives contracts with the dealer, or requesting a novation. A counterparty may also request to receive cash from options positions that are in-the-money by having them revised to at-the-money. Prime broker clients may remove collateral and cash, which results in further accelerating the liquidity crisis. The fact that dealer banks are often counterparties to other dealer banks increases the systemic risk in the financial markets where dealer banks play essential roles.
Another area that dealer banks are very active involving liquidity is the repo markets. Especially in cases where the dealer banks are highly leveraged, the liquidity position is severely threatened when the dealer banks solvency is questioned and counterparties are unwilling to renew repo positions overnight. Thus, a dealer bank is involved in many functions that result in increased liquidity pressures that traditional banks are not exposed to.
2018 Kaplan, Inc.
Page 243
Topic 55 Cross Reference to GARP Assigned Reading – Duffie
P o l
i c e s t o A l
l e v i a t e D e a l e r B a n k R i s k s

Write a Comment