LO 55.3: Describe policy measures that can alleviate firm-specific and systemic

LO 55.3: Describe policy measures that can alleviate firm-specific and systemic risks related to large dealer banks.
The 2009 Public Private Investment Partnership (PPIP) was instituted by the U.S. Treasury Departments 2008 Troubled Asset Relief Program (TARP) to help dealer banks and the financial industry recover from the crisis at hand. One of the policy objectives was to mitigate the effect of adverse selection in the market for toxic assets, such as the CD Os backed by subprime mortgages. Adverse selection is the principle that buyers are only willing to buy the assets at a deep discount due to the information asymmetries that exist regarding the assets true value. A dealer bank may be forced to sell illiquid assets in order to meet liquidity needs. This results in additional losses due to the lack of demand for those assets. The PPIP subsidizes bidders of toxic assets by offering below-market financing rates and absorbing losses beyond a predetermined level.
The United States Federal Reserve System and the Bank of England provided new secured lending facilities to large dealer banks when they were no longer able to obtain credit from traditional counterparties or the repo market. When the dealer banks solvency is questioned, tri-party clearing banks are likely to limit their exposure to the dealer bank. A tri-party repo utility is proposed as an alternative and would be designed to have fewer conflicting incentives and less discretion in rolling over a dealers repo positions. New standards could be adapted for transaction documentation, margin requirements, and daily substitution of collateral with respect to repos. These standards could be incorporated through either the new repo utility or traditional tri-party clearing approaches.
Another potential approach is the creation of an emergency bank that could manage the orderly unwinds of repo positions of dealer banks with liquidity difficulties. The central bank would grant access to the discount window for the emergency bank to insulate critical clearing banks from losses during this unwinding process.
Capital requirements will most likely be increased and include off-balance sheet positions in an effort to reduce the leverage positions of dealer banks. The separation of tri-party repo clearing from other clearing account functions would also reduce a dealer banks leverage by tightening the dealers cash-management flexibility.
Central clearing will reduce the threat of OTC derivatives counterparties fleeing a questionable dealer bank. Although this would not eliminate the liquidity effect resulting from a derivative counterparty reducing their exposure to a particular dealer bank, it would reduce the total exposure to the dealer that would need to be managed through clearing.
Some large dealer banks and financial institutions are viewed as being too-big-to- fail based on the systemic risk their insolvency would place on the financial markets. Therefore, another proposed resolution for large dealer banks with questionable solvency that are deemed too-big-to-fail is to provide bridge banks similar to the approach used for traditional banks.
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Topic 55 Cross Reference to GARP Assigned Reading – Duffie
Ke y C o n c e pt s
LO 55.1 Large dealer banks are active participants in over-the-counter (OTC) derivatives, repo, and securities markets. Their functions in these markets, as well as asset managers and prime brokers, result in a variety of liquidity risks when their solvency is questioned and counterparties reduce their exposure with them.
LO 55.2 A liquidity crisis is accelerated when prime broker clients or counterparties in the OTC derivatives or repo markets question the solvency of a dealer bank and desire to exit their positions or reduce their exposures with the dealer bank.
LO 55.3 The creation of emergency banks in the form of tri-party repo utilities and clearing banks are policy proposals to mitigate firm specific and systemic liquidity risk in the OTC derivatives and repo markets. The U.S. Treasury Departments 2008 Troubled Asset Relief Program (TARP) was designed to mitigate adverse selection in toxic asset markets by providing below market financing and absorbing losses above a pre-specified amount.
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Topic 55 Cross Reference to GARP Assigned Reading – Duffie
C o n c e pt Ch e c k e r s
1.
2.
3.
4.
5.
A dealer banks liquidity crisis is least likely to be accelerated by: A. the refusal of repurchase agreement creditors to renew their positions. B. C. a counterpartys request for a novation through another dealer bank. D. depositors removing their savings from the dealer bank.
the flight of prime brokerage clients.
Banks are most likely to diversify their exposure to a specific asset class such as mortgages by grouping these assets together and selling them to: A. hedge funds. B. government agencies. C. the U.S. Federal Reserve. D. special purpose entities.
The formation of large bank holding companies results in diseconomies of scope with respect to: A. risk management. technology. B. C. marketing. D. financial innovation.
One potential solution for mitigating the liquidity risk caused by derivatives counterparties exiting their large dealer bank exposures is most likely the: A. use of central clearing. B. use of a novation through another dealer bank. C. requirement of dealer banks to pay out cash to reduce counterparty exposure. D. creation of new contracts by counterparties.
Which of the following items is not a policy objective of the U.S. Treasury Departments 2008 Troubled Asset Relief Program to help dealer banks recover from the subprime market crisis? A. Provide below-market financing rates for bidders of toxic assets. B. Absorb losses beyond a pre-specified level. C. Force the sale of illiquid assets in order to better determine the true value. D. Mitigate the effect of adverse selection.
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Topic 55 Cross Reference to GARP Assigned Reading – Duffie
C o n c e pt C h e c k e r An s w e r s
1. D 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. 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.
2. D Banks can diversify their exposure to a specific asset class, such as mortgages, by grouping
these assets together and selling them to special purpose entities.
3. A Some argue that information technology, marketing, and financial innovation result in
economies of scope for large bank holding companies. Conversely, the recent financial crisis raised the concern that the size of bank holding companies creates diseconomies of scope with respect to risk management.
4. A One potential solution for mitigating the liquidity risk caused by derivatives counterparties
exiting their large dealer bank exposures is the use of central clearing through a counterparty. However, central clearing is only effective when the underlying securities have standardized terms. The reduction of a counterpartys exposure through novation, entering new offsetting contracts, or requiring a dealer bank to cash out of a position will all reduce the liquidity of the dealer bank.
5. C The U.S. Treasury Departments 2008 Troubled Asset Relief Program was designed to create policies to help dealer banks recover from the subprime market crisis by mitigating the effect of adverse selection, by providing below-market financing rates for bidders of toxic assets, and by absorbing losses beyond a pre-specified level. Forcing the sale of illiquid assets would worsen the liquidity position of the troubled dealer bank.
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The following is a review of the Operational and Integrated Risk Management principles designed to address the learning objectives set forth by GARP. This topic is also covered in:
St r e ss Te st i n g Ba n k s
Topic 56
E x a m F o c u s
This topic focuses on the use of bank stress testing to determine if liquidity and capital are adequate. The discussion focuses primarily on capital adequacy but notes that the issues are similar with respect to liquidity. For the exam, understand the details of the 2009 Supervisory Capital Assessment Program (SCAP), the first stress testing required after the 20072009 financial crisis. Also, be able to explain the issue of coherence in stress testing and describe the challenges with modeling the balance sheet using stress tests in the context of the stress test horizon. Finally, understand the differences in disclosure between U.S. and European stress tests and the way that stress test methodologies and disclosure have changed since the 2009 SCAP.
S t r e s s T e s t i n g
In the wake of the 20072009 financial crisis, regulators and other policymakers realized that standard approaches to risk assessment, such as regulatory capital ratio requirements, were not sufficient. At that point, supervisory stress testing became a popular tool for measuring bank risk. There was a pop-quiz quality to the post-financial crisis stress tests. They were difficult to manipulate because they were sprung on banks at short notice. As a result, the information provided by the stress tests to regulators and the market was truly new. This allowed financial markets to better understand bank risks and, as a result, regain a level of trust in the banking sector.
The goal of stress testing, as well as capital/liquidity and economic capital/liquidity (i.e., internal, bank-specific) models, is to assess how much capital and liquidity a financial institution needs to support its business (i.e., risk taking) activities. It is relatively easy for banks to swap out of lower risk assets and into higher risk assets. Stress testing provides clarity about the true risk and soundness of banks.
Stress testing is an old tool that banks and other firms have used to examine risk. It asks the question what is the institutions resilience to deteriorating conditions? and simulates financial results given various adverse scenarios. Stresses are generally of two basic types: scenarios or sensitivities. An example of a scenario is a severe recession. An example of sensitivity is a significant increase in interest rates. Risk managers can stress test the sensitivity of a single position or loan or an entire portfolio.
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Topic 56 Cross Reference to GARP Assigned Reading – Schuermann
S u p e r v i s o r y C a p i t a l A s s e s s m e n t P r o g r a m (SCAP)

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