The Failure Mechanics of Dealer Banks

In this chapter, the major banks’ operated lines of business with all risk factors faced under each line of business will be described. We identify situations likely to lead to a liquidity crisis at a dealer bank and give an explanation on responses that can mitigate these risks. Finally, we identify the policy measures that can alleviate firm-specific and systemic risk related to large dealer banks.

Major Banks’ Operated Lines of Business

A bank is basically an intermediary between depositors desiring short-term liquidity and borrowers seeking to finance projects. An unexpected surge in depositors’ cash withdrawals or borrowers showing signs of not being able to repay their loans makes depositors concerned over the solvency of the bank.

The social costs of banks failures are treated by the following standard policy tools:

  1. Regulatory supervisions: and the requirement for risk-based capital reduces the chance of solvency-threatening capital losses;
  2. Deposit insurance: which lowers individual depositors’ incentives; and
  3. Regulatory resolutions mechanisms: through which the authorities are given powers liquidate or restructure a bank efficiently.

Major dealer banks in the recent financial crisis suffered from the new forms of bank runs. Dealer banks are often considered too big to fail since they are mostly parts of large sophisticated organizations and the economy can be damaged by their failures.

Suppose a bank, \(A\), is a protagonist dealer bank with a capital position that is severely weakened by trading losses. To shore up the value of its business, a new equity capital is of necessity to the bank. However, there is the question, from the new equity’s potential providers, of whether their capital infusions would do more than improving the bank’s creditor’s positions. Furthermore, they feel that they lack enough information about \(A\)’s asset value and business opportunities that will be available in the future for the price of new shares to be offered.

Some of \(A\)’s scarce capital will be applied to bail out critical customers from significant losses incurred in investments arranged by \(A\) to protect the bank’s reputation and signal strength. Bank \(A\) is vulnerable to the flight of its creditors, customers, and counterparties, and those who deal with it begin to draw back.

By offering hedge funds and other major investors services like IT, execution of trades, accounting reports, and holding cash and securities for hedge funds, bank \(A\) operates a significant brokerage business. The hedge funds start moving their cash and securities to prime brokers that are well capitalized since they are aware of the trouble at bank \(A\). The financial flexibility of \(A\) will, therefore, be greatly reduced since it partly depends on the cash and securities of its customers to finance its own business.

Some of \(A\)’s derivatives counterparties begin to lower their exposures to \(A\). The trades that drain cash away from \(A\) to its counterparties are becoming more and more prominent. Moreover, other dealer banks are encouraged to trade derivatives that insert the other dealers between \(A\) and its original derivatives counterparties, called novations. As a result, those counterparties get insulated from \(A\)’s default risk. The dealers, therefore, avoid novations which expose them to \(A\)’s default. The cash collateral will further dwindle rapidly.

\(A\)’s short-term secured creditors refuse to renew their loans to \(A\) to avoid getting mixed up in the mess following the event of default by \(A\). The majority of the short-term secured loans are in repo form; most of which have a one day term. Therefore, \(A\) has to seek new financing or to conduct costly fire sales of its securities.

\(A\)’s liquidity position is now grave and the securities are routinely held by the clearing bank in amounts that can cover these overdrafts. \(A\) will be declared bankrupt after the clearing bank decides to stop processing the cash and securities transactions of \(A\) due to their exposure to \(A\)’s overall position.

Financial institutions like \(A\) represent relatively large global financial groups that both trades in securities and derivatives and still operate traditional commercial banks or significantly engage in investment banking, asset management, and prime brokerage.

The main lines of dealer banks’ business are:

  1. Securities dealing, underwriting, and trading;
  2. OTC derivatives; and
  3. Prime brokerage and asset management.

What Do Large Dealer Banks Do?

For simplicity, large dealer banks will be treated as members of a distinct class despite there being many significant variations with respect to many aspects. The most insignificant lines of businesses of these dealer banks that will be focused on are: securities markets, securities lending, repurchase agreements, and derivatives.

In addition, proprietary trading is engaged in by dealer banks when they speculate on their own accounts. Various other dealer banks will operate internal hedge funds and private equity partnerships as part of their asset management businesses, by effectively acting as a general partner with limited-partner clients.

Securities Dealing, Underwriting, and Trading

There is always an intermediation by dealer banks between securities issuers and investors in the primary market, and among investors in the secondary markets. Sometimes acting as an underwriter, a dealer purchases equities or bonds from an issuer and over time sells them to investors in the primary markets.

Sellers will hit the dealer’s bid prices and buyers will hit its ask prices in the secondary markets. The intermediation of OTC securities markets is dominated by dealer banks, covering bonds issued by corporations, municipalities, certain national governments, and securitized credit products.

Furthermore, interdealer brokers and electronic trading platforms intermediate trade between dealers in some securities. Dealers are also active in secondary equity markets despite public equities being easily traded on exchanges. Speculative investing is popular among banks with dealer subsidiaries and can be partly aided by the ability to observe inflow and outflow of capital from certain securities classes.

Repos markets are likewise good intermediation points for securities dealers. A counterparty will post government bonds, corporate bonds, government-sponsored enterprises’ securities, or other securities like CDOs as collateral against the performance of a borrowed or lent loan.

Most repos are short-term, typically overnight, and are commonly renewed with the same dealer. A haircut that reflects the securities’ risk or liquidity mitigates a repo’s performance risk.

Some repos are tri-party for counterparty risk to be mitigated. Normally, the third party is a clearing bank holding the collateral and returns the cash to the trader thereby facilitating the trade and somewhat insulates the lender from the borrower’s default risk.

Over-the-Counter Derivatives

The contracts transferring financial risk from one investor to another are called derivatives. They are traded OTC on exchanges. OTC derivatives can be customized to suit a client’s needs since they are privately negotiated. For most OTC derivatives trades, one counterparty has to be the dealer. It usually lays off most or all of the risk of its client’s inflated derivatives positions by running a matched book, profiting on the differences between bid and offer terms.

Proprietary trading is conducted in OTC derivatives markets by dealer banks as in their securities business. The market value measures the notional amount of an OTC derivatives contract, and for bond derivatives, the measure is the face value of the asset whose risk is transferred by the derivative.

All derivatives contracts must have a total market value of zero, as an accounting identity. This implies that there should be an equal number of long and short positions. Wealth is transferred by derivatives from one counterparty to another rather than directly added or subtracted from the total stock of wealth.

Fractional costs of bankruptcies can lead to net losses caused by derivatives. Also, the risk is socially transferred from those ill-equipped to bear it to others who are well equipped to bear the risk. There is also a further risk of the counterparty failing to meet its promised payments.

The amount of exposure to default as a result of counterparties failing to perform their contractual obligations is a useful gauge of counterparty risk in OTC markets. Collaterals reduce these exposures.

Under normal circumstances, the trades of various OTC derivatives between a given pair of counterparties are legally combined between the two counterparties under a master swap agreement, and being in line with the standards set by the International Swaps and Derivatives Association.

There was a reduction in the range of acceptable forms of collateral that dealers took from their OTC derivatives counterparties, as the 2007 financial crisis deepened. According to statistics, cash was the form of collateral for over 80% of collateral for these agreements.

Prime Brokerage and Asset Management

There are several large dealers who are extremely active prime brokers to hedge funds and other large investors. They provide customers with a variety of services ranging from securities holding management, clearing, and cash management services to securities lending, financing, and reporting.

By lending securities placed with a dealer by prime brokerage customers, additional revenue will be generated by the dealer.

The large asset-management divisions often found in dealer banks are for catering the institutional and wealthy individual clients’ needs. The divisions hold securities for clients, are in charge of cash, and provide alternative investment vehicles like private equity partnerships often managed by the same bank.

A large dealer bank may be perceived by a limited partner in an internal hedge fund to be more stable as compared to a stand-alone hedge fund because the dealer bank might voluntarily support an internal hedge fund at a time when they extremely need the support.

Off-Balance Sheet Financing

Dealer banks have made an extensive application of off-balance sheet financing. A good example is a financial institution originating or buying residential mortgages and other loans financed by a sale of the loans to a financial corporation set up for this express purpose. The proceeds of the debt issued by the special purpose entity to third-party investors are used to pay the sponsoring bank for the assets.

Due to regulatory minimum requirements and accounting standards, there has been no necessity for banks to treat the assets and debt obligations of special purposes entities since the debt obligations of such entities are usually contractually remote from the sponsoring bank. Therefore, a special purpose entity is off balance sheet.

A structured investment vehicle is a form of special purpose off-balance-sheet entity that finances residential mortgages and other short-term debt loans sold to investors like money-market funds.

Failure Mechanisms for Dealer Banks

In the event that the solvency of a dealer bank gets threatened, there can be a rapid change in the relationship between the bank and its derivatives counterparties, prime brokerage clients, and other clients. There are similarities between the concepts at play and those of a depositor run at a commercial bank.

There is also a lack of default insurance by most of the insured depositors exposed to dealer banks as compared those at a commercial bank, or still, they do not wish to bear the frictional costs of getting involved in the bank’s failure procedures even if they have insurance. The following are the key mechanisms leading to the failure of a dealer bank:

  1. The flight of short-term creditors;
  2. Prime brokerage clients’ departure;
  3. Various cash-draining undertakings by derivatives counterparties designed to lower their exposures to the dealer banks; and
  4. The loss of clearing-bank privileges.

The Flight of Short-term Creditors

One of the forms through which the assets of larger dealer banks tend to be financed by the banks is the issuing of bonds and commercial paper. The purchasing of their securities inventories have recently been financed by the short-term repurchasing agreements. The money-market funds, securities borrowers, and other dealers are often the counterparties to these repos.

In case of a failure by the repo creditors of dealer banks to renew their positions en masse, there will be doubts about the ability of the dealer banks to finance their assets with sufficient amounts of new private sector banks. Therefore, the dealer will sell its assets hurriedly to buyers aware of the need for it to be quickly sold. This is called a fire sell and can lead to lower and lower prices for the assets.

In case the dealer’s original solvency concerns were prompted by declines in the market values of the collateral asset themselves, an asset fire sale’s proceeds could be insufficient to meet the dealer’s cash needs.

Fatal inferences by participants in other markets of the dealer’s weakened condition could be as a result of a fire sale. During a financial crisis, the financing problems of a dealer bank could be exacerbated.

The risk of a liquidity loss can be mitigated by the dealer bank in the following ways due to a run by short-term creditors:

  1. Establishing lines of bank credit;
  2. Dedicating a buffer stock of cash and liquidity securities for emergency liquidity needs; and
  3. Laddering the maturities of its liabilities to refinance only a small portion of the debt within a short period of time.

Teams of professionals are always present for major dealer banks to manage liquidity risk by controlling the distribution of liability maturities and managing the availability of pools of cash and other noncash collateral acceptable to secured creditors.

Broad and flexible lender-of-last-resort financing to large banks is a popular response by central banks to the systemic risk created by the potential for fire sales. The time needed for financial claims to be liquidated is bought by such financing in a timely manner.

Secured financing to regulated commercial banks has always been provided by the U.S. Federal Reserve through its discount window. However, the discount window is not accessible to dealers not regulated as banks.

For the cash that was lost by the exit of repo counterparties and other less suitable funding sources to be replaced, there may be lessening of the extent to which a dealer bank is financed by traditional insured bank deposits during a solvency crisis.

The Flight of Prime Brokerage Clients

The cash and securities left by customers in their prime brokerage accounts are sometimes partly used by prime brokers to finance themselves. In the U.K., securities and cash in prime brokerage accounts are generally comingled with assets of prime brokers and are, therefore, available to the prime brokers for the purposes of their business.

A prime broker in the U.S. must aggregate its clients’ free balances in safe areas of the broker dealer’s business-related activities to servicing its customers or deposit the funds in a reserve bank account to prevent the comingling of customer and company funds.

The financing provided by prime brokers to their clients is typically secured by the assets of those clients’ prime brokers. In the U.S., the asset of a client can also be used as collateral to finance a dealer bank’s margin loans through re-hypothecation.

The weakening of a dealer bank’s financial position may lead hedge funds to move their prime brokerage accounts elsewhere. The cash liquidity problems of a prime broker in the U.S. can be exacerbated by its prime brokerage business with or without the clients running.

The dealer could continuously demand a hedge fund cash margin loans backed by securities left by the hedge fund in its prime brokerage account, under its contract with the prime broker.

The prime broker may have to use its own cash to meet the demands of other customers on short notice since the running of prime brokerage customers can leave them with insufficient cash to be pulled from their free credit balances to meet the said demands.

When the Derivatives Counterparties Duck for Cover

In the event that a dealer bank is perceived to have some solvency risk, the counterparty of an OTC derivative looks for opportunities to reduce its exposures to that of the dealer bank. The following are the mechanisms that are possible in this case scenario:

  1. Borrowing from the dealer reduces the counterparty’s exposure;
  2. Entering new trades with the dealer causing the dealer to pay out cash for a derivatives position; and
  3. Cash can be harvested by the counterparty from any derivatives positions having swung in its favor over time.

Novation to another dealer is also a good way for a counterparty to reduce its exposure to the dealer. Often, a collateral posting call is necessary for OTC derivatives agreement. Furthermore, the increase in collateral is frequently called from a counterparty whose credit rating gets downgraded below a stipulated level.

In a section of contingencies, terms for the early termination of derivatives are included in the master swap agreements, and this includes one of the counterparties defaulting.

Most OTC derivatives are exempted by law as “qualifying financial contracts” from the automatic stay at bankruptcy holding up other creditors of a dealer. A large post-bankruptcy drain on the defaulting dealer is the impact of unwinding the derivatives portfolio of the dealer.

Loss of Cash Settlement Privileges

The refusal of the clearing bank to process transactions marks the final step of the collapse of a dealer bank’s ability to meet its daily obligations. Daylight overdraft privileges will be extended by a clearing bank to its creditworthy clearing clients in the normal course of business.

A right to offset a contractual right to discontinue making cash payments, thus reducing the account holder’s cash below zero during the day, is always in possession of a clearing bank in case the cash liquidity of the dealer is under scrutiny. This is after the value of any potential exposures by the clearing bank to the account holder has been accounted for.

Policy Reponses

For many years, there have been developments in the policies for prudential supervision, capital requirements, and traditional commercial banks’ failure resolutions, and they have been relatively settled. Policies for reducing the risks possessed by large systematically important financial institutions have had significant new attention brought to them due to the financial crisis.

In both the U.S. and Europe, increased capital requirements, new supervisory councils, and special abilities to resolve the financial institutions as they approach insolvency are the currently envisioned regulatory changes for financial institutions that are critical for the banking system as a whole.

Practice Questions

1) Which of the following standard policy tools is NOT applicable in the treating of the social costs of bank failures?

  1. Regulatory supervisions and the requirements for risk-based capital
  2. Deposit insurance
  3. Regulatory resolutions mechanisms
  4. Regulatory requirements guiding the departure of prime brokerage customers

The correct answer is D.

When treating the social costs of bank failures, the standard policy tools that are used include: regulatory supervision and requirements for risk-based capital, deposit insurance, and regulatory resolutions mechanisms.

There are no such things as regulatory requirements guiding the departure of prime brokerage customers when treating the social costs of bank failures.

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