Recognise the scenarios in which a dealer bank may run into a liquidity crisis, and describe the actions that can limit the danger.
The idea
A dealer bank is vulnerable to a liquidity crisis because much of its balance sheet is financed with short-term secured and unsecured funding while its assets are harder to sell. Typical scenarios include repo lenders and commercial paper investors refusing to roll funding or raising haircuts after a loss or a rumour. Derivatives counterparties may demand extra collateral after a rating downgrade. Prime brokerage clients may withdraw free cash balances and move positions. Clearing agents or central counterparties may raise margin. These feed on each other because every withdrawal signals weakness. Actions that limit the danger are a buffer of unencumbered high-quality liquid assets sized by stress tests and valued after stressed haircuts, longer funding maturities, diversified lenders and collateral, contingent funding plans, and limits on rating-trigger exposure. Exam point: a buffer counts only if it is unencumbered and can reach the entity that needs the cash.
A practice question
Which event best illustrates the start of a liquidity crisis at a dealer bank?
- Repo and commercial paper lenders refuse to roll funding after rumours of losses, forcing asset sales at a discount - correct
- A gradual rise in policy rates that slowly narrows net interest margin over several years while funding stays fully availableWhy not: This is an earnings pressure over years, not a sudden loss of funding.
- A loss on one trader's position equal to 1% of equity, absorbed by capitalWhy not: A loss within capital is a solvency matter that capital absorbs; it does not by itself stop funding.
- An equity issue that funds an increase in long-term bond holdingsWhy not: Longer-dated equity funding reduces rather than creates a liquidity strain.
A dealer with short-term funding and less liquid assets is exposed to withdrawal of that funding. The crisis starts when lenders refuse to roll, forcing fire sales.
A harder one
A dealer bank has a liquidity pool of USD 6,000 million (after haircuts). A one-notch downgrade immediately triggers a USD 900 million derivative collateral call. Afterwards, net cash outflows from non-rolled funding and client withdrawals are expected at USD 450 million per day. The pool supports the dealer for how many full days?
- 13 daysWhy not: Ignores the downgrade collateral call: 6,000 / 450 = 13.3 days.
- 12 daysWhy not: Rounds 11.33 up to 12; only 11 full days are covered.
- 4 daysWhy not: Treats the downgrade call as a recurring daily outflow: 6,000 / (450 + 900) = 4.4 days.
- 11 days - correct
The collateral call is a one-off: 6,000 - 900 = 5,100. At 450 per day, 5,100 / 450 = 11.33, so 11 full days of outflows are covered.
The hardest tier
A dealer bank reports a large liquidity pool, yet it runs out of cash in a stress. Which is the most likely reason for the failure of the pool?
- Government securities always lose most of their value in a stress, so they cannot support fundingWhy not: Government securities hold value; the failing is where and whether they are free, not their price collapse.
- A liquidity pool only matters for solvency, not for meeting cash outflowsWhy not: A liquidity pool exists to meet cash outflows; solvency is a capital question.
- Part of the pool is encumbered or held in legal entities where regulation or tax limits transfers, so it cannot meet needs elsewhere in the group - correct
- Securities can never be monetised in a stress unless they are held as cashWhy not: High-quality securities can be repoed or sold, with haircuts; the claim is too strong.
A pool helps only if its assets are unencumbered and can be moved to the entity facing the outflow. Encumbered or trapped assets overstate usable liquidity.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →