Evaluate regulatory and policy steps that might lower the risks that big dealer banks pose to themselves individually and to the wider system.

FRM® Part II · Liquidity and Treasury Risk Measurement and Management · The Failure Mechanics of Dealer Banks · FRM2.LTR.8.c

The idea

Policy responses aim to make a dealer less likely to fail and less damaging if it does. On liquidity, the liquidity coverage ratio requires high-quality liquid assets of at least 100 percent of net stressed cash outflows over 30 days, with inflows capped at 75 percent of outflows. The net stable funding ratio requires available stable funding to be at least 100 percent of required stable funding over one year. On capital, there are risk-based minimums, a non-risk-weighted leverage ratio, surcharges for global systemically important banks and loss-absorbing capacity for resolution. Structural measures include the Volcker rule limiting proprietary trading, central clearing and margin for standardised OTC derivatives, resolution plans, and temporary stays on termination rights. Exam point: each rule has a cost, for example central clearing lowers bilateral exposure but concentrates risk in clearing houses.

Formulas

Liquidity coverage ratio

LCR = HQLA ÷ NCO

HQLA: the stock of high-quality liquid assets
NCO: net cash outflows over a 30-day stress period

At least 100%, with inflows capped at 75% of outflows. It tests 30-day going-concern resilience, not what happens in resolution.

Net stable funding ratio

NSFR = ASF ÷ RSF

ASF: available stable funding, each liability and equity item weighted by its ASF factor
RSF: required stable funding, each asset weighted by its RSF factor

At least 100% over one year. Inverting the ratio is the usual slip.

A practice question

From the question bank, with the reason each wrong option is wrong.

The liquidity coverage ratio (LCR) is best defined as:

High-quality liquid assets divided by total balance sheet assets, with a required minimum of 3%Why not: Describes a liquid asset share resembling a leverage ratio, not the 30-day stress coverage test.
Available stable funding divided by required stable funding over a one-year horizon, with a 100% minimumWhy not: This is the net stable funding ratio, not the LCR.
High-quality liquid assets divided by net cash outflows over 30 stressed days, at least 100% - correct
Tier 1 capital divided by risk-weighted assetsWhy not: This is a risk-based capital ratio.

The LCR tests short-term resilience: liquid assets must at least cover net outflows over 30 stressed days. The NSFR covers one-year structural funding.

A harder one

A dealer bank has available stable funding of USD 820 million and required stable funding of USD 900 million. Its net stable funding ratio and compliance status are closest to:

110%, above the 100% minimumWhy not: Inverts the ratio: 900 / 820 = 1.10 instead of ASF / RSF.
91%, below the 100% minimum - correct
9%, far below the minimumWhy not: Uses the shortfall as a share of required funding, (900 - 820) / 900, rather than the ratio.
48%, far below the minimumWhy not: Divides ASF by the sum of ASF and RSF: 820 / 1,720.

NSFR = available stable funding / required stable funding = 820 / 900 = 91.1%. The minimum is 100%, so the bank has a structural funding shortfall of 80.

The hardest tier

A dealer bank has high-quality liquid assets of USD 120 million, projected 30-day stressed cash outflows of USD 200 million and projected 30-day stressed cash inflows of USD 180 million. Applying the Basel rule that inflows are counted up to 75% of outflows, its LCR is closest to:

240% - correct
600%Why not: Counts all inflows: 120 / (200 - 180), ignoring the 75% cap.
60%Why not: Ignores inflows altogether: 120 / 200.
150%Why not: Adds inflows to the liquid assets in the numerator: (120 + 180) / 200.

Inflows are capped at 0.75 x 200 = 150, so net outflows are 200 - 150 = 50. LCR = 120 / 50 = 240%.

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