AJM43.6: Describe policymeasuresthat could alleviatesomeof the firm-specific and systemic risks related to Largedealer banks.
The 2009 PublicPrivateInvestmentPartnership(PPIP)wasinstituted bydieU.S.Treasury Department's2008TroubledAsset Relief Program (TARP) tohelpdealer banks and thefinancial industryrecoverfrom thecrisisat hand.Oneof thepolicyobjectiveswasto mitigate the effect of adverse selectionin die marketfor “tonic’assets,such as theCDOs backedbysubprimemortgages.Adverse selectionis theprinciple diatbuyersareonly willingtobuytheassetsatadeepdiscount dueto the informationasymmetriesthatexist
regardingtheasset's truevalue.Adealer bank maybe forcedtosellilliquidassets inorder
to meetliquidityneeds. Thisresultsinadditional losses duetodie lackofdemandfor those
assets.ThePPIPsubsidizesbiddersof “toxicassets’byofferingbelow-marketfinancingfates and absorbinglosses beyonda predetermined level.
TheUnitedStatesFederal Reserve System and the Bank ofEngland provided newsecured lending facilities tolargedealerbanks when theywere nolongerabletoobtain credit from traditional counterpartiesordierepomarket."When the dealer bank’ssolvencyis
questioned,tri-partyclearing banksarelikelytolimittheirexposuretothe dealer bank.
Atri-partyrepoutilityisproposedasan alternativeandwouldbedesigned tohavefewer conflictingincentivesandless discredonin rollingovera dealer’s repopositions. New standardscould beadaptedfor transactiondocumentation,margin requirements, and daily subsdtutionof collateralwith respect to repos.These standardscouldbeincorporated througheither thenew repoutilityor traditional tri-partyclearingapproaches.
Another potential approachisthecreationofan“emergencybank*1that couldmanage die orderly unwindsof repo positions of dealer banks withliquidity difficulties*The central bankwouldgrantaccessto thediscount windowfor theemergencybank toinsulatecritical clearingbanksfrom lossesduring thisunwindingprocess.
Capital requirementswillmostlikelybeincreasedandincludeoff-balance sheetpositions inanefforttoreduce theleveragepositions of dealer banks.Theseparation of tri- partyrepo clearingfrom ocherclearingaccountfunctionswouldalsoreducea dealer bank’sleverageby tighteningthedealer’scash-managementflexibility.
Centralclearingwillreduce the direat ofOTCderivatives counterpartiesfleeinga
questionabledealer bank.Althoughthis would noteliminate dieliquidityeffectresuldng from aderivativecounterparty reducing theirexposuretoa particulardealer bank,itwould reducethe total exposure to die dealer diat would need tobemanaged throughclearing.
Somelargedealer banks and financialinstitutions areviewed asbeing“too-big-to- fail” basedonthe systemic risk theirinsolvencywould placeon thefinancialmarkets.
Therefore,anotherproposed resolutionforlargedealer banks withquestionable solvency
chataredeemedtoo-big-co-failis to providebridgebanks similar to theapproach usedfor traditional banks.
Topic43
CrossReferencetoCARP AssignedReading-Duffie
KEY CONCEPTS
AIM43.1
Largedealer banksareactive participantsinover-die-counter(OTC)derivatives, repo, andsecuritiesmarkets. Theirfunctionsin thesemarkets,as wellasasset managersand primebrokers, resultin avariety ofliquidity risks when their solvencyIsquestionedand counterparties reducetheirexposurewith them.
AIM43.2
Largedealer banksaresecurityunderwritersin the primarysecuritiesmarket and provide liquidityasimportant counterpartiesin the OTCderivativesmarket and repo markets.
Theyareprime brokers tohedgefundsand ateinvolvedin manyoff-balance sheetactivities, suchasspecial purpose entides(LSPES).The systemic riskin these markets isincreased by
thefact dratdealer banksateoften counterpardes toother dealer hanks.
AIM43.3
The financial crisisbrought new awareness todiseconomiesof scopein risk management
andcorporategovernance.
AIM43.4
Aliquiditycrisis isacceleratedwhen prime hroker clientsorcounterpardesin theOTC
derivativesorrepomarkets question diesolvencyofa dealer bank and desire toexittheir positionsor reducetheir exposures with thedealer hank.
AIM43.5
The basiceconomicprinciplesofaliquiditycrisisfora dealer bankaresimilartoa
traditional bank run.However, the institutional mechanisms and systemicdestructiveness
are much morewidespreadforadealer hank.
AIM43.6
Thecreationofemergencybanksintheform of tri-partyrepo utilitiesandclearingbanks
are policyproposalsco mitigate firmspecificand systemicliquidity riskintheOTC derivatives and repomarkets. TheU.S.Treasury Department’s 200LETroubledAsset Relief Program (TARP) wasdesignedtomitigateadverse selection in “toxic”asset marketsby providingbelow marketfinancingand absorbinglosses abovea pre-specifiedamount.
Page134 ©2013Kaplan,Inc.
Topic43
CrossReferencetoGAKPAssignedReading—Duffie
CONCEPT CHECKERS
Adealer banksliquiditycrisis is leastlikelytobe accelerated by:
A. therefusalofrepurchaseagreementcreditorsto renewtheir positions.
B. theflightof primebrokerageclients.
C. a counterparty'srequestforanovation throughanother dealerbank.
D. depositors removingtheir savings fromthedealerhank.
Banks aremostlikelytodiversify theirexposuretoaspecilicassetclass suchas mortgagesby groupingtheseassetstogetherandsellingthem to:
A. hedgefunds.
B. governmentagencies.
C. the U.S.Federal Reserve.
D. special purposeentities.
The formationoflarge hankholdingcompanies resultsin diseconomiesofscope with respect to:
A. riskmanagement.
B. technology.
C. marketing.
D. financialinnovation.
1.
2.
3.
4. Onepotential solution formitigating theliquidityriskcaused byderivatives counterparties exiting theirlargedealerbankexposuresismostlikelythe:
A. useof centralclearing.
B. use ofa novationthrough anotherdealerbank.
C. requirement of dealer hanks to payoutcashtoreducecounterpartyexposure.
D. creation ofnewcontractsbycounterparties.
Whichof thefollowingitems isnotapolicyobjectiveof theU.S.Treasury
Department’s20DHTroubledAsset Relief Programtohelpdealer hanks recover from thesuhprimemarketcrisis?
A. Provide below-marketfinancing ratesfor bidders of "‘toxic”assets.
B. Absorb lossesbeyonda pre-specidedlevel.
C- Forcethe saleofilliquidassetsinordertobetter determine the‘'true”value.
D. Mitigatetheeffect of adverse selection.
5.
43
CrossReferencetoGARPAssigned Reading-Dufllie
CONCEPT CHECKER ANSWERS
1. D Aliquiditycrisisforadealer hankisacceleratedifcounterpartiestrytoreducetheir exposure by restructuring existingOTC derivativeswith the dealerorbyrequestinganovation.The flightof repocreditorsandprimebrokerageclientscanalsoacceleratea liquiditycrisis.
Lastly,the lossof cash settlementprivilegesisthe finalcollapseofadealer banksliquidity
2. D Bankscandiversifytheir exposuretoaspecificassetclass,suchasmortgages,bygrouping theseassetstogether and sellingthemtospecial pmposcentities.
3. A Someargue that information technology marketing, and financialinnovation resultin economiesofscopeforlargebankholdingcompanicsLConversely,therecentfinancialcrisis raised theconcern that thesizeof bankholdingcompaniescreatesdiseconomiesof scope with respectto riskmanagement.
4. A Onepotentialsolutionfor mitigating theliquidityriskcaused by derivativescounterparties exitingtheirlargedealer bankexposuresistheuseof centralclearing througha counterparty However, centralclearingisonlyeffective when theunderlyingsecurities havestandardized
terms.The reductionofacounterparty'sexposure throughnovation,enteringnewoffsetting
contracts, orrequiringadealer hanktocashoutofaposition will all reduce theliquidityof the dealerbank,
5. C The U.S. Treasury Departments2008TroubledAssetRelief Programwasdesignedto create policiestohelpdealer banksrecoverfromthesubprimemarketcrisisbymitigating the effect ofadverseselection,by providingbclow-markctfinancingratesfor bidders of“toxic”assets,
and byabsorbingJossesbeyondapie-spccificdlevel. Forcing the sale ofilliquidassetswould
worsen theliquiditypositionof the troubled dealerbank,
©2013Kaplan,Inc.
Page136
ThefblluwingisIreviewoftheOjicbniuiulandJlHegtaLedRiskManagement,principle*tieiigiiedLoaddrES*
dieAIMMaLEiiiEiiLs ôelforihby GARTđ, This(ju|)icis alsu Covered in: