AIM43-4: Identifyfactors thatcanprecipitateor acceleratea liquiditycrisisat adealer bank and what prudent riskmanagement stepscanbe taken tomitigate these risks.
Aliquiditycrisisforadealer bankisacceleratedifcounterpartiestry to reducedieir exposureby restructuringexistingOTCderivatives with die dealerorby requestinga novation (as discussedin thefollowing).Theflightofrepocreditorsand primebrokerage clientscanalso acceleratealiquiditycrisis.Lastly, the lossofcashsettlementprivilegesis the finalcollapseofadealer bank’s liquidity.
Asmentioned previously, whenOTCderivativescounterparties question thesolvencyofa
dealer bank, theywillbegin toreducetheir exposurestothe dealer. Acounterpartycould reducetheir exposurebyborrowingfrom thedealerorby enteringinto newoffsetting derivadvescontractswith diedealer. Acounterpartymay alsorequest tohavein-the-money options revisedto at-the-money strikepricesand, thus, reducetheir exposure tothe dealer byreceiving cash from the option position.
Anothermeansthatacounterpartyhasof reducingdieirexposure toadealer isthrough a
novation to anotherdealer.Forexample,a hedgefundmay useacredit defaultswapfrom a dealerto protect themselvesfromalossonaborrower. If die hedgefundwasconcerned about thesolvencyof die dealer bank, dieyoouldrequest anovationfrom another dealer bankto protectthemselvesfrom default arising from theoriginaldealer hank.Achough thesenovations areoftengrantedbydealerbanks, in diecaseof BearStearns,die request wasdenied,which raised additionalconcernsregardingthesolvencyofBear Stearns.In addition todecreasing the reputation capital andfranchise value of this dealerbank,the liquidityposition wasalso underincreasedstress.A novationcould result in die removal of the cash collateral of theoriginal dealerhank and transfer of diis collateral to thesecond dealer bank.
Central clearing mitigatesdieliquidityriskcausedbyderivativescounterparties exiting theirlargedealer bankexposures. OTCderivativesare novatedor“cleared” toacentral clearingcounterpartythat stands between the original counterparties. Theuseofacentral clearingcounterpartyalso mitigates die systemic risk of financial marketsandinstitutions when thesolvencyofalargedealer bankisquestioned.However, the use of centralclearing
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counterparties Is onlyeffective withderivatives that containrelativelystandard terms.
Thus,this wasnot aneffective meansofdealing with the infamouscustomizedAIGcredit derivatives,
Furtherliquiditypressurecanariseifderivative counterpartiesdesireto reducetheir exposurebyenteringnewcontractsthatrequire diedealer banktopayoutcash.For example,adealer bank maytry tosignaltheirstrength tothe market hy quoting
competitivebid-askspreadsonanOTC option.If the bid priceis then accepted,die dealer mustsettlewithacash payment todiecounterpartywhich reducestheirliquidity.If the dealerrefusesto quotecompetitivehidprices,it mayfurther signal theirliquidityconcerns
to diemarket*
Money marketfunds,securitieslenders,and other dealer banks financesignificant
fractionsofa dealerhank’sassets throughshort-term repurchaseagreements.Asmentioned previously, ifthe repocounterpartyquestionsthesolvencyofadealer bank, theyare
unlikely to renewrepos.In thisevent, the repo creditors may havean incentive, orhe legallyrequired, tosell thecollateralimmediately. Ifthesaleof the collateralisless than the cash position, then die dealercounterpartymay facelitigation for die improperdisposalof
assets.Withoutagovernment,orcentral bank steppinginasa lenderof last resort,dealer banks haveno place toturnwhen reposare not renewed.Theycouldreinvest their cashin
newrepos, butothercounterpartiesare unlikelyto take these positions ifthedealer bank’s solvency isquestioned,
Thedealerhankcan mitigatetheliquidity riskcausedhyarun of short-term creditors by establishinglinesof bankcredit, holdingcash andliquidsecurities,and byladdering the maturities ofitsliabilities. When adealer bankladdersitsliabilities,thematurities arespreadoutover timeso thatonlyasmall fraction ofitsdebt needsto be refinanced overnight.In 2008,theNewYork FederalReserveBankcreated thePrimary Dealer Credit Facilityto finance securities ofinvestment banks.Immediately following thefailureof
Lehman,the remainingtwo dealerbanks,MorganStanley andGoldmanSachs,became regulatedbankholdingcompanies.Asa bankholdingcompany,the firmsgainedaccessto the discountwindow and could turn to thegovernmentfor financialsupport,including
FDJCdeposit insurance and loanguarantees,
Primehrokerageaccountsarea sourceof cash inflows forlarge dealer banks.In normal circumstances,the cash andsecuritiesof primehrokerageclientsarea sourceofliquidity for the bank.In the United Kingdom,assetsfrom client prime brokerageaccountsare
commingledwith the hanksownassets. However, in the UnitedStates,dealer hanksare allowedto pool themoney togetherinto a separate account from the bank’sown funds.
Thus,die prime brokerisable touse the cashfromoneclienttohelpmeettheliquidity needsofanotherclient.
Asmentioned previously,when thesolvencyofa prime broker isquestionable,ahedgefund coulddemand cashmarginloans from the dealer thatarehacked bydie securitiesheldin theiraccountwith the prime broker.Theprime brokermay notbe able to usethosesame securitiesascollateral with other lenderswho may question theirsolvency.Lenders may
notfindanyincentive rolend to thequestionabledealer hank.Thus,even withouta run hy primebrokerageaccounts,considerablestraincouldhe placedon die dealer bank’sliquidity position.
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In addition,if prime broker clients do leaveoilshort notice, then their cash andsecurities arenolongerin thepoolof funds to meetthe needs of other clients. In thiscase,the dealer hankmust useits owncashto meetliquidity needs.The reductionof collateralsecurities
caused bytheflightof primebrokerageclientscan lead toasystemicshortageof collateral andaliquiditycrisis.In thefuture, hedgefundsarelikelyDOmitigate their exposuretoafew dealer hankshy diversifyingtheir sources of primebrokeragewithcustodian hanks.
Under normalconditions,aclearinghankmayextenddaylightoverdraft privileges to clearingcustomerswhoarecreditwordiy,However,when diesolvencyofadealer bank isquestioned; dieclearingbank mayrefuse to process transactions thatareinsuflficiendy funded by the dealer banks cash fundaccount. Forexample,in thecase of Lehman'sdefault,
J.P Morgan Chasewastheclearingbank diat invokeditsTullright of offset.51Underdlls legalright, j,P MorganChase was abletooffset dieirexposuresusing Lehman'scash,andat
thesame time,discondnued tomake cashpaymentsduringthedayonLehman transactions thatwould bringLehman’saccount belowzero.The failure to meetits transactions
obligationsoil thatdayforcedLehmanintobankruptcy.Tomidgatethis riskin thefuture,
‘'emergency hanks’' areproposed toactaseitheraclearinghankora tri- partyrepo"utility.”
AIM43.5: Compare aliquiditycrisis atadealer banktoa traditional bankrun.
The basiceconomicprinciples causingaliquiditycrisis,and potentially theinsolvency ofa large dealer hank,arenot diat differentfrom thetraditionalretail hank run. Banks mayfinanceilliquid assetswith short-termdeposits. However, an unexpected liquidity demandfrom depositorsor theinabilityof borrowerstorepay their loans may lead to concernsabout the solvency of die hank.If theconcern persists, a hank runcould leadto
liquidityproblems,and theconcernaboutthe bank’s failure could end upasaself-fulfilling prophecy.
Whilediebasiceconomicprinciplesofabankrun aresimilarfor large dealer banks andretail hanks, theinstitutional mechanisms and thesystemicdestructivenessarevery different.Forexample, dealerhanks playanessential rolein providing liquidityin the OTCderivatives andsecuritiesmarkets. When thesolvencyofadealer hankisquestioned, counterparties of these marketsandprimebrokerageclientsbegin toreduce their exposure
to the dealer. TheOTCderivativescounterpartymay reduce theirexposure byborrowing from diedealer,enteringnewoffsettingderivativescontractswith thedealer, or requesting a novation,Acounterpartymay also request toreceivecashfrom options positions thatare
in-the-money byhavingthem revised toat-die-money.Prime hroker clientsmayremove collateral andcash, whichresultsinfurtheracceleratingtheliquiditycrisis.Thefact chat
dealer hanksareoften counterparties toother dealer banksincreasesthe systemic riskinthe financial marketswheredealer hanksplayessential roles.
Anotherarea that dealer banksarevery activeinvolving liquidityistherepomarkets.
Especiallyincaseswhere the dealer banksarehighlyleveraged, theliquidity position isseverelydireatened when the dealer bankssolvencyisquestionedandcounterparties areunwillingto renewrepo positionsovernight.Thus,adealer hankisinvolvedin many functions thatresultinincreased liquiditypressures that traditionalhanksarenot
exposedro.
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