Major Lines of Business

• The main lines of business of large dealer banks include the following –

1. Securities dealing, underwriting, and trading
2. Over-the-counter derivatives
3. Prime brokerage and asset management

1. Securities Dealing, Underwriting and Trading

• Dealer banks intermediate in the primary market between issuers and investors of securities, and in the secondary market among investors.

• In the primary market, the dealer bank, sometimes acting as an underwriter, effectively buys equities or bonds from an issuer and then sells them over time to investors.

• In secondary markets, a dealer stands ready to have its bid prices hit by sellers and its ask prices hit by buyers. Dealer banks dominate the intermediation of over-the-counter securities markets, covering bonds issued by corporations, municipalities, certain national governments, and securitized credit products.

• Banks with dealer subsidiaries also engage in speculative investing, often called proprietary trading, which can be aided in part by the ability to observe flows of capital into and out of certain classes of securities.

• Securities dealers also intermediate in the market for repurchase agreements. The performance risk on repo is typically mitigated by a “haircut” that reflects the risk or liquidity of the securities. For instance, a haircut of 10 percent allows a cash loan of $90 million to be obtained by posting securities with a market value of $100 million.
• For settlement of their repo and securities trades, dealers typically maintain “clearing accounts” with other banks.

Risks associated with securities dealing, underwriting and trading –

• Due to the lax regulations surrounding the capital requirement of the dealer banks before the crisis, they were operating at very high levels of leverage.

• Thus, one can see the problems that such institutions would face in case there is a serious shakedown in the financial system. The solvency risk that these institutions faced during the crisis, raised many questions regarding the stability of the dealer banks. The idiosyncratic risk associated with individual firms can increase sharply if there is even a rumor of financial problems at the firm, provided that there is enough paranoia in the market.
• Further, it was realized during the financial crisis, that sometimes due to various reasons, the government might not step in to save financial institutions. This is a big problem because once dealer banks are stuck in a position where their repos are not renewed, they are almost solely reliant on the government to step in as the lender of the last resort.

• Further, it is important to note that dealer banks often act as counterparties for other financial institutions and are crucial for the smooth functioning of the financial system. Thus, if a major dealer bank goes bankrupt, it can cause shock waves that can reverberate throughout the financial system.

2. Over The Counter Derivates

• Because over-the-counter derivatives are negotiated privately, they can easily be customized to a client’s needs. For most over-the-counter derivatives trades, one of the two counterparties is a dealer.

• The dealer usually lays off much or all of the risk of its client-initiated derivatives positions by running a “matched book”, that is, by aiming for offsetting trades, profiting on the differences between bid and offer terms.

• As in their securities businesses, dealer banks also conduct proprietary trading in over-the- counter derivatives markets. It is an accounting identity that the total market value of all derivatives contracts must be zero – that is, the total amount of positive (purchased) positions is equal to the total amount of negative (sold) positions.

Risks associated with over-the-counter derivatives –

• Contingent on events that may occur over time, derivatives transfer wealth from counterparty to counterparty, but do not directly add to or subtract from the total stock of wealth. Indirectly, however, derivatives can cause net losses through the frictional costs of bankruptcies, such as legal fees, and other costs associated with financial distress.
• Dealer banks are important players in the OTC market. Usually, the market is dominated by a small group of very large financial institutions and so a problem at one institution can cause a sharp rise in systematic risk throughout the OTC market.

• The recent crisis, provides evidence of how when major financial institutions that have tentacles across the financial system (and especially in the OTC market) go bankrupt, it can create a systematic crisis that may cause further bankruptcies – as all of a sudden hundreds of institutions would be holding just one end of huge OTC contracts.

3. Prime Brokerage and Asset Management

• Several large dealers are extremely active “prime brokers” to hedge funds and other large investors. A prime broker provides clients a range of services, including-

i. Management of securities holdings

ii. Clearing

iii. Cash-management services

iv. Securities lending

v. Financing

vi. Reporting (which may include risk measurement, tax accounting, etc).

• A dealer may frequently serve as a major derivatives counterparty to its prime-brokerage clients. A dealer often generates additional revenues by lending securities that are placed with it by prime-brokerage clients.

Risks associated with prime brokerage and asset management –

• Some of the major risks associated with the dealer banks, acting as prime brokers, has to do with perception of the stability of such institutions in the eyes of their clients.
• If clients believe that the solvency situation of a dealer bank is in trouble, they may demand additional collateral, which would reduce the total amount of collateral that the dealer bank can post elsewhere. This would weaken the liquidity position of the bank.

• Another major problem would occur if the main clients of the dealer bank, acting as a prime broker in this case, decide to leave, resulting in huge amounts of cash, as well as collateral, getting evaporated from the coffers of the dealer banks.

Causes of Liquidity Crisis at Dealer Banks

• The main causes of liquidity crisis at dealer banks are –

1. The Flight of Short-Term Creditors

• Large dealer banks tend to finance their assets in various ways, including by issuing bonds and commercial paper. Increasingly over recent years, they have financed the purchase of their securities inventories with short-term repurchase agreements. The counterparties of these repos are often money-market funds, securities borrowers, and other dealers. Repos with a term of one day, called “overnight repo”, are common.

• Under normal pre-crisis conditions, a dealer bank might have been able to finance most of its holdings of agency securities, treasuries, corporate bonds, mortgages, and collateralized debt obligations by daily renewal of overnight repos with an average haircut of under 2 percent. The dealer could therefore hold these securities with little incremental capital.

• Before their failures, Bear Stearns and Lehman had leverage ratios (the ratio of assets to equity capital) of over 30, with significant dependence on short-term repo financing. Although the repo creditors providing cash to a dealer bank have recourse to collateralizing assets, with haircuts that protect them to some degree from fluctuations in the market value of the collateral, they may have little or no incentive to renew repos in the face of concerns over the dealer bank’s solvency.
• Additionally, the repo creditors could be legally required to sell the collateral immediately or could potentially face litigation over allegations of improper disposal of the collateral.

• The repo creditors can avoid these risks and other unforeseen difficulties simply by reinvesting their cash in new repos with other dealers. If a dealer bank’s repo creditors fail to renew their positions, the ability of the dealer to finance its assets with sufficient amounts of new private-sector cash on short notice is doubtful. The dealer may therefore be forced to sell its assets in a hurry to buyers that know it needs to sell quickly. This scenario, called a “fire sale”, can easily result in much lower prices for the assets than might be expected in a more orderly sale. The proceeds of an asset fire sale could be insufficient to meet the dealer’s cash needs, especially if the dealer’s original solvency concerns were prompted by declines in the market values of the collateral assets themselves.
• A fire sale could also lead to fatal inferences by other market participants of the weakened condition of the dealer. Further, the low prices recorded in a fire sale could lower the market valuation of the securities not sold, and thus reduce the amount of cash that could be raised through repurchase agreements collateralized by those securities, prompting a “death spiral” of further fire sales.

2. The Flight of Prime Brokerage Clients

• Prime brokerage, as described earlier, is an important source of fee revenue to some dealer banks. Under normal conditions, prime brokers can also finance themselves in part with the cash and securities that clients leave in their prime brokerage accounts.

• The ability to aggregate cash associated with clients’ free credit balances into a single pool, although separate from the prime broker’s own funds, provides flexibility to a prime broker in managing the cash needs of its clients. For example, the prime broker can use one client’s cash balances to meet the immediate cash demands of another.
• Suppose that a dealer has two prime brokerage clients. It holds cash belonging to Hedge Fund A of $150 million and has given a cash loan to Hedge Fund B for $100 million. The excess cash of $50 million must be held in a reserve account. But if Hedge Fund A moves its prime brokerage account to another dealer, then the original prime broker must come up with $100 million of cash from new sources.

• Margin loans for a dealer bank can also be financed using the client’s own assets as collateral, through “re-hypothecation”.

• Re-hypothecation of securities received from prime brokerage clients is, under normal conditions, a significant source of financing for the prime broker. When a dealer bank’s financial position is weakened, hedge funds may move their prime brokerage accounts elsewhere. A failure to run, as Lehman’s London-based clients learned, could leave a client unable to claim ownership of assets that had not been segregated in the client’s account and had been re-hypothecated to third parties.

• If prime brokerage clients do run, however, the cash that they pull from their free credit balances is no longer available to meet the demands of other clients on short notice, so the prime broker may be forced to use its own cash to meet these demands. The exit of prime brokerage clients whose assets had been used by the prime broker as collateral for securities lending can eliminate a valuable source of liquidity to the prime broker.
• Even clients that do not move to another prime broker may, in the face of concerns over their broker’s solvency, move some of their securities into accounts that restrict the access of the prime broker to the securities – which again would have a similar effect.

3. When Derivatives Counterparties Duck for Cover

• If a dealer bank is perceived to have some risk of a solvency crisis, an over-the-counter derivatives counterparty would look for opportunities to reduce its exposure to that dealer bank. A variety of mechanisms are possible here.

• A counterparty could reduce its exposure by borrowing from the dealer. Another strategy is to reduce the exposure by entering new trades with the dealer that cause that dealer to pay out cash for a derivatives position. A counterparty could also seek to harvest cash from any derivatives positions that have swung in its favor over time, and thereby reduce exposure to the dealer.
• All of these actions reduce the dealer’s cash position. If the dealer wants to avoid an adverse signal of its weakness, the dealer cannot afford to refuse its counterparties the opportunity to make these trades at terms prevailing elsewhere in the market.

• A counterparty to the dealer could also reduce its exposure through novation to another dealer. For instance, a hedge fund that had purchased protection from a dealer on a named borrower, using a credit default swap contract, could ask a different dealer for a “novation”. The new dealer would thereby offer protection to the hedge fund and buy protection itself from the original dealer, thus insulating the hedge fund from the default of the original dealer.

• When Bear Stearns’ solvency was threatened in mid 2008, some of Bear Stearns’ counterparties asked other dealers for novation’s, by which those dealers would effectively absorb the risk of a failure by Bear Stearns. Although dealers routinely grant such novation’s but, in this case other dealers began to refuse these Bear Stearns novations. This in turn is likely to have spread alarm over Bear Stearns’s difficulties, leading to actions that are likely to have worsened Bear Stearns’s cash position.
• Most over-the-counter derivatives contracts are exempted by law as “qualifying financial contracts” from the automatic stay at bankruptcy that holds up other creditors of a dealer. The effect of unwinding the dealer’s derivatives portfolio is a large post-bankruptcy drain on the defaulting dealer, with priority to derivatives counterparties. This raises the incentive of other creditors to run from their exposures before default or to fail to finance a dealer threatened by a cash liquidity crisis, further accelerating the default.

4. Loss of Cash Settlement Privileges

The final step in the collapse of a dealer bank’s ability to meet its daily obligations is likely to be the refusal of its clearing bank to process transactions. In the normal course of business, a clearing bank would extend “daylight overdraft privileges” to its creditworthy clearing customers.

• For example, the cash required to settle a securities trade on behalf of a dealer client could be wired to the dealer’s counterparty (or that counterparty’s own clearing bank) before the necessary cash actually appears in the dealer’s clearing account on that day, under the premise that the dealer will receive sufficient cash from other counterparties during the day in the course of settling other transactions. Meanwhile, the dealer holds securities in its clearing account with a market value that is likely to be more than sufficient to cover any potential shortfall.

• When a dealer’s cash liquidity comes into doubt, however, a clearing bank has a “right of offset”, a contractual right to discontinue making cash payments that would reduce the account holder’s cash balance below zero during the day, after accounting for the value of any potential exposures that the clearing bank has to the account holder.
• In the case of Lehman’s default, for instance, it has been reported that Lehman’s clearing bank, JPMorgan Chase, invoked this right, refusing to process Lehman’s instructions to wire cash needed to settle Lehman’s trades with its counterparties. Lehman was unable to meet its obligations on that day and entered bankruptcy.

Policy Measures to Alleviate Firm-Specific & Systematic Risks

• Policies for the prudential supervision, capital requirements, and failure resolution of traditional commercial banks have been developed over many years and are relatively settled.

• The financial crisis, however, has brought significant new attention to policies for reducing the risks posed by large systemically important financial institutions, particularly dealer banks. The regulatory changes currently envisioned for systemically important financial institutions in both the United States and Europe include –

a) Higher capital requirements

b) New supervisory councils

c) Special powers to resolve the problems of financial institutions as they approach insolvency or illiquidity.

• Banks sponsoring securitization deals will also be required to hold at least a minimum level of exposure to the securitized cash flows, in an attempt to give them the incentive to lower the risk of these securitization structures.

• Capital requirements are likely to be higher for derivatives that are not guaranteed by a central clearing counterparty. Information about derivatives positions will be placed into repositories available to regulators. To this point, however, proposed regulations are unlikely to result in the safe resolution of dealer banks that depend on large amounts of overnight repo financing and have large over-the-counter derivatives portfolios. Most repos and over-the-counter derivatives are qualifying financial contracts that are exempt from automatic stays at bankruptcy.
• Runs by short-term secured lenders and over-the-counter derivatives counterparties may continue to contribute to the failure mechanics of large dealer banks and to systemic risk. Perhaps the most important source of systemic risk is the potential impact of dealer-bank fire sales on market prices and investor portfolios. In the recent financial crisis, the risk of fire sales was significantly mitigated by lender-of-last-resort financing by central banks, and by capital injections into dealer banks, such as those of the Bank of England and the U.S. Treasury Department’s Troubled Asset Relief Program (TARP). Some of these facilities are likely to be costly to taxpayers and to increase moral hazard in the risk taking of large dealer banks going forward, absent other measures.
• Another set of policy steps considers the problems of short-term tri-party repos, which are a particularly unstable source of financing in the face of concerns over a dealer’s solvency. Because triparty clearing banks have an incentive to limit their exposures to a dealer bank, they are likely to limit the access of a weakened dealer bank to repo financing and to clearing account functions. There are potential benefits of a tri-party repo “utility”, which would have less discretion in rolling over a dealer’s repo positions, meet high standards, and suffer from fewer conflicting incentives.

• Another approach, is central-bank insurance of tri-party repo transactions. Yet another approach under discussion is an “emergency bank”, to be financed by repo market participants, that could manage the orderly unwinds of repo positions of weakened dealers. The emergency bank would have access to discount-window financing from the central bank and would insulate systemically critical clearing banks from losses in the course of the unwinding process.

• The threat posed by the flight of over-the-counter derivatives counterparties can be lowered by central clearing. Sufficiently extensive and unified clearing can reduce the total exposure of market participants to any given dealer through the multilateral netting of positive against negative exposures.
• Obviously, the financial strength of large central clearing counterparties is crucial, as is their implicit government backing. Currently, the majority of over-the-counter derivatives positions are not centrally cleared. There has been modest progress toward clearing significant quantities of over-the-counter derivatives that are based on equities, commodities, and foreign exchange.

• The challenge of how to clear a greater share of derivatives and how to deal with the fact that many derivatives are not standard has only been partially addressed through legislative proposals that include higher regulatory capital requirements for uncleared derivatives. A further set of proposals addresses the pre-failure resolution of dealer banks that are suffering grievous financial distress.

• Dealer banks could be given regulatory incentives or requirements to issue forms of debt that, contingent on stipulated distress triggers, convert to equity. A proposition could be that distress-contingent convertible debt be complemented with regulations favoring mandatory rights offerings of equity that, similarly, are automatically triggered by leverage or liquidity thresholds.
• These two new instruments can be designed to recapitalize a financial institution before a destructive run is likely to commence, and to reduce a financial institution’s incentives for socially excessive risk taking.

• The financial crisis has made clear the need to reconsider the systemic risks posed by the failure of dealer banks and has provided new insights into the mechanics by which they fail. The task of building new institutional mechanisms to address these failure mechanics is timely and urgent.