Adam Kirk, James McAndrews, Parinitha Sastry, and Phillip Weed Matching Collateral Supply and Financing Demands in Dealer Banks • The 2008 failure and near-collapse of some 1. Introduction of the largest dealer banks underscored the complexity and vulnerability of the industry. anks are usually described as financial institutions that Baccept deposits of dispersed savers and use the deposited • A study of dealer banks finds that their unique funds to make loans to businesses and households. This sources of financing are highly efficient in description is accurate but incomplete, as banks also engage in normal times, but may be subject to marked other types of intermediation that finance economic activity. and abrupt reductions in stressful times. Some banks act as dealers in markets, providing liquidity and supporting price discovery by buying and selling finan- • Dealer banks’ sources of financing include cial instruments, helping to facilitate trade in markets. Banks matched-book repos, internalization, and also perform prime brokerage services—a role that involves collateral received in connection with over- providing financing to investors along with many ancillary the-counter derivatives trading. services, such as collateral management, accounting, and analytical services. The banks that engage in these activi- • Under some conditions, U.S. accounting rules ties, which we call dealer banks, facilitate the functioning of allow dealer banks to provide financing for financial markets. more positions than are reflected on their bal- To conduct their business, dealer banks rely on varied ance sheets. Rules that permit netting of certain and, in some cases, unique sources of funding. In most cases, collateralized transactions may not yield a true dealer banks’ lending is collateralized by securities or cash. As economic netting of dealer banks' exposures. in a standard bank, funding for a loan made by the bank may come from the bank’s own equity or from external sources, that is, from parties that are not borrowers from the bank. • A prudent risk management framework Unlike a standard bank, however, dealer banks can employ should acknowledge the risks that inhere in internal sources to fund a customer loan, either by taking a collateralized finance. trading position that offsets that of the customer receiving the Adam Kirk is a risk analytics associate, James McAndrews an executive The authors thank Tobias Adrian, Darrell Duffie, Steven Spurry, and James vice president and the director of research, Parinitha Sastry a former senior Vickery for helpful comments. The views expressed in this article are those of research associate, and Phillip Weed a risk analytics associate at the Federal the authors and do not necessarily reflect the position of the Federal Reserve Reserve Bank of New York. Bank of New York or the Federal Reserve System. Correspondence: [email protected] FRBNY Economic Policy Review / December 2014 127 loan or by utilizing an offsetting position taken by another subject to significant and abrupt reductions in stressful times, customer. For example, the bank may make a “margin loan” to relative to the external financing sources upon which other one customer, lending cash to finance the customer’s security banks rely. That conclusion raises many issues about how purchase, with the customer offering the purchased security as policy should address this type of financial sector vulnerabil- collateral for the bank loan. Another customer may request to ity, which we briefly discuss. In addition, the limitations of borrow the same security to establish a short position, offering existing sources of data on the extent of the use of collateral by cash to the bank as collateral for the loan. The two customers’ dealer banks leads us to recommend more extensive reporting pledges of collateral provide the bank with the resources to of dealer banking financing arrangements. fulfill both customers’ demands for borrowing. That dealer First, we create an analytical and stylized framework of banks can in some cases use the collateral pledged by one cus- dealer banks to outline their major collateralized finance activ- tomer to lend to another, or to fund a trade made by the bank, ities. Under certain circumstances, U.S. accounting rules allow confers a cost advantage since internal sources of funding are the dealer to provide financing for more positions than are re- generally less expensive than external market sources. Dealer flected on its balance sheet. Dealer banks can take advantage of banks also maintain specialization in collateral valuation and netting rules when calculating the size of their balance sheets. management, which reinforces the aforementioned financing For example, under both U.S. and international accounting cost advantages. Consequently, such collateralized lending to standards, the exposure of a dealer bank to a customer that has investors is concentrated in dealer banks. offsetting collateralized positions with the dealer bank can be The interdependence of the financing for the borrowing of reported as the net economic claim on the dealer bank by the one customer and the collateral posted by another customer customer. Consider the following (extreme) example. Suppose, makes the sources of funding for dealer banks vulnerable in as outlined above, Customer A borrows cash and provides ways that are different from those of standard banks. Consider a security as collateral to the dealer bank; suppose, further- that in a standard bank, when a borrower repays a loan, the more, that Customer B borrows the security and provides cash bank can often redeploy the repaid funds as a loan to another collateral to the dealer bank. The dealer bank uses the collateral borrower or as payment to a deposit holder. In contrast, when provided by one customer to satisfy the borrowing demands of a borrower repays the dealer bank, the borrower also reclaims the other. Now suppose that, later, Customer B borrows cash the collateral it posted to the bank. If the dealer has repledged and proffers a different security to the dealer bank as collateral, this collateral to finance another customer’s position, it must and Customer A borrows that security and supplies cash to the find a substitute for the reclaimed collateral returned to the dealer bank as collateral. Then because each customer’s expo- borrower. In other words, the dealer must scramble to find an sure may be eligible to be net on the balance sheet of the dealer, alternative source of the collateral in order to meet its obliga- the dealer may be able to report assets and liabilities equal tions. In times of financial market stress, external parties may to $0, even though it had provided financing in substantial be reluctant to lend to the dealer bank, even against collateral, amounts to the two customers. Consequently, a dealer bank’s so it can be costly and difficult for the bank to seek funding balance sheet captures only a portion of its gross provision of externally. This vulnerability of dealer banks, though similar financing to customers. to that faced by standard banks when depositors withdraw, As a result of this fact, we present both a stylized balance differs in that it occurs instead when borrowers repay their sheet and a stylized collateral record that together allow for loans, reflecting the profound interdependence between the a better representation of how dealers provide collateralized bank’s customers, their borrowing, and their pledges of collat- financing. We then apply this stylized framework to explain eral. Of course, not all of the dealer bank’s funding is internally how dealer banks perform key intermediation functions and generated and so, like standard banks, dealer banks engage in discuss the various methods by which dealer banks can reuse maturity transformation and thus are also susceptible to rapid collateral provided by customers. We review three of them in withdrawals of external sources of funding. detail: matched-book financing, internalization of collateral This article aims to provide a descriptive and analytical financing, and pledging of collateral received in over-the- perspective on dealer banks and their sources of financing. In counter (OTC) derivatives trading. The nature of these activ- reviewing the methods by which dealer banks reuse collateral, ities allows dealer banks to derive efficiencies in their use of we consider various concepts related to collateralized finance, collateral and assist in the performance of financial markets. many of which have been discussed in Duffie (2010, 2011), We also use and apply data in firms’ public disclosures Stigum and Crescenzi (2007), and Committee on the Global to our stylized framework, to the extent that dealer banks' Financial System (2013). We conclude that this type of financ- activities are reflected in such disclosures, and attempt to ing yields high levels of efficiency in normal times, but may be measure the degree to which firms economize and optimize on 128 Matching Collateral Supply and Financing Demands their collateral resources. To determine how much financing benefits captured in the collateralized financing arrangements a dealer bank provides to customers, one must examine the in which dealer banks specialize. First, in a violation of the “collateral record” of a dealer bank, which can be found in its Miller-Modigliani theorem and framework, dealer banks can 10-K and 10-Q public disclosures. However, the nature of the attract funding more cheaply by pledging