Matching Collateral Supply and Financing Demands in Dealer Banks
Parinitha Sastry, and
The failure and near-collapse of some of the largest dealer banks on Wall Street in 2008 highlighted the marked vulnerability of the industry. Dealer banks are financial intermediaries that make markets for many securities and derivatives. Like standard banks, dealer banks may derive the funding for a loan from their own equity or from external sources, such as depositors or creditors. Unlike standard banks, however, dealer banks rely heavily upon collateralized borrowing and lending, which give rise to “internal” sources of financing. This article provides a descriptive and analytical perspective on dealer banks and their sources of financing, both internal and external. The authors conclude that internal sources of financing may prove more efficient than external sources of financing in normal times, but may be subject to significant and abrupt reductions in stressful times. The analysis suggests that accounting rules that allow dealer banks to net certain collateralized transactions may obscure the banks’ actual economic exposure to their customers, and that a prudent risk management framework should acknowledge the risks inherent in collateralized finance.