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Answer: A significant portion of a dealer bank's over-the-counter derivatives counterparties reduce their exposure to the dealer.
## Explanation In modern dealer bank runs, the key mechanism that leads to failure is when **over-the-counter (OTC) derivatives counterparties reduce their exposure** to the dealer bank. Here's why: ### Traditional vs. Modern Bank Runs - **Traditional bank runs**: Involve retail depositors withdrawing funds from commercial banks - **Modern dealer bank runs**: Involve institutional counterparties reducing exposure through collateral calls and margin requirements ### Why Option C is Correct 1. **OTC Derivatives Exposure**: Dealer banks have extensive OTC derivatives positions with various counterparties 2. **Collateral Calls**: When counterparties become concerned about a dealer's solvency, they demand additional collateral or reduce exposure 3. **Liquidity Drain**: This creates a massive liquidity drain as the dealer must post more collateral or unwind positions 4. **Pro-cyclical Effect**: As the dealer's credit quality deteriorates, counterparties demand even more collateral, creating a vicious cycle ### Why Other Options Are Incorrect - **A**: Repo creditors renewing positions would actually provide stability, not cause failure - **B**: Prime brokerage clients selling securities might reduce assets but doesn't directly trigger a liquidity crisis - **D**: Clearing banks continuing payments would support the dealer, not cause its failure This modern bank run mechanism was evident during the 2008 financial crisis, where dealer banks like Bear Stearns and Lehman Brothers faced liquidity crises primarily driven by counterparties reducing exposure and demanding more collateral.
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The classic bank run occurred when depositors became nervous about the solvency of a bank and raced to withdraw their money, which prompted other depositors to take similar action. In recent years, dealer banks have experienced new forms of bank runs which have quickly eroded their liquidity position and ultimately caused their failure. Which of the following describes a key mechanism which leads to the failure of a dealer bank in this modern version of bank run?
A
A large group of a dealer bank's repo creditors simultaneously renew their positions.
B
Many of a dealer bank's prime brokerage clients sell securities in order to increase their cash balance.
C
A significant portion of a dealer bank's over-the-counter derivatives counterparties reduce their exposure to the dealer.
D
The clearing bank of a dealer bank continues making cash payments to the dealer.