by Adam Kirk, James McAndrews, Parinitha Sastry, and Phillip Weed – Liberty Street Economics, Federal Reserve Bank of New York
This post is the eighth in a series of thirteen thirteen thirteen  on Large and Complex Banks.
The failure or near-collapse of some of the largest dealer banks on Wall Street in 2008 highlighted the profound complexity of the industry. In some ways, dealer banks resemble well-understood traditional banks, which use deposits they receive from savers to make loans to businesses and households. Unlike traditional banks, however, dealer banks rely on complex and unique forms of collateralized borrowing and lending, which often involve the simultaneous exchange of cash and securities with other large and sophisticated financial institutions. During normal times, such transactions are highly efficient methods for allocating scarce resources. During times of stress, in contrast, they’ve proven to be destabilizing for the individual firms and, as recent history has shown, the financial system at large.
Dealer banks often receive collateral in connection with their lending and market-making activities. In many cases, the collateral received is permitted to be repledged in transactions that generate financing for the dealer bank. Dealer banks, aiming to maximize their income and minimize the cost of various regulatory constraints, optimize their business model by matching their sources and uses of collateral. The benefit from the reuse of collateral, namely the ability to secure additional low-cost financing, is enhanced when a dealer bank efficiently intermediates between those clients that demand cash and possess securities and those that demand securities and possess cash. In our contribution to this Economic Policy Review series, we focus on three categories of secured activities that exemplify such efficiencies: matched-book dealing, cash brokerage internalization, and derivatives dealing.
Matched-Book Dealing
Dealer banks often refer to a balance sheet in which repurchase agreements finance offsetting reverse repurchase agreements as a “matched book.†In a typical matched-book transaction, a client provides a security as collateral in exchange for cash and grants the dealer the right to repledge this collateral; the dealer then repledges this security to another client to source the cash. As a result, the dealer’s balance sheet does not reflect any security owned, though it does reflect both a claim to cash and an obligation to return cash at a future date. In practice, “matched-book†transactions aren’t always as perfectly “matched†as the name suggests; dealer banks often engage in significant amounts of maturity, credit, and collateral transformation, exposing them to interest rate, liquidity, and credit risk.
