Primary Dealers Capital Adequacy and Risk Management

Primary dealers are subject to capital adequacy and risk management requirements in order to ensure that they are able to withstand market shocks and meet their obligations.

Capital adequacy

Capital adequacy is the amount of capital that a primary dealer holds relative to its risk-weighted assets. Capital is a buffer that can be used to absorb losses, and risk-weighted assets are a measure of the riskiness of a primary dealer’s portfolio.

Primary dealers are typically required to maintain a minimum capital adequacy ratio (CAR). The CAR is calculated by dividing the primary dealer’s capital by its risk-weighted assets. The specific CAR requirement varies from country to country. For example, in the United States, primary dealers are required to maintain a minimum CAR of 15%.

Risk management

Risk management is the process of identifying, assessing, and managing risks. Primary dealers are required to have in place a comprehensive risk management framework. This framework should include:

  • Risk identification: Primary dealers should identify all of the risks that they are exposed to. This includes risks such as credit risk, market risk, and operational risk.
  • Risk assessment: Primary dealers should assess the likelihood and impact of each risk.
  • Risk management: Primary dealers should implement measures to mitigate or reduce the risks that they have identified and assessed.

MCQs and answers

  1. Which of the following is NOT a reason for primary dealers to be subject to capital adequacy and risk management requirements? (a) To withstand market shocks (b) To meet their obligations (c) To protect investors (d) To maximize profits
  2. Which of the following is a measure of the riskiness of a primary dealer’s portfolio? (a) Capital adequacy ratio (b) Risk-weighted assets (c) Leverage ratio (d) All of the above
  3. Which of the following is a component of a comprehensive risk management framework? (a) Risk identification (b) Risk assessment (c) Risk management (d) All of the above

Answers:

  1. (d)
  2. (b)
  3. (d)

Additional notes

Primary dealers play a vital role in the government securities market. By ensuring that primary dealers are adequately capitalized and have effective risk management frameworks in place, regulators can help to protect the government, investors, and the broader financial system.