Friday, June 6, 2014

Blackrock Pushes Back on FSOC Concerns About Securities Lending

In a May 29, 2014 white paper, Blackrock responded strongly to the Financial Stability Oversight Council’s (FSOC) 2014 Annual Report which raised concerns about asset managers and securities lending. In particular, Blackrock’s paper takes issue with FSOC’s assertion that indemnity provided to lending clients by asset managers acting as securities lending agents created extra risk because asset managers do not face the same capital and liquidity requirements as their bank counterparts. In response, Blackrock said that, “borrower default indemnification is an established practice in securities lending, provided by the majority of lending agents to a variety of clients.” Further, because all securities loans are fully collateralized, lending agents’ exposure for borrower default indemnification is quite limited.

For over two decades, it has been the practice of Lending Agents (both custodial banks and asset managers) to offer to some Lenders indemnification against “Borrower default”—that is, if the Borrower fails to return the securities that have been lent. Some Lenders are required by their investment policies to have this type of indemnification in order to participate in securities lending programs. Borrower default indemnification is limited to the “shortfall” that could occur in the event the collateral delivered is insufficient at the time of default to acquire replacement securities for those out on loan. 

. . . in order for the indemnification to be triggered, there would have to be both a Borrower default and the value of the collateral received would need to be insufficient for repurchase—a confluence of events that has been rarely experienced by any Lending Agent. Importantly, the Lending Agent does not guarantee the investment performance of the securities lending arrangement including the returns on any cash investment vehicle.

In addition, Blackrock explains, borrower default is extremely rare.  

In the more than 30 years since BlackRock and its predecessor entities started our securities lending program, there have been three instances of Borrower default in our program (and four instances in the industry in total). In each instance, BlackRock (including its predecessor entities) has held collateral sufficient to fund the repurchase of securities on loan and has never had its indemnification agreements triggered or had to use its own monies to repurchase a security on a client’s behalf. 

Because of the vanishingly small risk associated with borrower default, under GAAP (generally accepted accounting principles), the associated liability is more often than not deemed immaterial.  

Blackrock takes particular exception to the FSOC’s assertion in their 2014 Annual Report that borrower default indemnification by asset managers is a “Potential Emerging Threat.”  In that document, the FSOC warned:

“Some asset managers are now providing indemnification to securities lenders as part of their securities lending business. There are likely benefits for asset managers from combining indemnification provision with securities lending, but there also is the potential for enhanced risks. Unlike banks, asset managers are not required to set aside capital when they provide indemnification. Also, although asset managers have access to management fees, they do not have access to banks’ stable deposit funding base. Consequently, the indemnification that asset managers provide may be a source of stress on their own balance sheets, while at the same time resulting in lower protection for the lenders relative to indemnities provided by banks.” 

Blackrock strongly rebuts the FSOC’s concerns noting that borrower default indemnification is not new, nor are banks in a better position than asset managers to meet what has historically been a very minute risk.  

Securities lending indemnification is not a new practice, and this statement implies that banks have stronger credit profiles than asset managers and that they can use their deposit base to support securities lending. 

We can only speak for BlackRock. We are rated A1 and AA- by Moody’s and S&P, respectively, which is among the highest in the asset management industry and equal to or higher than other Securities Lending Agents (See Exhibit 2). As noted above, the contingent liability is disclosed in our financial statements, and BlackRock maintains a high level of liquidity. Importantly, BlackRock does not rely on wholesale short-term funding or FDIC-insured deposits for its liquidity.

At this point, the FSOC has not responded to Blackrock’s publication.