On June 22, 2016, the Financial Stability Board (FSB) published a consultation paper proposing a framework to address four areas it sees as structural vulnerabilities from asset management activities that could potentially present financial stability risks. The consultation, Proposed Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities, proposes 14 policy recommendations to address four categories of structural vulnerabilities:
- liquidity mismatch between fund investments and redemption terms and conditions for fund units;
- leverage within investment funds;
- operational risk and challenges in transferring investment mandates in stressed conditions; and
- securities lending activities of asset managers and funds.
This consultation is part of the FSB’s larger effort launched in 2015 to understand and address potential financial stability risks from structural vulnerabilities associated with asset management activities, in part due to recent growth in asset management activities. The policy recommendations proposed in the consultative document are designed to provide authorities and asset management entities with the tools and data to effectively detect and address the identified risks. The FSB intends to finalize the policy recommendations by the end of 2016, some of which will be implemented with assistance from the International Organization of Securities Commissions (IOSCO).
With regard to securities lending, the FSB sees a number of potential systemic risks associated with securities lending activities by asset managers, including maturity/liquidity transformation and leverage associated with cash collateral reinvestment, procyclicality associated with securities financing transactions, risk of fire sales of collateral securities, and inadequate collateral valuation practices. While the consultation acknowledges that, “in general, regulatory tools and risk management practices seem to be in place for funds that engage in securities lending as beneficial owners and for asset managers acting as agent lenders,” the FSB sees regulatory inconsistency and borrower default indemnification as particularly in need of attention.
"Another potential vulnerability that may have systemic implications is the risk associated with agent lender indemnifications especially if done on a large scale. If most securities lenders would not engage in securities lending absent such a guarantee, an impairment of the value of this indemnification commitment could lead lenders to withdraw suddenly from the market, forcing securities borrowers to exit their positions or find another lender of securities, possibly affecting asset prices and market liquidity. A defaulted indemnification commitment could lead to widespread concern about the ability of other agent lenders to meet their indemnification commitments. Although very few asset managers seem to be currently involved in providing such indemnifications, the scale of exposures can be as large as that of some global systemically important banks (G-SIBs)."
According to the consultation, FSB believes that “the existing FSB policy recommendations to address financial stability risks associated with securities financing transactions, if implemented appropriately,should eventually introduce consistency in the design and risk coverage of policy tools in addressing financial stability risks across jurisdictions.” On the other hand, FSB sees serious gaps in regulatory measures addressing indemnity associated with securities lending activities:
"Although data on asset managers’ involvement in agent lender activities is limited, a few asset managers provide agent lending services, and sometimes offer indemnification to securities lenders for losses associated with the non-return of lent securities. While some of the risks associated with indemnification (e.g. counterparty, collateral value) are similar to those faced by beneficial owners and are subject to similar regulatory measures, some risks remain that are not fully addressed by regulatory measures:
- Potential losses associated with indemnification-related exposures - Agent lender banks (and bank-affiliated asset managers subject to consolidated prudential oversight) are subject to the Basel capital requirements for potential losses resulting from indemnification-related exposures. In contrast, asset managers and other entities that are not affiliated with banks do not face capital requirements related to their indemnification exposures in any jurisdictions.
- Opacity risk related to indemnifications - To address opacity risk related to indemnifications, some jurisdictions require publicly offered investment funds to disclose any indemnities provided by securities lending agents. For bank-affiliated asset managers, the FSB recommended that the Enhanced Disclosure Task Force should work to improve public disclosure for financial institutions (i.e. banks) on any indemnifications provided as agent to securities lending clients, including a maturity profile of those contingent liabilities where appropriate. However, such a recommendation does not exist for other types of financial institutions offering securities lending indemnities."
FSB also sees other gaps in the regulation of agent lender indemnities that could lead to undue concentration of systemic risk outside of the banking sector:
"The difference in regulatory requirements relating to indemnification risk for bank and non-bank agent lenders may create an incentive for agent lending activity to migrate away from prudentially regulated entities and could potentially result in a concentration of systemic risks outside the banking sector. If a shock occurred that was large enough to overwhelm an asset manager’s ability to meet its indemnification commitments, such an impairment could precipitate a contraction of securities lending activity more generally if clients of other asset managers question the value of the indemnification they have received. Such a withdrawal could disrupt other market participants’ funding strategies, short positions, and collateral management activities, exacerbating market stress. These risks may be effectively addressed through an appropriate regulatory framework that enhances consistency of treatment across agent lenders, irrespective of entity types."
FSB recommends that regulatory authorities take action to better monitor indemnity provided by agent lenders/asset managers to clients in relation to their securities lending activities. If these monitoring efforts detect the development of material risks or regulatory arbitrage that may adversely affect financial stability, the consultation recommends that authorities should verify and confirm asset managers adequately cover potential credit losses from the indemnification provided to their clients.
Comments on the consultation are due by September 21, 2016.