Tuesday, September 27, 2016

SIFMA's Full-Throated Defense of Securities Lending

Author: David Schwartz J.D. CPA

In a 65-page comment letter responding to the Financial Stability Board’s (“FSB”) June 22, 2016 consultation paper, "Proposed Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities,” SIFMA vigorously championed securities lending, and by extension, the asset management industry.  While supportive of the FSB’s recommendations, the lengthy comment letter explains in detail how the concerns expressed in the consultation, particularly with respect to securities lending, are already addressed by market practices, structures, and existing regulation.  


The 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. As we described in our June 26, 2016 blog post, the FSB’s consultation proposes fourteen policy recommendations to address four categories of structural vulnerabilities:


  1. liquidity mismatch between fund investments and redemption terms and conditions for fund units;
  2. leverage within investment funds;
  3. operational risk and challenges in transferring investment mandates in stressed conditions; and
  4. securities lending activities of asset managers and funds.


Among the proposals made by the FSB in the consultation were the implementation of robust liquidity risk management programs, access to a wide range of risk mitigation tools, a better understanding of the use of leverage and securities lending practices across jurisdictions, and effective operational risk plans and practices.


SIFMA has no quarrel with these recommendations generally, but disagrees with the FSB on two critical areas. According to SIFMA, the FSB’s approach with respect to asset management is flawed because the asset management industry is uniquely different from the banking industry, and thus using risk metrics and mitigation techniques appropriate for banks is not appropriate in this context. They also point out that a "deep and intricate regulatory framework that governs the everyday operations of asset managers and investment funds already address many of the concerns presented in the consultation.” For this reason, SIFMA argues that the asset management industry is "well-equipped to continue its track record for successfully meeting shareholder redemptions through normal and stress conditions without presenting a systemic risk to global financial stability."


With regard to the consultation’s proposals on securities lending, SIFMA points out that securities lending in general is not a source of systemic risk. The indemnification practices identified by the FSB as potentially creating systemic risk, while widely employed, are already well regulated. Further, SIFMA points out tht the risk related to individual indemnification liability commitments "is self-contained and limited to the difference between replacement cost of the security and the value of the collateral pledged.”  SIFMA maintains that existing and pending regulations adequately address any risks that may be associated with the practice, and that further regulatory measures may make the practice economically unviable, ultimately limiting securities lending activity to the detriment of financial markets, and potentially increasing systemic risk rather than reducing it.  


As aptly summed up in SIFMA’s own words, securities lending indemnification is a necessary and low-risk activity in an already well-regulated industry. 


"The FSB’s securities lending recommendation relates to a practice—the provision of indemnification by asset manager lending agents—that is triggered in a narrow, specific set of circumstances where a borrower defaults and the borrowed security exceeds the value of the collateral posted in relation to that loan. Historically, there have been an extremely limited number of borrower defaults and none of these defaults have resulted in material financial distress of agent lenders offering securities lending indemnification, given overcollateralization and other risk management practices associated with securities lending. Additionally, numerous existing and proposed regulatory measures as well as risk management practices mitigate risks associated with securities lending."


SIFMA concluded their letter with a recommendation that the FSB hold off extending their asset management risk framework to securities lending indemnification until more and better data about the associated risks can be developed.  


"At any rate, given the limited nature of potential risks associated with borrower default indemnification, this issue does not rise to the level of systemic risk. In light of these considerations, we recommend that the FSB forego issuing specific recommendations until such time as more information demonstrates a clear need for action at the global level to safeguard financial stability. We stand ready to provide information to the FSB and other policymakers in an effort to analyze and understand securities lending activities."


The full text of SIFMA’s comment letter is available via:  http://www.sifma.org/issues/item.aspx?id=8589962265