Sunday, December 21, 2014
Borrower default indemnification, sometimes referred to as a “securities replacement guarantee,” is fairly common in the securities lending industry. Under the typical arrangement, should a borrower of a security fail to return it at the end of the loan, the lending agent agrees to purchase a replacement security for the lender using the proceeds of the collateral posted by the borrower for the loan. The indemnity is applicable if the price of the replacement security exceeds the value of the collateral. In such a case, the lending agent agrees to make up the difference.
For many years, banks have provided borrower default indemnification as part of their securities lending services, which has given beneficial owners additional assurance as to the safety of their lending programs, and has allowed pension funds and others for whom such indemnity is legally required to participate in the securities lending market as well. Up until now, banks offering this kind of guarantee have not been required to reserve capital for the associated contingency, and indemnification costs have typically been bundled into the overall fee for services agreed to by beneficial owners and their agents. Lately, however, the Financial Stability Oversight Council (FSOC) and others have questioned whether this kind of indemnification is a source of stress on the balance sheets of banks, and potentially a threat to financial stability. Also, banking and other regulators are exploring whether borrower default indemnification should be swept into new Basel III leverage ratios and reserve capital requirement, which could make indemnification unviable.
The FSOC’s most recent annual report noted:
"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."
Many, like Blackrock, say that the contingency is so small as to be immaterial, both on an “expected value” basis as well as an assessment of “stress risk," and thus there is no need to reserve for it.
"To date, we believe that the regulatory capital treatment of indemnification for U.S. agent banks has not been a significant contributor to risk weighted exposures and capital, as the overcollateralization of securities loans, often with Treasury securities or cash, translates to a low (or in some cases zero) risk-weighted charge. We understand that, with U.S. regulatory approval, some agent banks have had the option of using internal Value-at-Risk modeling methods as an alternative to standardized models-based approaches to comply with regulatory requirements. Going forward, the proposed rules contemplate a new set of "standardized" haircuts based on loan and collateral type, which will need to be applied to both loans and collateral, with no correlation offset. This is likely to increase the risk-weighted exposure and capital associated with indemnification."
"Based on its review, and recognizing that actual estimates of risk weighted exposure will be both institution- and portfolio-specific, BlackRock is reasonably confident that its unencumbered liquidity holdings are comparable to our understanding of the proposed regulatory capital treatment of securities lending."
In addition to being unnecessary from a risk perspective, forcing lending agents to reserve for indemnity exposure or imposing liquidity requirements may also make indemnification uneconomically expensive or eliminate it from the securities lending business entirely. This in turn would push out many beneficial owners from securities lending whom are required to have buyer default indemnity for regulatory reasons. According to Blackrock:
"Borrower default indemnification is an established practice in securities lending, provided by the majority of Lending Agents to a variety of their clients. Some clients may only participate in securities lending programs if there is explicit indemnification. Capital, liquidity or other similar requirements imposed on indemnification, if too high, will make indemnification uneconomical, and likely reduce participation by Lenders in the practice of securities lending. This reduction will negatively impact both asset owners who have benefitted from the income derived from securities lending activities, and market liquidity."
The effective dates for the Leverage Ratio and final Basel III capital reserve standards are approaching, with some coming online in mid 2015, and others phasing in by 2018. Uncertainties abound about the effect of these new rules on securities lending and indemnification. Beneficial owners and lending agents are busy trying to get a grip on myriad issues like:
How borrower default indemnification is considered for purposes of calculating a lending agent’s leverage ratio;
Whether securities finance transactions will be excluded for purposes of the supplemental leverage ratio;
If and how Basel III and market risk capital rules will increase the capital costs associated with providing borrower default indemnification;
How borrower default indemnification will be treated for purposes of the Orderly Liquidation Authority under the Dodd-Frank Act; and
What effect counterpart concentration limits will have on restricting borrower default indemnification.
Borrower default indemnity has become a fixture in the securities lending market because it plays a necessary role in generating income for beneficial owners and supporting financial market liquidity. Though these standards are not specifically aimed at securities lending, whether they take the form of increased capital charges, leverage restrictions, or other prohibitions, they could have the effect of making broker default indemnification very rare, and where available, more expensive across the board.
Lending agents would be wise to turn their attention to ways in which they can continue to provide traditional levels of indemnification. In the alternative, because actual instances in which a lending agent is on the hook for borrower default is so vanishingly rare, agents could explore new and betters ways to monitor and control for credit risk, making borrower default indemnification virtually unnecessary.