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These rules have the potential to significantly change
the securities lending markets in two ways: first,
the rules will impact either the economics or the
perceived safety of securities lending by looking to
explicitly rather than implicitly price indemnification;
second, the competitive landscape between lenders
could shift as limits are imposed on the amount of
exposures key counterparties can have to each other.
Lender Indemnification Set to Become an
On-Balance Sheet Item
In 2009, the Financial Stability Board (an organization
brought together to harmonize banking policy
across the G20 nations) delegated one of their most
significant policy areas, banking supervision, to the
Basel Committee on Banking Supervision (BCBS)
which was mandated by the G20 to revise the
core principles for banking supervision, originally
established in October 2006. The subsequent review
led to the rollout of a new set of minimum standards
for supervising the banking system.
The reforms and standards emerging from this work
are collectively referred to as the “Basel III” accords—a
global regulatory framework for more resilient banks
and banking systems
2
. These reforms were developed
centrally to improve the banking sector’s ability to
absorb shocks arising from financial and economic
stress, improve risk management and governance,
and strengthen banks’ transparency and disclosures.
The Basel III regulatory capital proposals were
completed in June 2011, while the liquidity proposals
were completed in January 2013 with a subsequent
update to this proposal in January 2014.
As part of the capital rules under Basel III, the
Committee laid out new capital demands that are
likely to impact the borrower default indemnification
that securities lending agents offer. Under the old
Basel I regime, borrower default indemnification was
not viewed as capital attractive if the loan collateral
was cash or OECD sovereign debt. These assets were
seen as having a 0% risk weighting. Under Basel
III, indemnification will almost certainly result in the
generation of risk-weighted assets (RWAs), which in
turn will need to be backed by Tier 1 capital.
Thereare twomethods tocalculate theRWAassociated
with indemnification under the Basel III rules. The
“standardized” approach uses pre-determined risk
weightings, such as 15% for main index equities,
which result in large RWAs and substantial Tier 1
capital requirements. The “advanced” approach uses
risk sensitivities of the loaned securities, considers
the counterparty to the trade and evaluates the
collateral posting. This approach almost always
generates a smaller RWA and thus a lower Tier 1
capital requirement.
The ability to select one over the other method of
calculating RWA may be limited for U.S. banks and
other lenders doing business in the U.S. that are
subject to provisions of the Dodd-Frank Wall Street
Reform legislation. The “Collins Amendment” to
that legislation specifically states that even if a bank
adopts the advanced approach to calculating their
Tier 1 capital, they must still calculate their RWAs
under both the standard and advanced approach and
base their Tier 1 capital ratio on whichever calculation
results in the higher RWA.
In either case, the standard and the advanced
calculation approach both make the indemnifications
that lenders offer capital attractive and would require
the banks providing this service to set aside capital to
cover the cost.
Section IV: New Bank Regulations Strain
Lending Environment
The post-GFC equilibrium described in preceding sections will increasingly be challenged by
emerging regulations that will have a direct impact on the securities lending environment. While
voluntary actions undertaken by asset owners and lenders have worked to create more stability
in recent years, regulators are looking at systemic risks across the financial sector. Certain
aspects of the securities lending markets are being reconsidered as part of this examination and
rules are emerging to create more accountability, enhance liquidity and reduce the likelihood of
future issues.
2. http://www.bis.org/publ/bcbs189.pdf