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Opportunities and Challenges for Hedge Funds in the Coming Era of Optimization
This regulation could work to significantly change the
economics of agency lending. Today, indemnification
is an implied guarantee that is not priced into the
transaction itself. The need to set aside increased
Tier 1 capital to cover indemnification is seen as
negligible because all transactions collateralized by
cash or high-grade OECD securities carried a 0%
risk weighting and the industry operated largely
under these collateral parameters. As the risk
weightings on these transactions rise, the cost of
indemnification will become a consideration. Right
now, full implementation of the Basel III rules is not
anticipated until 2018, but many banks are already
beginning to calculate and announce their Tier 1
capital ratios as measured under the new rules.
Many asset owners rely on the guarantees afforded
through indemnification to confidently place their
lendable assets into lending programs. If agent
lenders are forced to explicitly set aside additional
capital to cover indemnification, many may choose to
forego offering the guarantee.
Dodd-Frank Rule 165 Challenges Large
Industry Providers
The other major piece of regulation likely to directly
impact the securities lending markets in the U.S. is
Dodd Frank Rule 165(e). This regulation seeks to
limit the risks that the failure of any one individual
firm could pose to a systemically important
counterparty by establishing single-counterparty
credit concentration limits. These limits would apply
to all U.S. bank holding companies with >$50 billion in
assets and to designated non-bank entities (covered
companies) designated by the Financial Stability
Oversight Committee.
Rule 165(e) prohibits covered companies from having
a credit exposure to any unaffiliated company in
excess of 25% of the covered company’s capital stock
and surplus. This capital stock and surplus calculation
is derived by adding the covered company’s total
regulatory capital to its excess loan loss reserves.
The Act defines credit exposure to an unaffiliated
company as the following:
All repos, reverse repos, securities borrowings
and lending transactions with the company
All guarantees, acceptances or letters of credit
issued on behalf of the company
All purchases of or investment in securities issued
by the company
Counterparty credit exposure to the company in
connection with a derivative transaction.
The rule is even more burdensome tier of compliance
for a subset of firms that are considered to be major
covered companies that have $500 billion or more in
assets. These companies many not have an aggregate
net credit exposure of in excess of 10% to any other
major covered company or to any foreign banking
organization with $500 billion or more in assets. The
aggregate net exposure will include the net credit
exposure between all of a company’s subsidiaries and
all subsidiaries of the counterparty.
There is also a potential that the rules could apply
to foreign banking organizations with >$10.0 billion
in U.S. assets, but the Federal Reserve is studying
this issue further, in part to monitor how regulatory
language develops around Basel III’s large exposure
requirements which aim to achieve a similar, but less
restrictive goal.
The practical impacts of Rule 165(e) could work to
significantly change the lending landscape in the U.S.
This is illustrated in Chart 25.
“ It will be interesting to see the regulatory piece
play out and which firms will stay. The capital needs
of this business will change with the regulations,”
— Agent Lender
“ Basel III has shed light that there is a real and significant
cost to indemnification,” — Agent Lender
“ If an agent lender lends indemnified securities, this
creates a balance sheet obligation. If the securities loan
is not indemnified, there is no balance sheet impact,”
— Securities Lending Consultant
“ Agents are being tight lipped about indemnification.
No one wants to be out in front of it. Everyone is
waiting to see how it will be calculated under Basel III,”
— Asset Owner—Money Manager