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Several repercussions have resulted from this change
in approach.
Margins on lending programs have come in
as most organizations are choosing more
conservative collateral reinvestment options. In
many instances, organizations are choosing to
insource their collateral reinvestment to exert
better control over this key source of risk.
Many asset owners have imposed minimum
spreads that lenders must obtain in order to
put their general collateral supply out on loan,
particularly in the equity markets. This is leaving
an increased portion of the lendable supply pool
unutilized, particularly in this low interest rate
environment. While the value of supply out on loan
is approaching pre-Crisis levels, the percentage of
supplies out on loan is steadily decreasing.
Some asset owners with large pools of unutilized
government bonds are now redirecting that supply
to their internal cash management teams where
they can perform repo and reverse repo to better
utilize that supply. This is especially true of asset
owners with cash management funds that qualify
to directly access the Federal Reserve Board of
New York’s reverse repo program where they can
trade as a direct counterparty with the Fed.
Regulations emerging as part of the Dodd-Frank Act
and from the Basel III accords are poised to make this
post-GFC landscape even more challenging.
New guidelines on how to account for assets posted
as collateral on indemnified loans are likely to require
lenders to set aside much larger amounts of Tier
1 capital. This is leading to a growing dialog about
the value and need for indemnification against
borrower default in lending programs. Prospects for
this to become an explicit rather than implicit cost in
valuing a loan are likely, at least for a subset of clients
as lenders look to offset the cost to their balance
sheet. More and more participants may choose or
be required to forego indemnification in the
emerging environment.
More monitoring of cumulative exposures between
counterparties is also likely. Individual custodial
or trust banks must look at the totality of their
exposure to their various lending counterparties.
Custodial banks with affiliated broker-dealer
organizations will have to look across both sets of
exposures in determining their position vis-à-vis
other organizations. The industry’s largest banks
may need to limit their exposure to each other to
no more than 10% of their total obligation. For
smaller counterparts with lower exposures, current
proposals still envision a threshold of no more than
25% exposure to any single counterparty. Clearing
CCPs for lending transactions may gain traction given
these changes.
Competition for using supply as collateral versus
putting supply out on loan is also likely to build
in response to the new derivative clearing rules
emerging from Dodd-Frank and EMIR. Margin
postings against collateral transactions are expected
to rise significantly whether those postings are
directed to cleared swaps on CCPs or to non-cleared
swaps where margin may be segregated in third-party
custody accounts. The bulk of such collateral postings
is likely to consist of high quality liquid assets (HQLA)
and demand for such supply is expected to spike.
These factors are driving lenders toward a new type
of “supply optimization.” In order to create multiple
paths to market to more fully utilize the supplies
being provided to them by asset owners, leading
organizations are looking to bring together a broader
suite of lending and derivative services under a single
management structure. This is allowing for a more
client-centric coverage approach and for the creation
of “solutions” teams that are able to coordinate with
multiple product experts tomodel out and recommend
Conclusion
Post-GFC, the design of agency lending programs changed extensively. Asset owners sought
to exert more controls over risks being taken on their collateral reinvestments and more
transparency into the activities of their lenders in order to provide better oversight and
guidelines to these programs. Incentives were recalibrated. Instead of looking to utilize as much
of the lendable pool of assets as possible to generate collateral for reinvestment, the majority
of asset owners now look for lenders to maximize the intrinsic value of the individual securities
they have out of loan.