Securities lending squeezed
Anthony Harrington discusses the effects of the Basel III capital adequacy regulations on the securities lending business
At a glance
• Bank capital adequacy rules are having an impact on securities landing.
• Basel III rules on capital adequacy sets out a standardised approach to quantifying the appropriate risk-related capital reserve instead of firms being able to utilise internal models for value at risk.
• Over the longer term some clients/lenders such as pension funds could lend directly to hedge funds.
No sensible person can be against the idea that banks should hold enough capital in reserve to provide a buffer against systemic shocks. However, the Basel III regulations, which codify how much capital should be held against various kinds of risk, are having a negative impact on securities lending.
This effect is reaching the point where market participants, such as Paul Wilson, JP Morgan’s head of agent lending product and portfolio advisory services, are suggesting that the landscape could be changing. Sweeping innovations in the business models driving securities lending could be imminent.
Before Basel III, agent lender organisations (the traditional intermediaries between securities owners and borrowers), tended to use internal risk models when calculating the exposure that might incur by indemnifying the client (the owner of the securities), in the event of a borrower default. Under such a model, risk could be calculated to zero or near zero, since the securities lending industry makes a practice of having all transactions both fully collateralised and marked-to-market.
The collateral generally – certainly where shares are concerned – also undergoes a ‘haircut’ of at least 10%, sometimes more. So the lending agent could rest on the idea that it was holding 110% collateral and had an agreement with the lender that the lending agent would either replace the securities with the same or agreed equivalent securities, or the equivalent in cash.
Under those circumstances, exposure could be minimal. It could be driven even lower by the agent lender doing due diligence on the quality of the borrower. What this meant was that the agent lender would either have no capital expense to bear or a small one. It could bank all, or nearly all, the fee for the transaction.
As an aside, the proof of how efficient the fully collateralised model is was demonstrated following the collapse of Lehman Brothers in September 2008. All the securities lending involving Lehman was unwound without significant losses. The collateral posted was sufficient – the system worked.
However, Basel III has changed the game. Instead of firms being able to utilise internal models for value at risk, it sets out a standardised approach to quantifying the risk-related capital reserve.
Take a simple scenario where the transaction involves an equity loan against equity collateral, typically with a haircut of 10%, so collateralised to 110%. Under a standardised approach, supervisory haircuts must be applied both to the loan side and to the collateral. The net result is that a shift from a 10% surplus to an 11% shortfall (99% collateral versus an increased view of the loan which is 110% of what it was).
This shortfall is viewed in the model as a significant risk against which agents have to hold additional capital reserves – an unattractive and expensive proposition.
To make matters more complicated, the way the Basel III methodology works hits different organisations in different ways. It takes into account all activities being carried out by the organisation in question. As a result, some organisations in the agent lending business are finding securities lending to be a much more capital intensive business than other organisations which may, on the surface, appear to be similar organisations.
This means there is no logical tweak that can be made to the Basel III model to cure this unintended consequence for securities lending, aside from scrapping it. After all the trouble the regulators have gone to formulating the standard model, that is not going to happen soon. So it is going to have to be the industry, rather than the regulator, who accommodate the new costs involved in securities lending.
For JP Morgan, Wilson says, one response has been to look to focus on asset owners and assets where there is a strong demand to borrow, by growing its third-party business. “We are now actively lending for approximately 25 clients across some 15 custodians. We are really highly focused on specific clients who have large portfolios of in-demand assets, such as emerging markets, corporate bonds and ‘specials,’” he says.
Wilson argues that it is all about having a sophisticated model to be able to realise the potential revenue from the client’s portfolio and arrive at a fee that gives both client and lender acceptable levels of return. “There is no doubt that lenders will see a reduced return by comparison with pre-Basel III levels,” Wilson notes.
‘Specials’ are securities that are in demand and have intrinsic value, therefore commanding a higher fee level from the borrower.
Wilson says it is important for agent lenders to be able to calculate not only the potential revenue from portfolios, but also estimate the cost. Based upon calculating these, a variety of programme approaches and structures can be proposed that generate acceptable levels of return to both the client and agent, he says.
The likelihood is that lenders will see lower levels of return. However, if a 90-10 fee split between lender and agent, is assumed and if that goes to 85-15 as a consequence of Basel III. That means that the agent has seen a 50% fee increase, while for the lender it is only a 6% or 7% additional cost – so it is not dramatic enough to be a showstopper for most lenders.
Longer term, Wilson argues, structural changes may become apparent, with clients/lenders such as pension funds and other sophisticated asset owners looking to lend directly to hedge funds. “The industry is talking about this now, but it is probably still some way off in the future before it becomes mainstream,” he says.