The current market environment is a good one for funds to be able to increase the revenue they generate by securities lending. It follows that it’s also a time where the lending program is subject to greater risk. LOUNARDA DAVID, principal and regional director of Mercer Sentinel – Asia Pacific, presents a guide for trustees wishing to minimise their potential downside.

The credit crunch which was initiated by defaults in the US sub-prime mortgage market is seeing a broader impact on financial markets globally. A real outcome of this domino effect is the repercussion on the risk management and monitoring environment surrounding financial activity. Securities lending which is fundamentally a credit and financing activity has also been affected by recent market events. Market volatility, combined with a lack of balance sheet transparency, makes credit risk management more challenging. This is compounded by the fact that security loans and collateral values can diverge at any given point and timing in a default situation is critical for recovering loans.

In the unstable market conditions currently being experienced, how do security lenders best manage their risks? Borrowers have a multitude of reasons for demanding securities. Two of these are to access high quality securities or secure short-term financing. Securities lending agents lend to borrowers, who have undertaken a thorough credit review process and typically post and maintain collateral positions in excess of the loan value.

In market conditions where assessment of credit risk is difficult such as when collateral values are unstable, lending agents are challenged in maintaining adequate security against the loans. In addition, many borrowers in agency programs lend to prime brokers or hedge funds. The lenders of these securities are more likely to be exposed in the event that these parties become stressed such as when the market de-levers and collateral or margin is called. In particular, if there is a counterparty default and a drop in collateral value, but the loan value does not move in parallel, then the collateral may no longer cover the loan exposure. Most clients are protected by indemnity arrangements, however, there may be systemic and market issues which may compromise these.

While central banks have been attempting to restore confidence and continuity to markets, the overall situation appears to have eroded further. Funding costs have increased and counterparties are also increasing collateral requirements and requiring higher quality collateral such as cash and treasuries, or increasing margin amounts. With respect to securities lending, some borrowers have also been looking to borrow high quality securities against lower quality non-cash collateral, or replace cash collateral with non-cash collateral. Recalling loans or making cash/non-cash switches could force reinvestment portfolio sales, thus realising losses.

On the flip side for lenders of securities, while risks have increased, so have return opportunities. During recent months, widening credit spreads have created the opportunity to increase securities lending revenue. Lenders with appropriate reinvestment strategies – who can navigate through the current market conditions and appropriately measure and manage their potential risks – may be able to increase their lending revenue.

It is critical that lenders ensure the lending program in which they participate is well administered and transparent with the appropriate risk management framework and processes. At a minimum, they should assess the following areas to enhance prudent management and governance of their lending programs:

1. Review lending contracts and collateral guidelines to ensure a thorough understanding of contractual rights in the event of insolvency or collateral issues;

2. Review the approved counterparty and borrower lists including where the counterparty is located, the jurisdiction in which collateral is held, and if possible, whether the counterparty is the ultimate borrower;

3. Review your loan exposures and concentrated credit risks within the approved counterparties and borrowers;

4. Ensure a good understanding of the processes followed by the lending agent in the case of a credit event and determine the potential gaps between valuing the loan and perfecting collateral;

5. Review the general parameters of loan exposures, including average loan duration, any term loans at a fixed rate versus a floating rate and the term length, and the frequency of re-rating term loans. Evaluate whether lending is being undertaken at current risk premiums and whether term loans potentially expose you to interest rate mismatch risks or increased credit risks;

6. Review the security composition of the outstanding loans and the percentage versus the overall portfolio on loan. Any illiquid or hard to replace securities should be reviewed to determine if you wish to recall the loan;

7. Review collateral pools or reinvestment funds to identify potentially illiquid securities and evaluate the impact on your overall position; and

8. Determine if the lending agent is unwinding undesirable positions and how proper collateralisation levels are maintained.

Lenders may also wish to establish a red flag system, whereby the lending agent will inform the lender of particular events such as when an approved counterparty goes into technical default.

The market anomalies may endure for months, therefore, it is critical that lenders regularly monitor their activities and ensure that collateral levels remain sufficient.

Whilst the opportunity exists to benefit from current market conditions, lenders must always acquaint themselves with the issues involved and be cognisant of the risks and ensure they are being appropriately managed.

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