Which regulations are of most concern to Northern Trust as an agent lender?
At Northern Trust, we track regulations that may directly impact the services provided to lenders by securities lending agents, as well as those that would have an indirect effect on borrower demand for securities. The regulations that we are particularly focused on at this time, due to timing and scope, are the US implementation of Basel III capital rules, Dodd-Frank Section 165(e) single counterparty credit limits, Basel III large exposure and leverage ratio proposals, the Volcker Rule, and the Financial Stability Board Review’s (FSB) of shadow banking.
Many of these regulations affect lending agents because of the borrower default indemnification they provide to the clients in their securities lending programmes. Two of the proposed rules, Basel III large exposures and Dodd-Frank single counterparty credit limits, are similar in concept and limit an institution’s cumulative exposure across business lines to a given counterparty. Indemnified securities lending is one type of activity that is part of the exposure calculation. Both of these regulations are currently in draft form.
The US implementation of Basel III capital rules, on the other hand, was finalised in July 2013 and affects the amount of capital agent lenders must set aside as a result of the indemnified lending activity. Given the introduction of a standardised approach in the rules for the US implementation of Basel III, along with the Collins Amendment, indemnified securities lending activity may be more capital intensive for agent lenders in the future.
The Basel III supplemental leverage ratio proposal is an example of a regulation that may have more of an indirect impact on agent lending activity. Under the draft rule, indemnified lending transactions would not have a material contribution to the leverage ratio measure for agent lenders, but the treatment of securities lending activity for borrowers acting as principal on such transactions may affect their demand for certain types of securities. Additionally, compliance with the Volcker Rule may have implications on the securities lending cash collateral vehicles that an agent lender offers.
Finally, the FSB’s Review of shadow banking published recommendations in August 2013 for securities lending matters related to transparency and cash reinvestment. It is also considering further policies on minimum haircuts.
How is securities lending being treated in terms of exposure?
The way that securities lending exposure is measured under certain regulations is punitive relative to the actual risk associated with the transactions. Generally speaking, several of the regulations apply a haircut-based approach to measuring securities lending exposure, with the haircuts themselves being conservative. Under the haircut-based methodology, the securities lending exposure is calculated based on the difference between collateral and loan values, with both collateral and loan amounts being adjusted (either down or up, respectively) by prescribed regulatory haircuts driven by their security type and other characteristics. Additional haircuts are applied in the instance of a currency mismatch between collateral and loan.
The rules are particularly penalising on indemnified loan transactions collateralised by non-cash collateral, such as equities, given that there appears to be an implicit assumption that the loan and collateral positions (even of the same security types) move in opposite directions. It would be more appropriate to take into account whether the loan and collateral positions are correlated and to consider the likely direction of markets in times of stress and counterparty default. Custody banks (including Northern Trust) have urged regulators to consider alternative ways of measuring securities lending activity using methods that capture some of these correlations and an element of right way versus wrong way risk.
Which regulation will have the biggest impact?
This will likely depend on the institution. Certainly, institutions that have been deemed to be in the Basel global systematically important banks (GSIB) or the global systemically important financial institutions (G-SIFI) categories by the FSB are going to be subject to more stringent rules under certain regulations. These institutions may be more sensitive to the Basel III large exposures or Dodd-Frank single counterparty credit limits since the threshold concentration for exposure to any single counterparty is lower (10 to 15 percent) for activity between institutions having GSIB and G-SIFI status compared to the 25 percent for others.
How will indemnification
be affected?
It is difficult to say at this point. Although the capital rules have been finalised, other regulations are still in draft form.
Historically, borrower default indemnification was an accommodation that agent lenders offered to clients. In the past, this indemnification may have been more explicitly priced in the clients’ fee arrangements. The industry has evolved, and due to competitive pressures, borrower default indemnification is more commonplace and in most cases, an expectation or a requirement for clients to participate in securities lending.
Given the finalisation of the US implementation of Basel III capital rules, indemnified securities lending activity will become more expensive for US agent banks to offer. There is an effective date of January 2015 for the new capital rules, but institutions will need to disclose their capital ratios prior to that time, such that the impact may be seen sooner. Basel III capital rules do not prevent banks from offering indemnification altogether, but their return on capital may be impacted by the increased cost of offering such indemnification.
Securities lending profitability is very much considered in the custody bank’s pricing models, so the broader custody pricing may also be impacted in the future. Finally, under either the Basel III large exposures or Dodd-Frank single counterparty credit limits as proposed, there may be more limitations on an agent bank’s capacity to provide indemnification.
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