BoE Sec Lending Committee urges rethink on loan indemnification
17 May 2023 UK
Image: AdobeStock/William
The Bank of England Securities Lending Committee has highlighted a need for the industry to rethink its approach to loan indemnification if securities loan trades are to remain profitable to agent lenders supporting this activity.
When providing indemnification to lenders, the Committee observes that agent lenders are required to hold additional capital to account for the risks associated with securities lending.
As SFT has noted elsewhere, drawing on the research of State Street’s Glenn Horner and Credit Benchmark’s Mark Faulkner among others, this regulatory capital cost can be in the region of 10 to 13 bps. However, historically this cost has not been fully recognised nor fully compensated in pricing.
Given that the returns on securities lending are relatively low, the Committee reports, “the bulk of lending will struggle to be profitable to the agent if indemnified”.
With this in mind, the Committee advises that agent lenders will need to adjust their pricing or lenders will need to forfeit indemnification.
This recommendation is easier to proffer than to deliver and the Committee offers no clear pathway at this stage to executing this proposal, recognising that indemnification remains very important to many clients to ensure that securities lending is risk free.
“If the current paradigm continues, members felt that market liquidity will reduce,” notes the Committee in its minutes of the meeting, which took place on 29 March.
Reflecting on recent market conditions, the Committee reflected more broadly on constraints imposed by risk-weighted asset (RWA) consumption, with the rolling impact of Basel IV beginning to be felt more widely in the eyes of a number of attendees.
Members indicated that the market is “not broken”, but it is possible that fewer firms will be able to lend securities in Europe in times ahead and that banks are “disincentivised” by regulatory capital considerations to take risk.
One consequence is that synthetic lending may continue to play a more prominent role, with total return swaps potentially offering a more capital-efficient mechanism for meeting lending and borrowing objectives.
Swap-based transactions are not operationally easy, notes the Committee, but “lenders need to do what they can to get lending done”. These dynamics may also drive greater use of pledge to reduce the RWA impact of lending activities.
Reflecting on the road to Basel 4 implementation, the Committee welcomed decisions from the European Union and UK not to apply minimum haircuts which, it suggests, would have been “penal” on lending activity in some non-government instruments.
The Capital Requirements Regulation 3 (CRR3) is moving towards finalisation in the EU, with the UK’s Prudential Regulation Authority (PRA) publishing a consultation paper, CP16/22, on changes to the Basel capital regime on 30 November 2022.
As reported in SFT, a number of securities finance and derivatives trade associations published their responses to the PRA consultation on Basel 3.1 implementation in April.
For some attending the BoE Securities Lending Committee, the output floor proposals under this regulation remain a point of contention. The aim is to standardise rules for RWA treatment with a floor set at 72.5 per cent by 2027.
This, the Committee notes, will capture a large number of rated and unrated corporates and will provide no attenuation for the lower risk attached to short-dated transactions. For internal risk modelling, risk weights previously applied at 10 to 20 per cent will potentially rise to 65 to 100 per cent.
In the context of the US transition to T+1 equities settlement by the end of May 2024, the Securities Lending Committee noted that although there is strong engagement around this issue in the US, there has been less discussion elsewhere, particularly when firms are not trading in USD.
Some members highlighted that next-day settlement may create challenges around loan recalls in the accelerated settlement timeframe. The Committee reminded us that without working through these issues carefully in advance, the likely outcome will be a rise in mismatched settlement instructions and settlement fail rates, with ‘specials’ trades particularly being a point of concern.
On the subject of sustainable lending, the Committee indicated that although clients had previously been talking voluably about efforts to integrate ESG considerations into their investment and securities lending strategies, there has been a recent drop off in this discussion. While lenders are exercising recalls and proxy voting to fulfil their voting obligations as shareholders, there has been little noteworthy acceleration from collateral takers in their steps to apply ESG screening to received collateral. with collateral schedules “rarely affected”.
In turn, repos and other securities finance transaction types with underlying green collateral have attracted “limited interest”. Several members suggested that ESG considerations have been deprioritised as other global events, including the invasion of Ukraine, have consumed greater attention.
The Committee continued its efforts to improve diversity and inclusion within the securities finance industry. It noted that many trading desks still do not support flexible working and do not have a proper infrastructure to make flexible working operate effectively.
On balance, the industry could do a better job of selling and socialising itself, the SLC concludes — for example, through diversity-led recruitment programmes, thereby encouraging greater diversity among entrants to the industry and better retention across their career paths.
When providing indemnification to lenders, the Committee observes that agent lenders are required to hold additional capital to account for the risks associated with securities lending.
As SFT has noted elsewhere, drawing on the research of State Street’s Glenn Horner and Credit Benchmark’s Mark Faulkner among others, this regulatory capital cost can be in the region of 10 to 13 bps. However, historically this cost has not been fully recognised nor fully compensated in pricing.
Given that the returns on securities lending are relatively low, the Committee reports, “the bulk of lending will struggle to be profitable to the agent if indemnified”.
With this in mind, the Committee advises that agent lenders will need to adjust their pricing or lenders will need to forfeit indemnification.
This recommendation is easier to proffer than to deliver and the Committee offers no clear pathway at this stage to executing this proposal, recognising that indemnification remains very important to many clients to ensure that securities lending is risk free.
“If the current paradigm continues, members felt that market liquidity will reduce,” notes the Committee in its minutes of the meeting, which took place on 29 March.
Reflecting on recent market conditions, the Committee reflected more broadly on constraints imposed by risk-weighted asset (RWA) consumption, with the rolling impact of Basel IV beginning to be felt more widely in the eyes of a number of attendees.
Members indicated that the market is “not broken”, but it is possible that fewer firms will be able to lend securities in Europe in times ahead and that banks are “disincentivised” by regulatory capital considerations to take risk.
One consequence is that synthetic lending may continue to play a more prominent role, with total return swaps potentially offering a more capital-efficient mechanism for meeting lending and borrowing objectives.
Swap-based transactions are not operationally easy, notes the Committee, but “lenders need to do what they can to get lending done”. These dynamics may also drive greater use of pledge to reduce the RWA impact of lending activities.
Reflecting on the road to Basel 4 implementation, the Committee welcomed decisions from the European Union and UK not to apply minimum haircuts which, it suggests, would have been “penal” on lending activity in some non-government instruments.
The Capital Requirements Regulation 3 (CRR3) is moving towards finalisation in the EU, with the UK’s Prudential Regulation Authority (PRA) publishing a consultation paper, CP16/22, on changes to the Basel capital regime on 30 November 2022.
As reported in SFT, a number of securities finance and derivatives trade associations published their responses to the PRA consultation on Basel 3.1 implementation in April.
For some attending the BoE Securities Lending Committee, the output floor proposals under this regulation remain a point of contention. The aim is to standardise rules for RWA treatment with a floor set at 72.5 per cent by 2027.
This, the Committee notes, will capture a large number of rated and unrated corporates and will provide no attenuation for the lower risk attached to short-dated transactions. For internal risk modelling, risk weights previously applied at 10 to 20 per cent will potentially rise to 65 to 100 per cent.
In the context of the US transition to T+1 equities settlement by the end of May 2024, the Securities Lending Committee noted that although there is strong engagement around this issue in the US, there has been less discussion elsewhere, particularly when firms are not trading in USD.
Some members highlighted that next-day settlement may create challenges around loan recalls in the accelerated settlement timeframe. The Committee reminded us that without working through these issues carefully in advance, the likely outcome will be a rise in mismatched settlement instructions and settlement fail rates, with ‘specials’ trades particularly being a point of concern.
On the subject of sustainable lending, the Committee indicated that although clients had previously been talking voluably about efforts to integrate ESG considerations into their investment and securities lending strategies, there has been a recent drop off in this discussion. While lenders are exercising recalls and proxy voting to fulfil their voting obligations as shareholders, there has been little noteworthy acceleration from collateral takers in their steps to apply ESG screening to received collateral. with collateral schedules “rarely affected”.
In turn, repos and other securities finance transaction types with underlying green collateral have attracted “limited interest”. Several members suggested that ESG considerations have been deprioritised as other global events, including the invasion of Ukraine, have consumed greater attention.
The Committee continued its efforts to improve diversity and inclusion within the securities finance industry. It noted that many trading desks still do not support flexible working and do not have a proper infrastructure to make flexible working operate effectively.
On balance, the industry could do a better job of selling and socialising itself, the SLC concludes — for example, through diversity-led recruitment programmes, thereby encouraging greater diversity among entrants to the industry and better retention across their career paths.
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