The Financial Stability Board (FSB) has published an interim report on securities lending. The report follows the Cannes Summit in November 2011, when G20 Leaders endorsed the FSBs report Shadow Banking: Strengthening Oversight and Regulation which sets out recommendations with a work plan to further develop them during the course of the year.
Various workstreams have been launched under the FSB to develop policy recommendations to mitigate potential systemic risks in the following areas: banks interactions with shadow banking entities; money market funds; other shadow banking entities; securitization; and securities lending and repos.
A progress report on these areas was submitted to the G20 Finance Ministers and Central Bank Governors in April 2012. The latest report is a product of the FSB workstream on securities lending and repos as a means to enable the workstream to develop policy recommendations in this area.
In reviewing current market practices with existing practitioners, the FSB has classified the markets into four main, inter-linked segments: a securities lending segment which comprises lending of securities by institutional investors to banks and broker-dealers against the collateral of cash or securities; a leveraged investment fund financing and securities borrowing segment which comprises financing of leveraged investment funds long positions by banks and broker-dealers using both reverse repo and margin lending secured against assets held with the prime broker, as well as securities lending to hedge funds by prime brokers to cover short positions; an inter-dealer repo segment which comprises primarily government bond repo transactions amongst banks and broker-dealers that are typically cleared by CCPs; and a repo financing segment which comprises repo transactions primarily by banks and broker-dealers to borrow cash from cash rich entities, including central banks, retail banks, money market funds, securities lenders and increasingly non-financial corporations.
The parts of the markets that constitute shadow banking, according to the FSB workstream, are as follows: a repo financing by non-bank entities; leveraged investment fund financing that may lead to further leverage and maturity transformation; and collateral swaps or collateral downgrade/upgrade transactions) that can further lengthen transaction chains or allow banks to meet their liquidity requirements.
The FSB workstream surveyed market participants and existing regulatory frameworks and preliminarily identified the following seven issues arising from the securities financing markets that might pose risks to financial stability:
i. lack of transparency markets are complex, rapidly evolving and can be opaque for some market participants and policymakers;ii. procyclicality of system leverage and interconnectedness securities financing markets can influence the leverage, complexity and the level of risk-taking within the financial system in a procyclical and potentially destabilizing wayiii. other potential financial stability issues associated with collateral re-use collateral re-use can reinforce procyclicality, and may have other potentially destabilizing effects on the financial systemiv. potential risks arising from fire-sale of collateral assets non-defaulting counterparties can be expected to sell collateral securities immediately following a default in order to realize cash or buy bank lent securities, triggering collateral fire sales:v. potential risks arising from agent lender practices agent lenders practices in handling customer assets and in offering indemnities to their customers against the risk of borrower default need further investigation.vi. securities lending cash collateral reinvestment by reinvesting cash collateral received from securities lending transactions, securities lenders (including non-banks) can effectively perform bank-like activities that involve maturity / liquidity transformation and leverage; andvii. insufficient rigor in collateral valuation and management practices inappropriate collateral valuation and management practices may create vulnerabilities, as seen during the early stage of the financial crisis
From the issues identified, the FSB will now develop policy measures to address risks, where necessary, by the end of 2012. The full report is available here. The FSB is inviting comments on the report by May 25 2012.
(JDC)