Pressure from lenders to cut risk, raise returns, increase transparency and unbundle services point to uncertain future for the industry
Despite the contraction in the size of the securities lending industry, in line with the decline in short selling and the availability of leverage throughout the securities industry, the annual Global Custodian Securities Lending Survey continues to grow. The survey, now in its third year as a separate analysis from the Global Custodian survey of the global custodian banks as agent lenders, attracted 169 responses – up by a fifth on 2009. Ten out of 19 providers-BNY Mellon, Brown Brothers Harriman, Citi, Deutsche Bank, eSecLending, J.P. Morgan, Northern Trust, PNC GIS, RBC Dexia IS and State Street-received enough responses to be rated.
Unsurprisingly, in the wake of the collapse of a major counter-party and amid continuing problems in cash collateral reinvestment pools, responses from institutional lenders emphasized the need to mitigate risk. “Risk management is the topic at the moment,” wrote one. “But I think besides this adequate collateral management is key in managing a part of the risk and will be emphasized by the lenders.” A major US pension fund said its greatest anxiety about one of its agent lenders was still the need to “reduce risk on the collateral re-investment side.”
Which helps to explain why Brown Brothers Harriman, which has long pursued the most risk-averse strategy in the industry and escaped cash collateral reinvestment problems altogether, topped the survey for a second year in a row. Generous scores were supplemented by a range of superlatives from clients impressed by the approach to risk management taken by the Boston-based agent lender.
But other consequences of the crisis were evident in the survey too: the demand from institutional lenders for higher returns to compensate for risks of which they are now more aware, and for greater transparency and insight into exactly what risks are being taken. “Additional earnings” are what one $200 billion fund wants from its securities lending program, while “reporting” cropped up repeatedly as an area in which agent lenders need to improve.
Some agent lenders see transparency as an opportunity. “The renewed importance placed on the transparency between lending agents and beneficial owners, as supported by ongoing communication and open dialogue, is an extremely positive outcome for the industry,” says one. But agent lenders facing revenue falls of 70-80% in the last year are also subjecting their entire business models to a comprehensive re-consideration. An era in which agent lenders waive custody fees in return for the right to lend assets at generous spreads is drawing to a close, as beneficial owners now appreciate the risks this entailed.
Asked to itemize the most important change to have occurred in the securities lending industry over the previous 18 months, an agent lender explained that beneficial owners were not only more focused on transparency, reporting, and risk management, but had started “scrutinizing the size and scope of their securities lending agent’s balance sheet / capital base that backs borrower indemnification. These changes have led to more robust and frequent oversight from investment professionals when, traditionally, most oversight was conducted by operations or back-office personnel.”
The agent lenders which succeed in 2010-11 will be those that adapt successfully to the changed balance of power between themselves and their institutional clients. Already there are signs of the “unbundling” of custody, cash management, collateral management and securities lending, and the spread of lending business across multiple providers to mitigate risk. An agent lender reported in the survey “increased interest by clients in using professional asset managers for the reinvestment of cash, as well as investing cash in-house.”
Such developments point to a more complicated structure for the industry in future, in which the ability to co-ordinate and report the work of a variety of specialists is rich in opportunity as well as threat.
The full results of the Securities Lending survey, and a full explanatory methodology, can be accessed here.