Higher Capital Requirements Could Limit Borrower Default Indemnification

At the 30th annual RMA conference on securities lending, panelists discussed how post-financial crisis regulation could pose challenges for the securities finance industry, particularly in terms of capital requirements and how these may make it more difficult to provide indemnification.

In the U.S., panelists said that there is likely to be more regulation than the benchmark set by the international framework of Basel III and recommendations from the Financial Stability Board. For example, U.S. banks face a 6% Supplementary Leverage Ratio (SLR), which is 3% higher than the minimum set by Basel III. While the panelists said U.S. banks are in good shape for most capital requirements, the banks are not where they need to be yet for the SLR.

When the final regulations come into effect, the panel said that available collateral will be reduced, while the number of risk-weighted assets will increase. “That’s what will create stress in the system,” said moderator Greg Lyons, a partner at the law firm Debevoise & Plimpton, referring to the higher ratio of collateral divided by risk-weighted assets.

As a result, borrowers in securities finance transactions will ask, “Is this business worth the capital costs?” said Glenn Horner, managing director at State Street Global Markets.

An even larger change from the increased capital requirements could be agent lenders not including indemnification for all securities lending transactions. Panelists said that if there is no exclusion for indemnification in the capital rules, then banks may supply indemnity on a more selective basis.

This protection against default may only go to larger beneficial owners with whom the banks have a sizable relationship or if the specific lending transactions are particularly profitable. However, banks may not be able to afford the capital costs of supplying smaller clients with indemnity as well.

The rules still need to be finalized, however, and more clarity is on the horizon. “There will be one more year of big transition,” said Lyons. “By 2015, regulation will really hit in a more dramatic fashion.”