Watson Wyatt, a leading global consulting firm, has recommended its clients suspend securities lending activity if they are in any doubt about their lending guidelines and arrangements. In a note to UK clients the firm asserts that the risk reward trade off around this activity has changed and that, in some instances, it may no longer be worthwhile.
“Recent market events have had a substantial impact on securities lending practitioners and their clients,” says Colin Rainbow, head of custody consulting at Watson Wyatt. “So it is imperative that pension funds review their lending arrangements to ensure they fully understand the risks involved and confirm their lending guidelines are appropriate.”
The firm identifies counterparty risk, collateral and indemnification as the three key areas that pension funds should focus on when dealing with their lending agents, typically custodians. Regarding counterparty risk, agents were able to re-purchase most clients’ assets within two days of the Lehman Brothers default. While the lending industry coped well with the process, it highlighted the risks involved. On collateral, the firm is advising that pension funds ensure the collateral agreed for their lending programme is in line with their risk tolerances and that it should be generally high quality. While it acknowledges that it would be an extreme chain of events that invokes indemnification and then for it to fail, Watson Wyatt recommends that its clients be aware of the potential risks.
“We recommend UK pension funds first research collateral types and amounts as well as their reinvestment guidelines, particularly where cash collateral is taken. Then they should investigate counterparty restrictions and any collateral indemnification provisions provided by lending agents. Having done this, if the risk relative to the reward is found to be unacceptable they should immediately suspend securities lending where possible or initiate a gradual withdrawal. Alternatively, they could remain in the programme once they have changed the lending guidelines by amending the collateral requirements, reviewed the borrowers and indemnification structure and strengthened any cash collateral reinvestment guidelines,” Rainbow says.