Highlights from the FSOC 2014 Annual Report for securities lending and collateral management

The US Financial Stability Oversight Council has released its 2014 Annual Report. This document contains some important forward-looking risks for market professionals in securities finance and collateral management. We highlight the major points below.

Call options in money market funding. “Banks are building in optionality to the money market instruments they issue to raise funding. Some instruments give investors the option to put paper back to the bank ahead of the maturity date. Others allow the bank to call the paper prior to its scheduled maturity. These options satisfy investors’ needs for liquidity, but they serve other purposes as well. For example, some institutions have been issuing debt with an embedded call option, despite the additional cost. The willingness to bear this cost appears to be driven by these institutions’ belief that they do not need to hold liquid assets against these liabilities provided they call them 30 or more days prior to maturity. However, to the extent that this practice creates expectations of future callbacks, a deviation from this practice can be interpreted as a negative signal by market participants.”

Asset managers and securities lending indemnification. “Some asset managers are now providing indemnification to securities lenders as part of their securities lending business. There are likely benefits for asset managers from combining indemnification provision with securities lending, but there also is the potential for enhanced risks. Unlike banks, asset managers are not required to set aside capital when they provide indemnification. Also, although asset managers have access to management fees, they do not have access to banks’ stable deposit funding base. Consequently, the indemnification that asset managers provide may be a source of stress on their own balance sheets, while at the same time resulting in lower protection for the lenders relative to indemnities provided by banks.”

Implicit government bail-out insurance of the largest banks. “Both rating agencies are still of the opinion that there is some chance that the official sector will provide support to the largest banks if they become financially distressed. It is possible that these remaining expectations of official sector support reflect the incomplete state of Dodd-Frank Act implementation. To the extent that this is the case, the full implementation of the orderly resolution facility and the phasing in of enhanced prudential standards in coming years should help reduce remaining perceptions of government support to large, complex, interconnected financial institutions.”

Interest rate risk. “The first threat is that a bigger interest-rate shock might still occur. While a larger shock is less likely, given the normalization of rates that we have seen so far, it can certainly not be ruled out…. A second concern with interest rate volatility risk relates to the recent growth in floating rate loans and the loosening of underwriting standards. Since most leveraged lending is done with floating rate instruments and borrowers have high levels of debt, a sharp rise in short term interest rates could also have significant adverse effects to these borrowers’ credit risk and possibly their credit holders.”

Bilateral repo and securities lending data. “regulators and policymakers currently have no reliable, ongoing information on bilateral repo market activity, which is more difficult to collect because activity in this segment does not flow through a settlement agent like tri-party and GCF repo transactions do…. There are similar data gaps regarding the securities lending activities of financial institutions. “

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