Laser sharp lending
13 September 2016
When considering oversight for a lending programme, lenders need to not only stay focused, but focused on the right areas, according to Dan Rudd of J.P. Morgan
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Lenders, particularly those new to securities lending or considering it for the first time, often ask how they should monitor their programmes once an agent lending programme has been established. Unsurprisingly, oversight is an essential function of a lender’s participation within a securities lending programme, and there are various areas of focus needed to identify whether a securities lending programme is achieving the beneficial owner’s objectives while staying within the expected risk profile.
The monitoring should encompass three areas: lending, collateral and performance. Within each area, various metrics should be reviewed on a periodic basis. Oversight can be conducted through reporting, due diligence reviews and ongoing communication with the lending agent.
Lending
The first area of oversight focuses on the loan side of the transaction. Specific metrics should be reviewed daily, while others can be done monthly. Lenders should be aware of the counterparties (that is, the borrowers) involved in their programme, review the market value of securities on loan to each, and understand the proportionate share that each borrower has to its overall programme. Lenders may want to limit concentration risk by requiring their lending agent to use a diverse universe of borrowers.
Since lenders are typically indemnified by their lending agent against borrower default, they need to be comfortable that their lending agent has the capital resources available to stand behind the indemnification. Therefore, it’s important for lenders to be aware of their lending agent’s financial condition. It is worth noting that we are seeing an increasing number of conversations regarding unindemnified programmes, be it full or partial activities, for example, loans to particular counterparties, within a programme. Where the lender agrees to remove the indemnification it will typically receive a more favourable fee split, however, the oversight of such an arrangement will be ever more important with the increased transfer of risk to the lender.
Collateral
The second area of oversight involves the review of the collateral. Â鶹´«Ã½ lending transactions are collateralised with either cash or securities. In either case, it’s incumbent upon lenders to know whether their lending agent indemnifies them in the event of borrower default. Indemnification protects against the risk that the value of the securities or cash collateral delivered to the lending agent is not sufficient to cover the return of the collateral to the borrowers at the end of the loan, or in the unlikely event of a borrower default. In the case of cash collateral, lenders should have documented, well-defined and transparent cash collateral investment guidelines.
The process of overseeing the cash collateral in a securities lending programme should look to encompass a similar process to that of any short duration fixed-income mandate.
As financial market conditions change, lenders should work closely with their lending agent to fully understand the implications for the programme. A transparent, two-way understanding of how these events or actions can affect or influence a programme’s profitability and performance is critical in order to assess whether a mandate is positioned appropriately to be in-line with its expected risk and return. Regular or periodic discussions should be had about cash collateral investment strategy, investments held and overall programme philosophy between lenders and their lending agent.
When securities, rather than cash, are used to collateralise a loan transaction, a lender’s exposure to its lending agent increases if the lending agent does indemnify against borrower default. Knowing the types of securities utilised to collateralise their loans, and whether indemnification is provided against a short fall in the value of the collateral, will help lenders discern how much (if any) of their lendable portfolio’s risk profile has been altered, and therefore how their portfolio may be impacted by market movements. Effectively, if one security type is loaned out to a borrower and collateralised with another security type, a mismatch scenario would ensue, and the risk profile of the lender’s portfolio could be altered. Consequently, it’s important to be aware of any correlations between security types.
Programme performance
The last area of oversight involves the assessment of the programme’s overall performance with respect to investment return, core drivers and the associated risks taken. It’s not enough to focus solely on earnings; a lender should seek a clear understanding of how those earnings were achieved. Earnings can be derived from two places—the demand to borrow securities and the investment of the cash collateral. When assessing the performance of a programme with cash collateral, lenders need to be aware of three types of spreads: gross, demand and investment. The investment spread is the yield the lender earns on the invested cash collateral less a risk free rate (generally, for the US dollar, this is now viewed as the overnight bank funding rate) and the demand spread is the difference between the risk free rate and the rebate paid back to the borrower. The combination of the two spreads equates to the gross spread. Wider investment spreads may indicate a greater assumption of investment risk. Similar to any other investment strategy, that risk is held by the lender. Therefore, investment guidelines should reflect the lender’s risk/return profile.
However, looking at trends and discovering the core drivers behind a programme’s results are also important oversight tools for lenders. Reviewing results and trends of various metrics such as earnings, utilisation rates, spreads, markets, collateral types and term will allow lenders to ask questions about their programme’s performance. Lenders will gain a better understanding of how changes in borrower demand and interest rates along with market activity affect their results and will help set further expectations. The lender should expect its lending agent to provide comprehensive reporting with access to both summary and granular data that enables them to view programme activity and assess performance against objectives.
Depending on a lender’s resources and the overall sophistication of their programme, more extensive due diligence reviews should be conducted with their lending agent on a quarterly or semi-annual basis to discuss in greater detail the market environment, performance results and attribution and the agent’s overall programme as well. For example, at J.P. Morgan, regional teams meet with lenders regularly to review activity and results and discuss opportunities.
Oversight is about education, monitoring and goals. Having a thorough understanding of securities lending, performing ongoing monitoring of the key metrics behind your programme, and having a defined set of goals with respect to lending motives and risk/return parameters, provides the framework for proper oversight. Increasingly, as regulations and markets become more complex, lenders need ready access to information and transparent data.Ìý
Ìý
As you embark on, or refine, your lending program, your agent lender should be able to provide you with reporting and tools that support your governance objectives and can help simplify oversight, such as:
A dashboard view of your program that gives you a rapid summary of current status
The ability to drill through from summary to position level detail
Online access to information, as well as delivery options and flexible output formats
Custom report generation on an on-demand basis
Board quality reporting, to present activity and performance to internal partners or for use in compliance reviews
Â鶹´«Ã½ lending continues to present an attractive opportunity for investors to generate additional alpha or income within a risk controlled environment.Ìý Simple, ongoing internal oversight, in combination with strong reporting tools and regular discussions with the lending agent, enables lenders to gain a better understanding and appreciation of the risk/return dynamics in their programme.
The monitoring should encompass three areas: lending, collateral and performance. Within each area, various metrics should be reviewed on a periodic basis. Oversight can be conducted through reporting, due diligence reviews and ongoing communication with the lending agent.
Lending
The first area of oversight focuses on the loan side of the transaction. Specific metrics should be reviewed daily, while others can be done monthly. Lenders should be aware of the counterparties (that is, the borrowers) involved in their programme, review the market value of securities on loan to each, and understand the proportionate share that each borrower has to its overall programme. Lenders may want to limit concentration risk by requiring their lending agent to use a diverse universe of borrowers.
Since lenders are typically indemnified by their lending agent against borrower default, they need to be comfortable that their lending agent has the capital resources available to stand behind the indemnification. Therefore, it’s important for lenders to be aware of their lending agent’s financial condition. It is worth noting that we are seeing an increasing number of conversations regarding unindemnified programmes, be it full or partial activities, for example, loans to particular counterparties, within a programme. Where the lender agrees to remove the indemnification it will typically receive a more favourable fee split, however, the oversight of such an arrangement will be ever more important with the increased transfer of risk to the lender.
Collateral
The second area of oversight involves the review of the collateral. Â鶹´«Ã½ lending transactions are collateralised with either cash or securities. In either case, it’s incumbent upon lenders to know whether their lending agent indemnifies them in the event of borrower default. Indemnification protects against the risk that the value of the securities or cash collateral delivered to the lending agent is not sufficient to cover the return of the collateral to the borrowers at the end of the loan, or in the unlikely event of a borrower default. In the case of cash collateral, lenders should have documented, well-defined and transparent cash collateral investment guidelines.
The process of overseeing the cash collateral in a securities lending programme should look to encompass a similar process to that of any short duration fixed-income mandate.
As financial market conditions change, lenders should work closely with their lending agent to fully understand the implications for the programme. A transparent, two-way understanding of how these events or actions can affect or influence a programme’s profitability and performance is critical in order to assess whether a mandate is positioned appropriately to be in-line with its expected risk and return. Regular or periodic discussions should be had about cash collateral investment strategy, investments held and overall programme philosophy between lenders and their lending agent.
When securities, rather than cash, are used to collateralise a loan transaction, a lender’s exposure to its lending agent increases if the lending agent does indemnify against borrower default. Knowing the types of securities utilised to collateralise their loans, and whether indemnification is provided against a short fall in the value of the collateral, will help lenders discern how much (if any) of their lendable portfolio’s risk profile has been altered, and therefore how their portfolio may be impacted by market movements. Effectively, if one security type is loaned out to a borrower and collateralised with another security type, a mismatch scenario would ensue, and the risk profile of the lender’s portfolio could be altered. Consequently, it’s important to be aware of any correlations between security types.
Programme performance
The last area of oversight involves the assessment of the programme’s overall performance with respect to investment return, core drivers and the associated risks taken. It’s not enough to focus solely on earnings; a lender should seek a clear understanding of how those earnings were achieved. Earnings can be derived from two places—the demand to borrow securities and the investment of the cash collateral. When assessing the performance of a programme with cash collateral, lenders need to be aware of three types of spreads: gross, demand and investment. The investment spread is the yield the lender earns on the invested cash collateral less a risk free rate (generally, for the US dollar, this is now viewed as the overnight bank funding rate) and the demand spread is the difference between the risk free rate and the rebate paid back to the borrower. The combination of the two spreads equates to the gross spread. Wider investment spreads may indicate a greater assumption of investment risk. Similar to any other investment strategy, that risk is held by the lender. Therefore, investment guidelines should reflect the lender’s risk/return profile.
However, looking at trends and discovering the core drivers behind a programme’s results are also important oversight tools for lenders. Reviewing results and trends of various metrics such as earnings, utilisation rates, spreads, markets, collateral types and term will allow lenders to ask questions about their programme’s performance. Lenders will gain a better understanding of how changes in borrower demand and interest rates along with market activity affect their results and will help set further expectations. The lender should expect its lending agent to provide comprehensive reporting with access to both summary and granular data that enables them to view programme activity and assess performance against objectives.
Depending on a lender’s resources and the overall sophistication of their programme, more extensive due diligence reviews should be conducted with their lending agent on a quarterly or semi-annual basis to discuss in greater detail the market environment, performance results and attribution and the agent’s overall programme as well. For example, at J.P. Morgan, regional teams meet with lenders regularly to review activity and results and discuss opportunities.
Oversight is about education, monitoring and goals. Having a thorough understanding of securities lending, performing ongoing monitoring of the key metrics behind your programme, and having a defined set of goals with respect to lending motives and risk/return parameters, provides the framework for proper oversight. Increasingly, as regulations and markets become more complex, lenders need ready access to information and transparent data.Ìý
Ìý
As you embark on, or refine, your lending program, your agent lender should be able to provide you with reporting and tools that support your governance objectives and can help simplify oversight, such as:
A dashboard view of your program that gives you a rapid summary of current status
The ability to drill through from summary to position level detail
Online access to information, as well as delivery options and flexible output formats
Custom report generation on an on-demand basis
Board quality reporting, to present activity and performance to internal partners or for use in compliance reviews
Â鶹´«Ã½ lending continues to present an attractive opportunity for investors to generate additional alpha or income within a risk controlled environment.Ìý Simple, ongoing internal oversight, in combination with strong reporting tools and regular discussions with the lending agent, enables lenders to gain a better understanding and appreciation of the risk/return dynamics in their programme.
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