"Who knows what evil lurks in the hearts of men? The Shadow knows."
Narrator’s introduction to the radio broadcast of The Shadow.
Securities lending (SL) is one of the less-well-publicized shadow banking activities. Like repurchase agreements (repo) and asset-backed commercial paper, SL can be a source of very short-term wholesale funding, allowing a shadow bank to engage in the kind of liquidity, maturity and credit transformation that banks do. And, like other short-term funding sources, it can suddenly dry up, making it a source of systemic risk. When funding evaporates, fire sales and a credit crunch follow.
Indeed, SL played a supporting role in the 2007-09 financial crisis, being partly responsible for the collapse of the large insurance company AIG when the market seized in September 2008 (see chart). While SL has not garnered the attention of capital and liquidity regulation or central clearing, or even repo markets, it is still worth understanding what securities lending is and the risks it poses. That is the purpose of this post.
Securities Lending against Cash Collateral (Trillions of U.S. dollars)
Source: Foley-Fisher, Narajabad and Verani (2016), Figure 4.
In many ways, the financial system is like the power grid or the public water supply. The day-to-day mechanics of how it works are of little interest to all but the experts that design, build and maintain it. The detailed structure of financial markets—the steps needed to purchase a stock or bond, for example—are not something most people think or worry about. But when any of these systems stop working, suddenly everyone notices.
Securities lending is on this long list of things that very few people pay attention to. That may be a mistake. As it turns out, there remain institutions that use SL as a way to obtain cash that they can then use to invest in long-term, risky securities.
To understand the role of SL, let’s start with the basics. In an SL transaction, one party lends a security to another in return for either cash collateral or some other security plus a fee. The transaction is often done through a third-party agent. Importantly, the loan is normally over-collateralized (that is, the collateral value exceeds the market value of the security on loan) and open-ended, with both sides having the option to terminate at any time. (For complete details on the mechanics, see here). As the following chart shows, the collateral is usually cash. While the overall market has never recovered from its pre-crisis peak (see first chart above), it remains in the range of a not insignificant $500 billion.
Cash versus non-cash collateral (Percent of Total)
Source: Keane (2013).
Why would someone borrow a security and why would someone lend one? Borrowers’ needs—the demand for SL—arise from several factors. They may have an obligation to deliver a security that they do not own, so the loan allows them to avoid a delivery or settlement failure. Borrowers may wish to take a short position, selling a security they do not own in the hopes of buying it back at a lower price before returning it. Or, borrowers may have some arbitrage trade or hedge that requires the security—details can be complex.
On the supply side, the beneficial owners, as they are known, are typically institutions with a large portfolio of securities that are otherwise idle. In return for the security, the lender obtains a return equal to a fee plus the cash reinvestment rate. By making their portfolio of securities available for lending, the suppliers help to make the market more liquid and efficient. (See Keane for the details, including a discussion of the relationship between securities lending and repo.)
From a systemic perspective, the key question is how lenders reinvest the cash collateral they receive from the borrower. Some lenders or lending agents only invest the cash collateral they receive in short-maturity, high-quality, liquid securities. This means that there is little or no shadow banking involved: no liquidity, maturity or credit transformation. But a recent paper by Foley-Fisher, Narajabad and Verani shows insurance companies are doing something substantially more risky. They are using the cash collateral to purchase long-term, relatively illiquid bonds. In effect, the securities lenders are borrowing in a very liquid, short-term market to acquire illiquid, long-maturity assets. Just as it does for a bank, this liquidity and maturity transformation creates run risk for the shadow-banking insurers. Since runs can easily spread, turning into system-wide panics, this is something to worry about.
To understand what is going on, it helps to look at a simplified balance sheet of an insurance company. Insurers have a variety of assets—bonds, equity, real estate and the like. Their liabilities are a combination of obligations to customer/policyholders and debt. The difference between their assets and these liabilities is the firm’s net worth or shareholder equity. To give a sense of scale, take the example of MetLife, one of the largest U.S. insurance companies. At the end of September, their assets were $878 billion, of which roughly 40 percent were bonds. The vast majority of their liabilities—over 85 percent—were in the form of future policyholder benefits or policyholder accounts (a large fraction of which were separate investment accounts).
Typical insurance company balance sheet
Insurance companies are among the most highly leveraged financial intermediaries in the United States, with leverage well in excess of the average commercial bank. For example, based on book value as of end-September, MetLife’s leverage (the ratio of total assets to net worth) was 12.8. Using the market value of equity (rather than the book value), the estimate is 17.7. That compares to the average of 9.3 for U.S. commercial banks (based on the latest H.8 data from the Federal Reserve). Yet, there is reason to believe that the published numbers in the insurance industry understate effective leverage (see here.)
To assess the risks from SL, Foley-Fisher et al. examine the SL activities of insurers at the granular level of individual securities. According to their analysis, the securities lent tend to be marketable corporate bonds while those purchased using the cash collateral tend to be private placement securities. The following balance sheet shows the result of such a transaction.
Typical insurance company engaging in a securities loan
There are two things to note. First, since the securities lender remains the owner of the bond it lends, its balance sheet is now larger. Put another way, we can think of the supplier of the securities in the transaction as obtaining a collateralized loan analogous to an open-ended repo. That is, the insurance company is in essence borrowing cash that is secured by a corporate bond. And, it uses this mechanism to increase leverage. In the MetLife example, based on the market value of equity, leverage would be 16 (rather than 17.7) if we excluded the securities lending operations from their balance sheet.
The second thing to note is that the securities lending transaction facilitates banking activity. The private placement bonds are both less liquid and longer maturity than the cash collateral obtained through the SL transaction. This is why Foley-Fisher et al. call their paper “Securities Lending as Wholesale Funding” (our emphasis). And, as we know from experience, providers of wholesale funding can run. To understand the size of the problem, note that in the case of MetLife, the amount listed on its third-quarter 2016 public disclosure under “Payables for collateral under securities loans” equals 4.6 percent of liabilities, or 76 percent of market equity; and roughly 3 times cash.
To us, this looks like systemic risk. And, given that this form of systemic risk actually manifested itself in the case of AIG in September 2008, it is not an imaginary risk. At that time, when securities borrowers chose to terminate the SL transaction and recall their cash collateral, the Federal Reserve felt forced to step in and provide loans collateralized by the assets. The Fed had to substitute for the evaporation of private intermediation to avoid a chain reaction leading to systemic collapse (see here.)
Of course, these risks have not escaped the attention of the official sector. And the proposed solution, which we support, is to restrict what lenders can do with cash collateral. That is, to impose a restriction on the activity to ensure that every intermediary—regardless of its legal form—faces the same constraints on liquidity and maturity transformation. If an insurance company, a hedge fund, or an off-balance sheet bank-operated entity were obliged to invest the cash collateral in low-risk, short-maturity, liquid instruments, then the run risk would be minimized.
Put differently, we need to force financial system risk out of the shadows. As we wrote some time ago, this means that anyone engaged in a banking function or activity should face the same capital and liquidity standards as a bank. The alternative merely shifts systemic risk-taking from banks to shadow banks.