Purpose Financial institutions are lending securities
with increasing frequency. In some instances a financial institution
may lend its own investment or trading-account securities. More and
more often, however, financial institutions lend customers’ securities
held in custody, safekeeping, trust, or pension accounts. Not all
institutions that lend securities or plan to do so have relevant experience.
Because the securities available for lending often greatly exceed
the demand for them, inexperienced lenders may be tempted to ignore
commonly recognized safeguards. Bankruptcies of broker-dealers have
heightened regulatory sensitivity to the potential for problems in
this area. Accordingly, we are providing the following discussion
of guidelines and regulatory concerns.
Securities-Lending Market Securities brokers and commercial banks are the primary
borrowers of securities. They borrow securities to cover securities
fails (securities sold but not available for delivery), short sales,
and option and arbitrage positions. Securities lending, which used
to involve principally corporate equities and debt obligations, increasingly
involves loans of large blocks of U.S. government and federal-agency
securities.
Securities lending is conducted through open-ended “loan”
agreements, which may be terminated on short notice by the lender
or
borrower.
1 The objective
of such lending is to receive a safe return in addition to the normal
interest or dividends. Securities loans are generally collateralized
by U.S. government or federal-agency securities, cash, or letters
of credit.
2 At the outset, each
loan is collateralized at a predetermined margin. If the market value
of the collateral falls below an acceptable level during the time
a loan is outstanding, a margin call is made by the lender institution.
If a loan becomes overcollateralized because of appreciation of collateral
or market depreciation of a loaned security, the borrower usually
has the opportunity to request the return of any excessive margin.
When a securities loan is terminated, the securities are
returned to the lender and the collateral to the borrower. Fees received
on securities loans are divided between the lender institution and
the customer account that owns the securities. In situations involving
cash collateral, part of the interest earned on the temporary investment
of cash is returned to the borrower and the remainder is divided between
the lender institution and the customer account that owns the securities.
Definitions of Capacity Securities lending may be done in various capacities
and with differing associated liabilities. It is important that all
parties involved understand in what capacity the lender institution
is acting. For the purposes of these guidelines, the relevant capacities
are:
Principal. A
lender institution offering securities from its own account is acting
as principal. A lender institution offering customers’ securities
on an undisclosed basis is also considered to be acting as principal.
Agent. A lender institution
offering securities on behalf of a customer-owner is acting as an
agent. For the lender institution to be considered a bona fide or “fully disclosed” agent, it must disclose the names of the borrowers
to the customer-owners (or give notice that names are available upon
request), and must disclose the names of the customer-owner to borrowers
(or give notice that names are available upon request). In all cases
the agent’s compensation for handling the transaction should be disclosed
to the customer-owner. Undisclosed agency transactions, i.e., “blind-brokerage”
transactions in which participants cannot determine the identity of
the contra party, are treated as if the lender institution were the
principal. (See definition above.)
Directed agent. A lender institution which
lends securities at the direction of the customer-owner is acting
as a directed agent. The customer directs the lender institution in
all aspects of the transaction, including to whom the securities are
loaned, the terms of the transaction (rebate rate and maturity/call
provisions on the loan), acceptable collateral, investment of any
cash collateral, and collateral delivery.
Fiduciary. A lender institution
which exercises discretion in offering securities on behalf ofand
for the benefit of customer-owners is acting as a fiduciary. For purposes
of these guidelines, the underlying relationship may be as agent,
trustee, or custodian.
Finder. A finder brings together a borrower and a lender of
securities for a fee. Finders do not take possession of the securities
or collateral. Securities and collateral are delivered directly by
the borrower and the lender without the involvement of the finder.
The finder is simply a fully disclosed intermediary.
Guidelines All financial institutions that participate in securities lending
should establish written policies and procedures governing these activities.
At a minimum, policies and procedures should cover each of the topics
in these guidelines.
Recordkeeping. Before establishing a securities-lending program,
a financial institution must establish an adequate recordkeeping system.
At a minimum, the system should produce daily reports showing which
securities are available for lending and which are currently lent,
outstanding loans by borrower, outstanding loans by account, new loans,
returns of loaned securities, and transactions by account. These records
should be updated as often as necessary to ensure that the lender
institution fully accounts for all outstanding loans, that adequate
collateral is required and maintained, and that policies and concentration
limits are being followed.
Administrative procedures. All securities lent and all securities
standing as collateral must be marked to market daily. Procedures
must ensure that any necessary calls for additional margin are made
on a timely basis.
In addition, written procedures should outline how to
choose the customer account that will be the source of lent securities
when they are held in more than one account. Possible methods include
loan-volume analysis, automated queue, a lottery, or some combination
of these methods. Securities loans should be fairly allocated among
all accounts participating in a securities-lending program.
Internal controls should include
operating procedures designed to segregate duties and timely management
reporting systems. Periodic internal audits should assess the accuracy
of accounting records, the timeliness of management reports, and the
lender institution’s overall compliance with established policies
and procedures.
Credit
analysis and approval of borrowers. In spite of strict standards
of collateralization, securities-lending activities involve risk of
loss. Such risks may arise from malfeasance or failure of the borrowing
firm or institution. Therefore, a duly established management or supervisory
committee of the lender institution should formally approve, in advance,
transactions with any borrower.
Credit and limit approvals should be based upon a credit
analysis of the borrower. A review should be performed before establishing
such a relationship, and reviews should be conducted at regular intervals
thereafter. Credit reviews should include an analysis of the borrower’s
financial statement and should consider capitalization, management,
earnings, business reputation, and any other factors that appear relevant.
Analyses should be performed in an independent department of the lender
institution, by persons who routinely perform credit analyses. Analyses
performed solely by the person(s) managing the securities-lending
program are not sufficient.
Credit and concentration limits. After the initial credit analysis,
management of the lender institution should establish an individual
credit limit for the borrower. That limit should be based on the market
value of the securities to be borrowed and should take into account
possible temporary (overnight) exposures resulting from a decline
in collateral values or from occasional inadvertent delays in transferring
collateral. Credit and concentration limits should take into account
other extensions of credit by the lender institution to the same borrower
or related interests. Such information, if provided to an institution’s
trust department conducting a securities-lending program, would not
be considered material inside information and, therefore, would not
violate “Chinese Wall” policies designed to protect against the misuse
of material inside information. Violation of securities laws would
arise only if material inside information were used in connection
with the purchase or sale of securities.
Procedures should be established to ensure that credit
and concentration limits are not exceeded without proper authorization
from management.
When a lender institution is lending its own securities
as principal, statutory lending limits may apply. For national banks
and federal savings associations, the limitations in 12 USC 84 apply.
For state-chartered institutions, state law and applicable federal
law must be considered. Certain exceptions may exist for loans that
are fully secured by obligations of the United States government and
federal agencies.
Collateral
management. Securities borrowers pledge and maintain collateral
at least 100 percent of the value of the securities borrowed.
3 The minimum amount
of excess collateral, or “margin,” acceptable to the lender institution
should relate to price volatility of the loaned securities and the
collateral (if other than cash).
4 Generally, the minimum initial collateral on securities loans is
at least 102 percent of the market value of the lent securities plus,
for debt securities, any accrued interest.
Collateral must be maintained at the agreed margin. A
daily “mark-to-market” or valuation procedure must be in place to
ensure that calls for additional collateral are made on a timely basis.
The valuation procedures should take into account the value of accrued
interest on debt securities.
Securities should not be lent unless collateral has been
received or will be received simultaneously with the loan. As a minimum
step toward perfecting the lender’s interest, collateral should be
delivered directly to the lender institution or an independent third-party
trustee.
Cash as collateral. When cash is used as collateral, the lender institution is responsible
for making it income-productive. Lenders should establish written
guidelines for selecting investments for cash collateral. Generally,
a lender institution will invest cash collateral in repurchase agreements,
master notes, a short-term investment fund, U.S. or Eurodollar certificates
of deposits, commercial paper or some other type of money market instrument.
If the lender institution is acting in any capacity other than as
principal, the written agreement authorizing the lending relationship
should specify how cash collateral is to be invested.
Investing cash collateral in liabilities of
the lender institution or its holding company would be an improper conflict
of interest unless that strategy was specifically authorized in writing
by the owner of the lent securities. Written authorizations for participating
accounts are further discussed later in these guidelines.
Letters of credit as collateral. Since May 1982, letters of credit have been permitted as collateral
in certain securities-lending transactions outlined in Federal Reserve
Regulation T. If a lender institution plans to accept letters of credit
as collateral, it should establish guidelines for their use. Those
guidelines should require a credit analysis of the financial institution
issuing the letter of credit before securities are lent against that
collateral. Analyses must be periodically updated and reevaluated.
The lender institution should also establish concentration limits
for the institutions issuing letters of credit, and procedures should
ensure they are not exceeded. In establishing concentration limits
on letters of credit accepted as collateral, the lender institution’s
total outstanding credit exposures from the issuing institution should
be considered.
Written
agreements. Securities should be lent only pursuant to a written
agreement between the lender institution and the owner of the securities
specifically authorizing the institution to offer the securities for
loan. The agreement should outline the lender institution’s authority
to reinvest cash collateral (if any) and responsibilities with regard
to custody and valuation of collateral. In addition, the agreement
should detail the fee or compensation that will go to the owner of
the securities in the form of a fee schedule or other specific provision.
Other items which should be covered in the agreement have been discussed
earlier in these guidelines.
A lender institution must also have written agreements
with the parties who wish to borrow securities. These agreements should
specify the duties and responsibilities of each party. A written agreement
may detail acceptable types of collateral (including letters of credit);
standards for collateral custody and control, collateral valuation
and initial margin, accrued interest, marking to market, and margin
calls; methods for transmitting coupon or dividend payments received
if a security is on loan on a payment date; conditions which will
trigger the termination of a loan (including events of default); and
acceptable methods of delivery for loaned securities and collateral.
Use of finders. Some
lender institutions may use a finder to place securities, and some
financial institutions may act as finders. A finder brings together
a borrower and a lender for a fee. Finders should not take possession
of securities or collateral. The delivery of securities loaned and
collateral should be direct between the borrower and the lender. A
finder should not be involved in the delivery process.
The finder should act only as a
fully disclosed intermediary. The lender institution must always know
the name and financial condition of the borrower of any securities
it lends. If the lender institution does not have that information,
it and its customers are exposed to unnecessary risks.
Written policies should be in place
concerning the use of finders in a securities lending program. These
policies should cover the circumstances in which a finder will be
used, which party pays the fee (borrower or lender), and which finders
the lender institution will use.
Employee benefit plans. The Department
of Labor has issued two class exemptions which deal with securities
lending programs for employee benefit plans covered by the Employee
Retirement Income Security Act (ERISA)—Prohibited Transaction Exemption
81-6 (46 Fed. Reg. 7527 (January 23, 1981), supplemented 52 Fed. Reg. 18754 (May 19, 1987)), and Prohibited Transaction Exemption
82-63 (47 Fed. Reg. 14804 (April 6, 1982) and correction published
at 47 Fed. Reg. 16437 (April 16, 1982)). The exemptions authorize
transactions which might otherwise constitute unintended “prohibited
transactions” under ERISA. Any institution engaged in lending of securities
for an employee benefit plan subject to ERISA should take all steps
necessary to design and maintain its program to conform with these
exemptions.
Prohibited Transaction Exemption 81-6 permits the lending
of securities owned by employee benefit plans to persons who could
be “parties in interest” with respect to such plans, provided certain
conditions specified in the exemption are met. Under those conditions
neither the borrower nor an affiliate of the borrower can have discretionary
control over the investment of plan assets or offer investment advice
concerning the assets, and the loan must be made pursuant to a written
agreement. The exemption also establishes a minimum acceptable level
for collateral based on the market value of the loaned securities.
Prohibited Transaction Exemption 82-63 permits compensation
of a fiduciary for services rendered in connection with loans of plan
assets that are securities. The exemption details certain conditions
which must be met.
Indemnification. Certain lender institutions offer participating accounts indemnification
against losses in connection with securities lending programs. Such
indemnifications may cover a variety of occurrences, including all
financial loss, losses from a borrower default, or losses from collateral
default. Lender institutions that offer such indemnification should
obtain a legal opinion from counsel concerning the legality of their
specific form of indemnification under federal and/or state law.
A lender institution which offers an indemnity to its
customers may, in light of other related factors, be assuming the
benefits and, more importantly, the liabilities of a principal. Therefore,
lender institutions offering indemnification should also obtain written
opinions from their accountants concerning the proper financial statement
disclosure of their actual or contingent liabilities.
Regulatory reporting. Securities
borrowing and lending should be reported by commercial banks according
to the Instructions for the Consolidated Reports of Condition and
Income and by thrifts according to Thrift Financial Report instructions.
This Federal Financial Institutions Examination Council
policy statement, which was adopted by the Board May 6, 1985, was
revised effective July 21, 1997.
