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5000 - Statements of Policy
{{8-29-97 p.5249}}
FEDERAL FINANCIAL INSTITUTIONS EXAMINATION COUNCIL
SUPERVISORY
POLICY
SECURITIES LENDING
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 has 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 over-collateralized 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 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.
{{8-29-97 p.5250}}
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
counterparty, 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 of and 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
{{8-29-97 p.5251}}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 a
institution's trust department conducting a securities lending program,
would not be considered material inside information and therefore, 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.
{{8-29-97 p.5252}}
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
{{8-29-97 p.5253}}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 FR 7527 (January 23, 1981), supplemented
52 FR 18754 (May 19, 1987)), and Prohibited Transaction Exemption 82-63
(47 FR 14804 (April 6, 1982) and correction published at 47 FR 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 transactions 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.
By order of the Board of Directors, July 22, 1997.
[Source: 62
Fed. Reg. 40816, July 30, 1997, effective July 30, 1997]
[The page following this is 5265.]
1 Repurchase agreements, generally used by owners of
securities as financing vehicles are, in certain respects, closely
analogous to securities lending. Repurchase agreements however, are not
the direct focus of these guidelines. A typical repurchase agreement
has the following distinguishing characteristics:
-- The sale and repurchase (loan) of U.S. government or federal
agency securities.
-- Cash is received by the seller (lender) and the party
supplying the funds receives the collateral margin.
-- The agreement is for a fixed period of time.
-- A fee is negotiated and established for the transaction at
the outset and no rebate is given to the borrower from interest earned
on the investment of cash collateral.
-- The confirmation received by the financial institution from
a borrower broker/dealer classifies the transaction as a repurchase
agreement. Go Back to Text
2 Brokers and dealers registered with the Securities and
Exchange Commission are generally subject to the restrictions of the
Federal Reserve Board's Regulation T
(12 CFR part 220) when they
borrow or lend securities. Regulation T specifies acceptable borrowing
purposes and any applicable collateral requirements for these
transactions. Go Back to Text
3 Employee Benefit Plans subject to the Employee Retirement
Income Security Act are specifically required to collateralize
securities loans at a minimum of 100 percent of the market value of
loaned securities (see section concerning Employee Benefit Plans). Go Back to Text
4 The level of margin should be dictated by level of risk being
underwritten by the securities lender. Factors to be considered in
determining whether to require margin above the recommended minimum
include: the type of collateral, the maturity of collateral and lent
securities, the term of the securities loan, and the costs which may be
incurred when liquidating collateral and replacing loaned securities. Go Back to Text
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