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Indemnification in focus as FSB sets out final proposals to tackle fund risks

12 January 2017

A handful of large fund houses act as agent lenders offering indemnifications to their clients

Read more: indemnification FSB

Officials at the FSB have reiterated their calls for authorities to monitor indemnifications provided by asset managers acting as agent lenders.

Setting out a series of final policy recommendations this week, FSB experts said authorities should "verify and confirm" asset managers adequately cover potential credit losses from the indemnification provided to their clients. The specific recommendation forms part of a wider set of proposals first put forward in June last year relating to financial stability risks posed by certain asset management activities. 

A handful of large fund houses, including BlackRock, act as agent lenders offering insurance-like commitments known as borrower or counterparty indemnifications to their clients, notably their funds. The indemnity insures against potential losses when a counterparty defaults or does not return borrowed securities and the pledged collateral is not sufficient to cover replacement of the losses.

Agent lender banks are already subject to the Basel capital requirements for potential losses resulting from indemnification-related exposures. In contrast, asset managers that are not affiliated with banks do not face capital requirements related to their indemnification exposures in any jurisdictions.

"Authorities currently lack sufficient information/data on the agent lender activities to monitor trends and potential risks to financial stability associated with any indemnification they provide to lending clients," the regulator said this week. "When such information/data become available, authorities should verify and confirm that asset managers that provide indemnifications adequately cover potential credit losses from their indemnification."

Legal experts at BlackRock responded to the initial proposals in September last year, saying they were "supportive of efforts to collect additional data on borrower default indemnification provided by all securities lending agents."

However, the firm added that when undertaken along with sound risk management practices, borrower default indemnification it is unlikely to result in material losses to the entity providing the indemnification.

BlackRock added that it was not aware of any asset manager providing securities lending agent services on assets where they are not the asset manager. For example, BlackRock only acts as a lending agent on assets where it also provides asset management services.

In addition, the firm currently requires borrowers to post collateral between 102% and 112% of the value of the securities lent and collateral is marked-to-market daily. Overcollateralization provides a "safety cushion" in the event a borrower fails to return the borrowed security. 

Other policy recommendations put forward by the FSB (there are 14 in total) include further scrutiny on whether certain asset classes are suitable for open-ended fund structures, widening the range of risk management tools available to fund managers at times of market stress, and potentially strengthening investor disclosure on liquidity issues. IOSCO will flesh out many of the recommendations in 2017 and 2018 to put into practice.

Tim Cameron, managing director and head of SIFMA’s Asset Management Group said the trade body will review the final recommendations in detail with its members. "Upon first glance, we continue to have concerns with some of the FSB’s recommendations," he told Global Investor/ISF. "For example, stress testing of open-end funds or system-wide stress testing is not a viable concept and would yield no meaningful benefit for systemic risk management, as noted in our substantive comments to the FSB on its initially proposed recommendations."

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