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Opting out of indemnification may carry high cost

02 February 2017


Beneficial owners need to dedicate significant internal resources to risk monitoring if they are unwilling to pay for indemnification

Read more: securities lending

Beneficial owners are increasingly being offered different fee splits depending on whether their programme is indemnified – but securing a better fee split may not be worthwhile if the institution is not able to manage risk effectively.

The amount of programmes that are not indemnified remains small – at the at the IMN US Beneficial Owners conference session on the topic only two of 60 representatives did not have it – but the increasing balance sheet cost of providing it means some agent lenders are applying pressure to go without it.

However, indemnification – agent lenders protecting beneficial owners against losses from their lending programmes – remains a key component for many.

William Locke, chief risk officer at eSecLending, which has insurance-based indemnification, said that indemnification includes a package of risk management tools rather than just guarantees.

Each agent lender will have different processes but, speaking for his firm, Locke noted that it includes assessing credit risk of counterparties – approvals, due diligence, continuous reviews – monitoring market signals such as CDS spreads and share prices, daily interactions with counterparties and "talking to the Street".

"You incorporate all of that in and think ' how comfortable am I expending credit to that counterparty? And, you incorporate all that in to market risk management – what are you lending and what collateral are you taking back."

He noted that everything is viewed through a "risk lens" and continuous stress-tests are carried out: "This is all behind indemnification, its skin in the game for anyone offering indemnification. Without indemnification, you need to give serious thought to whether you have the resources and capabilities to have a comprehensive approach to handling your exposures."

Lance Wargo, North American head of agency securities lending, BNP Paribas, warned that the Lehman crisis exposed the importance of being able to act quickly to avoid losses in extremely volatile market conditions.

"There were some problems because not all agent lenders had good collateral liquidation programmes," he said. "There is definitely potential for losses on the lending side."

BNP Paribas offers traditional balance-sheet-based indemnification on its lending programmes.

"Now we are talking about having a two day stay protocol in effect," said Wargo. "Then, you are going to have to wait and you are taking a bigger risk than people think."

Brian Yeazel, managing director - fixed income, Northwestern Mutual, added: "There have been a number of changes with Dodd-Frank. Even now, if you lend to a SIFI [systemically important financial institution] no matter what agreements you have they could be put on hold for a period of time.

"That is where you may run into a period of wanting indemnification whether for execution risk – you can’t get your securities back on time – or even loss – from being undercollateralised."

Northwestern Mutual self-indemnifies, as it runs its own programme and has expert credit personnel internally. "The way we manage our programme right now, we can’t indemnify it. But we do evaluate the risks internally, and are comfortable with those risks."

James Vance, vice president and treasurer, Western & Southern Financial Group, said: "If you have indemnification, you should still attempt to have as much risk control as possible – it is not designed to completely absolve any beneficial owner."


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