Securities loans collateralized by cash—the most popular form of securities lending—can under certain conditions pose significant financial market risks, according to a report from the Federal Reserve Bank of New York. Initiatives to alleviate these potential risks should aim to improve transparency around cash reinvestment practices and to reexamine incentive issues present in standard compensation arrangements between securities owners and agent lenders.
In “Securities Loans Collateralized by Cash: Reinvestment Risk, Run Risk and Incentive Issues,” author Frank Keane provides a brief overview of securities lending, discusses the risks inherent in related cash reinvestment activities, and describes the incentive problems associated with the standard compensation scheme for lending agents. The author also points to the AIG experience to highlight how risk related to cash reinvestment—by even a single participant—could have destabilizing effects.
The report determines that the standard compensation scheme for securities lending agents, which typically provides for agents to share in gains but not losses, creates incentives for them to take excessive risk. “The asymmetric payoff of the standard compensation arrangement is similar to giving a call option to the agent, which, all else equal, provides the agent with an incentive to pursue high-risk investment strategies.”
To address potential risks in securities loans collateralized by cash transactions, the author suggests the implementation of improved transparency practices and realignment of incentives in agent compensation arrangements. Furthermore, an increase in data transparency, in particular around cash reinvestment choices, seems likely to lower the possibility of runs and is a reasonable cost to bear if it mitigates the risk of future financial system disruption.
Frank Keane is a policy advisor and assistant vice president in the Markets Group at the New York Fed.