FDIC Federal Register Citations

[Federal Register: July 21, 1997 (Volume 62, Number 139)]

[Notices]

[Page 38991-38994]

From the Federal Register Online via GPO Access [wais.access.gpo.gov]

[DOCID:fr21jy97-66]

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FEDERAL FINANCIAL INSTITUTIONS EXAMINATION COUNCIL

Revised Policy Statement on Securities Lending

AGENCY: Federal Financial Institutions Examination Council.

ACTION: Notice of revised policy statement.

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SUMMARY: The Task Force on Supervision, acting under delegated

authority from the Federal Financial Institutions Examination Council

(FFIEC), has revised the policy statement on ``Securities Lending'',

and is recommending that the FFIEC member agencies adopt and implement

the updated policy statement. The Council's three banking agencies

adopted the policy pursuant to section 1006(b) of FIRA. It was not

published in the Federal Register.

EFFECTIVE DATE: Effective immediately.

FOR FURTHER INFORMATION CONTACT:

FRB: Angela Desmond, Senior Counsel, Division of Banking

Supervision and Regulation, Board of Governors of the Federal Reserve

System, 20th & C Streets, NW, Washington, DC 20551 (202/452-3497).

OCC: Roberta L. Ouimette, National Bank Examiner, Asset Management

Division, Office of the Comptroller of the Currency, 250 E Street, SW,

Washington, DC 20219 (202/874-5331).

OTS: William J. Magrini, Senior Project Manager, Supervision

Policy, Office of Thrift Supervision, 1700 G Street, NW, Washington, DC

20552 (202/906-5744).

FDIC: Kenton P. Fox, Senior Capital Markets Specialist, Division of

Supervision, Federal Deposit Insurance Corporation, 550 17th Street,

NW, Washington, DC 20429 (202/898-7119).

The text of the Revised Policy Statement follows:

[[Page 38992]]

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 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.

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\1\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:

<bullet> The sale and repurchase (loan) of U.S. government or

federal agency securities.

<bullet> Cash is received by the seller (lender) and the party

supplying the funds receives the collateral margin.

<bullet> The agreement is for a fixed period of time.

<bullet> 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.

<bullet> The confirmation received by the financial institution

from a borrower broker/dealer classifies the transaction as a

repurchase agreement.

\2\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.

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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.

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.

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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, 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 U.S.C. 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.

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\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).

\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.

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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 that 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

[[Page 38994]]

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 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.

Dated at Washington, DC this 16th day of July 1997.

Federal Financial Institutions Examination Council.

Joe M. Cleaver,

Executive Secretary.

[FR Doc. 97-19132 Filed 7-18-97; 8:45 am]

BILLING CODE 6210-01-P, 6720-01-P, 6714-01-P, 4810-33-P