from the desk of Roy Zimmerhansl,
Practice Lead, Pierpoint Financial Consulting
Premise
The first time I got asked by a potential lending client as to whether an indemnification was worth the money was 1992. So I’ve been thinking about this for a long time. At that time, the offer was a non-indemnified 50/50 fee split between the institutional lender and the agent bank where I worked. The indemnified version was 60/40 in favour of the bank, so it was a meaningful difference in income. My answer was that it was up to them to decide if it was worth it. I added that from my perspective, I didn’t really think the bank would be willing to offer this insurance-like protection if it was ever going to be called on. However, I also said that if an indemnification was the difference between his institution agreeing to lend and not lend, then I definitely thought it was worth it because I believed then, and continue to believe today that this is a low-risk business which provides a reasonable risk-adjusted return.
You can read more of my thoughts on risk in the section "What are the risks of lending" in my blog post "Securities Lending - Pennies in front of a steamroller?". So better in than out, but of course, it’s more complicated today.
Background
For those readers unfamiliar with indemnifications, they provide protection against the impact on institutional lenders in the event of the default of a borrower. At the least, it provides for a return of the securities loaned to the defaulting borrower with the agent bearing the cost in the event the proceeds of the collateral aren’t sufficient to do that. At its broadest, it also covers fees, corporate actions, outstanding dividend and interest payments and cash reinvestment. Agents ensure they are able to meet this contingent liability in several different ways, from capital reserves through to insurance policies and backup liquidity lines. All of these items are part of our regular discussions with investors, and no doubt will be subjects for future blogs.
How much does it cost?
To determine whether indemnities are worth the money, first, you have to know the cost, so “How much?” is a great question. Ask any investor who has asked, and the majority will tell you that it’s not easy to get an answer. Why is that? In some cases, agents can’t actually provide a figure – there are too many variables, and it may not be clear even to them. Others may not want to provide a figure because they don’t want clients to think there is an option to opt-out. Some don’t want to do it because it is part of their secret sauce and revealing the figures may give clients and competitors an insight into their business that they don’t want to provide. Undoubtedly there are other reasons which I haven’t listed.
Of course, this only looks at the ongoing cost of capital or bank commitment lines or insurance premia, not how much agents have to stump up when a counterparty defaults and the machine moves into action. These are even more closely held figures, and many agents maintain they suffered no losses at all although the Lehman Brothers default did catch out some lenders
The cost quantification could lead some clients to suggest to agents that they would forego the indemnification and take a higher share of the fees. That might indeed sit very well with some agents and investors, but competitive pressures may not make this easy to pursue.
Why indemnifications do provide value
Today’s world seems to be motivated more by avoiding failure rather than taking an informed risk. A shame, because all successes are the end-product of the failures preceding that success, but again, a topic for another day. So, indemnifications go a long way to minimising the possibility of a loss resulting from engaging in securities lending. If you have a programme that generates positive income year after year and you hit the inevitable bump in the road and a counterparty defaults, indemnifications help you get as close to a zero-loss environment as can be practically achieved.
Several years ago, I calculated that 17 borrowing firms I have done business with or my clients made loans to, have gone out of business. I stopped counting at that time, and I’m sure I haven’t got every defaulted firm, and as the business spreads around the world, inevitably more firms will go bust, so this isn’t an idle offer. My point is that although Lehman Brothers might be the largest and most obvious example of where indemnities came into play, it’s not alone.
Why Indemnifications may not provide value
As I suggested earlier, the agents wouldn’t offer indemnities if they thought they were going to be drawn on. That’s an oversimplification because the reality is that the agent WOULD offer them if, on balance, the securities lending revenue that accrued as a result of providing an indemnification didn’t exceed the ongoing cost to offer it plus the occasional losses that are an inevitability over a sufficiently long timeline.
The cost question becomes critical here because without it, investors can’t make a reasonable assessment as to the value an indemnification provides, what risk they would be taking on by dropping indemnities and any additional fee share they would require to give it up.
There is also the hidden question of the extent to which high volume, low margin 'General Collateral' business does not get executed by agents because of the cost of indemnification. I am not speaking of the daily trade management operational costs (a separate issue we are passionate about), rather the cost of the contingent liability. Some loans are avoided because the agent’s costs make the GC loans an unattractive proposition.
Again, if you go to the blog mentioned earlier, you will see that quite a lot has to go wrong before the indemnity comes into play. As a result, in most cases the agent isn’t out of pocket because they have carefully selected the borrowers in their programme, they only accept liquid collateral, they carefully manage exposures day-in, day-out, and have robust processes for dealing with a default. No doubt though, there are times when it costs them real money to make clients whole.
So the questions for investors are “How much does it cost for my agent to offer an indemnity?”; “What are the costs in situations where a default has occurred?”; “How much GC business am I missing?”; and “If I dropped the indemnity, what would the fee split arrangement be?”
A Cautionary Note
My concern with the implementation of Basel III and related domestic regulations over the past decade was that the offer of indemnities would be removed from the smaller clients. While I understand the commercials, I cautioned more than one regulator that smaller institutions: would be less able to properly assess the risks of unindemnified lending; benefited more from lending revenues proportionately than bigger lenders; and were less able to absorb losses from defaults, no matter how infrequent.
The Verdict?
Perhaps unsurprisingly my answer will be that it depends on the needs of the individual investor that is lending. I have never been a fence-sitter, so hear me out. I still believe that if it is the difference between participating in lending or not, then of course indemnities offer value. If an organisation is sophisticated enough to assess the risks and takes a sufficiently long-term view to weather an occasional loss (no matter how unlikely), then I think that unindemnified lending may be a powerful decision that delivers extra value. That seems to me a more competitive market – agents with significant capital can continue to offer indemnified lending unfettered, sophisticated investors can capture more revenue, and agents excluded from GC because of indemnification costs rather than a lack of ability could start to compete in that space.
These are difficult and complex issues, and before making any decisions, we recommend that investors speak with trusted advisors. Nevertheless, we believe this is an important and topical issue and critical for competitive positioning in a revenue-challenged market.
P.S. What decision did the client referred to in the opening paragraph take? They opted for indemnified on a 60/40 basis in favour of the bank. They must have been happy with the arrangement because two years later, I was working at a borrower and was the beneficiary of exclusive access to their Thai portfolio. Quite lucrative for both of us, but it was unindemnified.
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