[Federal Register Volume 62, Number 139 (Monday, July 21, 1997)]
[Notices]
[Pages 38991-38994]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-19132]


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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:
     The sale and repurchase (loan) of U.S. government or 
federal agency securities.
     Cash is received by the seller (lender) and the party 
supplying the funds receives the collateral margin.
     The agreement is for a fixed period of time.
     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.
     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.

[[Page 38993]]

    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