American International (NYSE:AIG)
Historical Stock Chart
2 Years : From Dec 2011 to Dec 2013
The Financial Stability Board said Friday it had identified numerous risks to the safety of the financial system in the global market for securities lending, a vital cog in the machinery of most of the world's biggest markets.
At any time of any trading day, there are trillions of dollars tied up in lending and repurchase deals, mainly thanks to a big increase in collateralized borrowing in the world's biggest money markets, the FSB said. It warned that in many cases, securities lending and repo transactions help to raise the overall level of leverage in the financial system, making it more fragile.
At the same time, the structure of the market is often opaque, helping to conceal from regulators and from market participants the risks that are thus created.
The FSB made its comments in an interim report as part of its mandate to reduce the risks generated by "shadow banking," the creation of credit by entities that aren't regulated as banks. "Shadow banks" played a large part in the creation of bubble conditions before the crisis struck in 2007, by creating massive leverage outside the official and more tightly regulated banking sector.
After absorbing comments on its work, the FSB is due to recommend new regulatory measures for shadow banks to the Group of 20 largest industrialized and emerging economies by the end of this year.
The FSB's report was far from a blanket condemnation of the practice of securities lending.
"Liquid securities financing markets are...critical to the functioning of underlying cash, bond, securitization and derivatives markets," it acknowledged.
One of the most crucial functions of securities lending is that market participants often borrow securities for the purpose of shorting them--a process which itself is widely considered crucial for keeping markets properly liquid.
However, the FSB expressed concern that the ability to lend securities against cash collateral, and subsequently to re-deploy that collateral in other credit markets, effectively allows virtually any entity with a large portfolio to act like a bank, exposing itself to both credit and liquidity risks.
The temptation to do just that has risen sharply for many big portfolio players such as life insurers and pension funds, because loose monetary policy since the collapse of the U.S. investment bank Lehman Brothers in 2008 has driven down the returns they can earn on low-risk assets such as government bonds. Lending a part of their portfolio out in return for a fee adds precious few more basis points of yield for companies that are now struggling to meet their policyholders' expectations.
The FSB appeared particularly worried by the issue of rehypothecation, by which participants reinvest the proceeds of short sales, or cash collateral taken against loaned securities, to create new investment positions. At least until the crisis, it was common for the same collateral to be levered many times over through long "re-pledging chains," of which nobody had a proper overview.
Such practices not only raise the overall level of risk in the system, but also the level of interconnectedness, making it more likely that the collapse of one counterparty will have consequences for the whole system. The FSB cited both Lehman and AIG Inc. (AIG).
Although it didn't play up the risk, the FSB also noted a relatively high degree of concentration in certain segments of the market. Nearly two-thirds of the European repo market, for example, is accounted for by only 10 banks.
-By Geoffrey T. Smith, Dow Jones Newswires +44 207 842 9941; firstname.lastname@example.org