The risk management technique known as value at risk could allow for better monitoring of securities lending activities.
But it's unclear how easily and how quickly VAR will be adopted, if at all, by the securities lending industry.
Industry participants have been searching for a way to benchmark securities lenders that includes the many variables involved with the process.
Securities lending practices fell under scrutiny a few years ago following investment losses taken by Orange County, Calif., and in securities lending portfolios managed by Mellon Trust, Boston, and Harris Trust & Savings Bank, Chicago.
Officials for the biggest custodial bank for U.S. tax-exempt assets, State Street Bank & Trust Co., Boston, are leading the charge in adopting the use of value at risk as a way to evaluate securities lenders.
Value-at-risk techniques are getting a push from State Street as a way to translate the different strategies within the securities lending industry into a comparable number.
But some experts say that while VAR might have a use in evaluating securities lending, it won't be the answer to the benchmarking dilemma in the near term.
Basically, value at risk is a statistical attempt to identify the amount a portfolio will lose over a set time period, and with a given confidence level. For example, a $100 million portfolio of U.S. equities might have a value at risk of $3 million over a coming week, with a 95% degree of confidence.
VAR generally does not try to capture unusual events, and in those circumstances the losses could be much greater.
In securities lending, a custodian will lend out a portion of the securities in a client's portfolio, typically receiving cash collateral from the borrower. Because the cash collateral will be returned with interest, the securities lending agent will need to invest at a rate greater than the agreed upon interest rate to make any money for the client and securities lending agent.
Given that lenders can take a variety of tacks when investing that collateral, value at risk could be used to compare those differing approaches, according to its proponents.
For example, if different custodians competing for an assignment each expect to earn the same amount of securities lending revenue for the potential client, the one to select ideally would be the one taking the least amount of risk, said Ralph F. Vitale, executive vice president in the securities lending division of State Street. Value at risk could help institutional investors do that.
As part of that view, State Street is offering VAR as part of a new risk-adjusted performance measurement system for securities lending clients.
But investment consultants and other securities lenders are not jumping behind VAR as an answer.
Maarten Nederlof, vice president with the consulting firm Capital Markets Risk Advisors, New York, said value at risk potentially could be useful, but there are two things one would want to know.
The first regards mapping, a VAR technique that involves substituting market indexes or other proxies for the actual securities in calculating how portfolios are expected to behave. One would want to determine how well the mapping fits the securities lending process.
Also, one would want to know how much of the risk in securities lending actually can be captured by value at risk, he said.
Bo Abesamis, vice president and manager for Callan Associates Inc., San Francisco, said value at risk is one useful tool among many risk management methodologies that could be used to evaluate securities lenders.
The industry is doing the right thing in trying to build its risk management capability, but Mr. Abesamis said he doesn't think VAR holds all of the answers.
"You're modeling reality based on what you have observed. So there's a lot of caveats," he said.
The ideal risk management tool for securities lending has not been developed yet, he said.
Gene Picone, global product manager for securities lending at Chase Manhattan Bank, New York, said value at risk is a good tool for evaluating risk, but for now, it makes a difficult-to-understand process even more complicated.
"We're trying to keep this as simple as possible," he said.
Moreover, he said using VAR on Chase's securities lending investment portfolios wouldn't be very useful, because Chase runs a matched book, meaning it tries to minimize market exposure. Chase tries to earn its securities lending revenue through distribution, he said.
William Smith, managing director for securities lending with Bankers Trust Co., New York, a company that helped pioneer the use of value at risk among institutional investors with its RAROC 2020 service, said VAR might have a role in the process, but it isn't the answer.
Value at risk doesn't capture all aspects of the lending process, he said. Because the portfolios available for lending will vary from client to client, and VAR doesn't account for that, VAR is less useful, he said.
He said improved reporting and well-written investment guidelines are other necessary risk management controls.
Orrin Bargerhuff, head of consultant Bargerhuff & Associates, Dallas, said value at risk could be useful for institutional investors on the investment side, but on the lending side of the securities lending transaction, the lending bank might be the bigger beneficiary.
If a securities lending agreement is worded correctly, securities lending clients are basically protected against losses from the failure of lending counterparties, he said. So, the use of VAR on that side of the lending equation is likely to benefit lending agents more than clients, he said.
Institutions should weigh the benefits of VAR with the costs of implementing it, he said.
