One lesson pension fund executives should have learned from the financial market crisis is this: Securities lending revenue is not a free lunch.
The market meltdown revealed that the risks of securities lending lie in losses from collateral reinvestment, and in liquidity constraints that restrict underlying portfolios.
The problems essentially were the result of a lack of an investment plan for collateral, inappropriate benchmarking by pension funds, and misalignment of interests and fees and risks between the securities lending providers and pension funds. All resulted in pension funds assuming far more risk exposure than they intended.
A report released Jan. 19 by Finadium, a financial markets research and consulting firm, found 80% of pension plan executives favor using intrinsic-value-based securities lending programs, which lend based on the return from the value of securities on loan, while only 20% support lending that combines returns from the value of the securities on loan and collateral reinvestment.
“Sticking with intrinsic value lending (could have avoided) a substantial amount of trouble” that came from pushing risk boundaries on collateral reinvestment, the report said.
The $152.2 billion Florida State Board of Administration, for example, now has reduced the risk in its securities lending program because of losses, realized and unrealized, from the market crisis.
Instead of making bets on reinvesting the securities lending collateral in longer-term securities to boost the return of the program, the board switched to investing the collateral mainly in short-term securities. In addition, it is moving to an intrinsic-value approach to the program, lending securities in such demand they will receive a rate sufficient that it doesn't have to take reinvestment risk.
Pension executives forgot why they perceived securities lending as virtually riskless: Initially it relied on incremental returns from taking little investment risk.
Even now, as they reduce the risk of their programs, they should never fall back to thinking securities lending is without risk, and they should step up their evaluation of it.