Securities Lending Pays for Custody
Louise Story’s original article was the subject of an editorial in Friday’s New York Times, The Bank Wins. Both the original article and the editorial use the opportunity to engage in the popular and easy task of bank bashing. However, jumping onto this bandwagon simplifies and overlooks otherwise complicated dynamics underlying our financial system.
Securities Lending– typically knows as Sec Lending — most often is tied to the custody services provided by banks. In fact, in the early days of Sec Lending, the Sec Lending units of banks were often housed within the custody area of banks. And custody sales people often sold Sec Lending relationships. It wasn’t until the explosive growth area of the late 1990’s when they were granted status as separate divisions or areas within a financial firm.
Sec Lending became a very hot “valued-added” service for the custody banks. First, pension plans hate paying custody fees. But they have no choice because ERISA requires that plan assets be held by a custodian (either a bank or an insurance company). Second, from the bank’s perspective there is little sexy or exciting in the realm of custody other than various accounting and record-keepping services — essentially commodity type products. Sec Lending, however, holds out the prospect of significant fees.
Pension plans which engage in Sec Lending can net the revenue generated by Sec Lending against custody fees. The tight relationship between custody and Sec Lending is reflected in Mercer consultant, Jay Love’s statement that,”Whenever we say no Securities Lending,” then they say ‘well, we need to talk to you about your custodial fees.'”
Ms. Story also states that “Banks often pressure pension funds to participate in securities lending, pensions consultants say.” Yes, banks clearly want to sell Sec Lending services, but focusing on “pressure” seriously mischaracterizes the relationships between banks and pension fund decision-makers.
The custody and Sec Lending business is highly competitive. Banks don’t like to lose customers … especially to competitors. Fees and relationship are highly negotiable.
Pension plans have enormous leverage. They do not have to accept the terms foisted upon them by banks. And, they have the ability to shop terms around the various banks. This happens all the time. There are few secrets in custody/Sec Lending marketplace. Remember, the pension plans always have the option of saying “no”. Nothing requires Sec Lending. This is a powerful position from which to negotiate.
Ms. Story, and the Times editorial, paint a picture of hapless powerless pension plans who are manipulated and at the mercy of the big bad banks.
This simply isn’t the case. Pension plans must simply exert their fiduciary powers. Plan fiduciaries must assess the various risks posed by financial products and accept those risks when they are being adequately compensated. In order to assess risks, however, the risks have to be understood. And this is the rub. If Mr. Davis (see, Part I) of the New Orleans municipal employees fund is representative of pension decision makers, then assessing risk will be a daunting task. Clearly, he never understood Sec Lending and therefore was in no position to assess the risk.
To be fair, there were abuses by the banks in Sec Lending. Investment guidelines with respect to the investment of cash collateral were violated and if many of the facts set out by Ms. Story are corroborated then serious conflicts of interest arose. Absent these abuses, however, Sec Lending works. Plan fiduciaries simply have to exercise their fiduciary duties and decide whether they are adequately compensated for these risks.
In light of the abuses, Ms. Story and others suggest that further regulations might prevent future abuses. No new regulation is needed. Both ERISA and the current Securities Laws are very effective regulatory schemes. Instead, we need a system in which fiduciaries pose a force as strong as Wall Street’s. http://harrisonfiduciary.com/about/
Attention should be focused on the thousands of plan fiduciaries –many of whom are no different than Mr. Davis. As Ms. Story states, “no one would take Jerry Davis for a financial hotshot.” This is a difficult statement to parse. For it suggests an element of ridicule or even a patronizing attitude. No, Mr. Davis isn’t a financial hot shot. But, this isn’t a joke. He is in the position of making fiduciary decisions on behalf of thousands of workers. This is not about being a hotshot. This is about the prudent investment of hard earned retirement dollars.
With over $16 trillion held in retirement plans, it is not surprising that Wall Street devotes significant resources to developing products and services for this market. The people on Wall Street are both smart and aggressive. It’s not enough to state that Mr. Davis isn’t a financial hot shot. Plan participants deserve fiduciaries who are as well versed in investment products as the salesman of Wall Street.
Ms. Story has focused attention on a little understood, but highly profitable product for Wall Street. This spotlight is critically important. However, she should follow up her efforts by digging into the qualifications and competence of the fiduciaries overseeing America’s retirement plans. My prediction is that many would be shocked at what passes for fiduciary oversight. Strong, well trained investment fiduciaries could effect significant financial reform without a single new statute or regulation.