Estimating defaults in organized security lending markets

Author:Latif Cem Osken, Ceylan Onay, Gözde Unal
Position:Department of Management, Bogazici University, Istanbul, Turkey, and Istanbul Settlement and Custody Bank, Istanbul, Turkey
Pages:343-362
SUMMARY

Purpose This paper aims to analyze the dynamics of the security lending process and lending markets to identify the market-wide variables reflecting the characteristics of the stock borrowed and to measure the credit risk arising from lending contracts. Design/methodology/approach Using the data provided by Istanbul Settlement and Custody Bank on the equity lending contracts of... (see full summary)

 
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Estimating defaults in organized
security lending markets
Latif Cem Osken
Department of Management, Bogazici University, Istanbul, Turkey, and
Istanbul Settlement and Custody Bank, Istanbul, Turkey
Ceylan Onay
Management Information Systems, Bogazici University, Istanbul, Turkey, and
Gözde Unal
Department of International Trade, Bogazici University, Istanbul, Turkey
Abstract
Purpose – This paper aims to analyze the dynamics of the security lending process and lending
markets to identify the market-wide variables reecting the characteristics of the stock borrowed and to
measure the credit risk arising from lending contracts.
Design/methodology/approach – Using the data provided by Istanbul Settlement and Custody
Bank on the equity lending contracts of Securities Lending and Borrowing Market between 2010 and
2012 and the data provided by Borsa Istanbul on Equity Market transactions for the same timeframe,
this paper analyzes whether stock price volatility, stock returns, return per unit amount of risk and
relative liquidity of lending market and equity market affect the defaults of lending contracts by using
both linear regression and ordinary least squares regression for robustness and proxying the concepts
of relative liquidity, volatility and return constructs by more than variable to correlate ndings.
Findings – The results illustrate a statistically signicant relationship between volatility and the
default state of the lending contracts but fail to establish a connection between default states and stock
returns or relative liquidity of markets.
Research limitations/implications – With the increasing pressure for clearing security lending
contracts in central counterparties, it is imperative for both central counterparties and regulators to be
able to precisely measure the risk exposure due to security lending transactions. The results gained
from a limited set of lending transactions merit further studies to identify non-borrower and
non-systemic credit risk determinants.
Originality/value – This is the rst study to analyze the non-borrower and non-systemic credit risk
determinants in security lending markets.
Keywords Credit risk, Capital markets, Securities
Paper type Research paper
1. Introduction
The act of temporarily gaining the possession of a security in return for a fee is, in
simplest terms, security borrowing. In that context, the previous possessor of the
security is called the lender and the act is security lending. Although a fairly simple
transaction, the act of lending a security can have various motives and thus the details
of the transaction vary accordingly. This market also involves various risks such as
credit risk, liquidity risk, market risk, operational risk, legal risk, settlement risk,
custody risk, recall risk and manipulation and insider trading risks. While these risks
The current issue and full text archive of this journal is available on Emerald Insight at:
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Organized
security
lending
markets
343
Received 2 July 2015
Revised 10 December 2015
Accepted 1 February 2016
Journalof Financial Regulation
andCompliance
Vol.24 No. 3, 2016
pp.343-362
©Emerald Group Publishing Limited
1358-1988
DOI 10.1108/JFRC-07-2015-0032
are recognized by The International Organization of Securities Commissions (IOSCO),
only some of them could be measured. Value-at-risk models used for measuring the
exposure to market risks and internal rating models to measure the credibility of
borrowers are among these tools used in measurement of the given risks.
Security lending in Turkey can be executed in either Securities Lending and
Borrowing Market (referred as OPP after the Turkish name “Ödünç Pay Piyasası”
hereafter) operated by the I
˙stanbul Settlement and Custody Bank Inc. (Takasbank) or as
over-the-counter (OTC) transactions via brokerage rms. The brokerage houses that are
eligible to operate in Turkey can execute transactions in the OPP on behalf of their
customers or themselves; the constraints on the type of securities and the collaterals
related to transactions are discussed in detail in the “Market Risk” section. Takasbank
acts as the central counterparty (CCP) in every transaction in the market: it aims to
create an effective and secure platform for lenders and borrowers, as it acts as the buyer
for every offer and as the seller for every bid in every transaction for both matched
parties. This practice practically eliminates credit risk for the lender while creating
credit risk for the CCP.
Since 2 September 2013, Takasbank has been acting as the CCP in OPP and thus,
each and every transaction in OPP creates a credit exposure to Takasbank, in addition
to other risk types. Operating a security lending market, even without the CCP role,
creates a wide variety of risks for both the market operator and the participants.
However, it would be fair to assume that the greatest risk a CCP is exposed to is the
credit risk. As is the case with every other for-prot lending institution, CCP should nd
an optimum level of credit risk to maximize its prots: it cannot avoid credit risk and
expect to make prots and it cannot be exposed to too much credit risk as defaults may
erode all prots and even capital. As such, Takasbank has an internal rating model to
assess the credibility of the market participants to set credit limits and created a
dynamic collateral system in which the haircuts of the collaterals provided by the
borrowers can change in accordance with price movements. However, this internal
rating model ignores market-wide factors that can act as incentives for borrowers to
default for higher returns. Accordingly, we aim to develop a default indicator in
organized security lending markets in Turkey that focuses on market information such
as liquidity, return and volatility of the underlying asset.
“Managing the credit risk” is an issue as old as the concept of “credit” itself. The
classical approach depends almost exclusively on the analysis of the experts who makes
use of the character, capital, capacity and the collateral of the potential debtor (Altman
and Saunders, 1998). To overcome the subjectivity of the experts involved, most
nancial institutions are now using more objective methods to assess credibility.
Methods chosen range from purely statistical models where all the limit decisions are
made by the system to expert systems where little data are available on debtors and
underwriters use models to guide or drive decisions (Anderson, 2007).
Security lending, in its essence, has differences from bank loans. A borrower who has
both the motive and the cash needed to deliver the security borrowed can still default, if
he/she cannot acquire the security in time. This leads to an interesting conundrum from
the credit risk management perspective; the very fact that debtors who are both willing
and able to pay can still default. The added incentive to voluntarily default a lending
contract, arising from the possibility of acquiring the security with a lower cost in times
of extreme price drops of the security borrowed, just further complicates the default
JFRC
24,3
344

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