Securities Loans Collateralized by Cash: Reinvestment Risk, Run Risk, and Incentive Issues

Securities loans collateralized by cash are by far the most popular form of securities-lending transaction. But when the cash collateral associated with these transactions is actively reinvested by a lender's agent, potential risks emerge. This study argues that the standard compensation scheme for securities-lending agents, which typically provides for agents to share in gains but not losses, creates incentives for them to take excessive risk. It also highlights the need for greater scrutiny and understanding of cash reinvestment practices-especially in light of the AIG experience, which showed that risks related to cash reinvestment, by even a single participant, could have destabilizing effects. [PUBLICATION ABSTRACT]