UK - The Lehman Brothers' collapse and the subsequent turbulence has shown the risk/reward trade-off around securities lending may no longer be worthwhile for pension funds, Watson Wyatt has warned.

In a note to its UK pension fund clients today, the consultant has recommended funds should review their lending arrangements and suspend securities lending activity if necessary.

Pension funds should focus on counterparty risk, collateral and indemnification when dealing with their lending agents - typically custodians - said the firm.

Watson Wyatt added the Lehman Brothers default highlighted the risks involved in counterparty transactions, despite risk agents' ability to re-purchase most clients' assets within two days.

Looking specifically at collateral, the consultancy reiterated the call of other pension professionals and stressed pension funds should ensure the collateral agreed for their lending programme is in line with their risk tolerances and that it should be generally high quality.

"While [we acknowledge] that it would be an extreme chain of events that invokes indemnification and then for it to fail, Watson Wyatt recommends its clients be aware of the potential risks," said the consultant.

Colin Rainbow, head of custody consulting, has advised funds to research collateral types and amounts as well as their reinvestment guidelines, particularly where cash collateral is taken.

"They should investigate counterparty restrictions and any collateral indemnification provisions provided by lending agents. Having done this, if the risk relative to the reward is found to be unacceptable they should immediately suspend securities lending where possible or initiate a gradual withdrawal," he said.

Alternatively, they could remain in the programme once they have changed the lending guidelines by amending the collateral requirements, reviewed the borrowers and indemnification structure and strengthened any cash collateral reinvestment guidelines, he concluded.

If you have any comments you would like to add to this or any other story, contact Carolyn Bandel on +44 (0)20 7261 4622 or email carolyn.bandel@ipe.com

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