Securities Lending — Where Banks Win, But Can't Lose
One source of profit for banks is securities lending, where banks lend the securities of their customers which they are holding as custodians, to hedge funds and other investors who want to short the securities — stocks and bonds — being borrowed. The short sellers hope to profit by selling the borrowed securities short at a high price, then buying them back at a lower price after the securities have fallen in value. However, the short sellers must give the banks collateral, in the form of a cash security deposit, to borrow the stocks to reduce the banks' risks, since they are lending the securities of their customers — not their own securities.
While the securities are lent out, the banks take the collateral cash and — with the permission of the owners of the securities, which are often pension funds and mutual funds — invest the collateral to earn additional income.
If the investment of the collateral performs well, the banks take a percentage of the profits; if they lose, then only the owners of the lent securities takes the losses.
For instance, according to this article, Banks Shared in Profits on Securities Lending, but Not Losses - NYTimes.com, JPMorgan Chase & Company took 40% of profits made by lending out the securities of a New Orleans municipal pension fund, but when such investments lost $340,000 for the fund, the pension fund had to absorb the entire loss. By comparison, in 2007, the New Orleans pension fund earned $70,000 by agreeing to lend out $20,000,000 worth of securities. Large funds have greater bargaining power to reduce the bank's percentage of the profits to as low as 15%.
Banks motivate customers to agree to lend their securities by offering them lower custodial fees. A spokesperson for the Missouri State Employees' Retirement System reported that the fund asked several banks if they would share in the losses as well as the profits, but none of the banks were willing to do so.