Wait a second. Lending is not a risk-free activity. These index funds are supposed to be low risk. What happens in a short squeeze situation?
Anyway, loans are marked to market daily with collateral required. Details are here: https://personal.vanguard.com/pdf/ISGSL.pdf
It is absolutely a risk, but I think you err by saying index funds are supposed to be low risk.
Thanks for the link, but I think even with 102% collateral marked to market daily, short sellers could still default and cause the fund to lose gains. It would be a black swan event, but the losses would be much larger than the 3 basis points they claim to gain from lending. Missing a small number of up days in the market has a huge negative effect on returns.
The only time you lose money is if you want to sell and can't because you've loaned out your shares. But with a large index fund, that's extremely unlikely: you can easily lend out a small portion of your shares all the time (say 5%) with virtually no chance that too many customers will want to cash out all at the same time.