The Hindu Business Line : Should banks trade in shares?

Trading in shares by banks is close to speculation or gambling and the risks could, thus, be enormous. This calls for deeper scrutiny both by banks and the RBI, besides SEBI, lest the economy is visited yet again by another scam, with huge losses for the banking system, says R.Viswanathan.

A RECENT announcement by the country's biggest bank has the potential to expose the banking system to large losses. The total amount at risk for all the banks could range between Rs 18,000 crore and Rs 36,500 crore, depending on whether the regulatory restrictions of the Reserve Bank of India are fully complied with or not. The new area where the State Bank of India is reportedly venturing into is trading in shares of companies in the secondary market. Various facets of the business call for deeper scrutiny both by banks and the RBI, besides SEBI, lest the economy be visited once again by another scam, with huge losses for the banking system.

Banks the world over do not indulge in trading in shares for several reasons. In the US, after the Great Depression in 1929, banks were prohibited from the stock market by Glass-Steagall Act and this was lifted only a few years ago. The rationale was that this activity is fraught with risks, which the banks had better avoid. In India, for a long time, the RBI did not permit banks to trade in shares and frowned upon even lending against shares.

Although these are now freely allowed, subject to prudential norms, banks are generally reluctant to lend to share brokers against shares as security; when they do lend, the margins could be stiff at around 40 per cent.

The RBI has also placed prudential restrictions on the total exposure of banks to shares. The aggregate of direct and indirect (referring to loans against shares) investment shall not exceed the lowest of the following three:

a) 30 per cent of the bank's net worth or the investee company's paid-up capital, whichever is lower;

b) 5 per cent of the bank's advances, including investment in commercial paper as at the end of preceding March; and

c) 20 per cent of the bank's net worth, or, paid-up capital and free reserves.

The total advances of banks at end-March 2003 were Rs 7.3 lakh crore and the ceiling under (b) would be Rs 36,500 crore. The aggregate net worth of banks as on March 2002 was about Rs 84,000 crore and now the figure could be over Rs 90,000 crore and, therefore, the limit under

(c) would be Rs 18,000 crore. Thus, if banks do not follow the ceiling under (c), which is a later addition, they could put the higher figure of Rs 36,500 crore at risk in the stock market. And, the ceiling will keep on increasing, so long as banks are in the business of lending and earn profits from operations.

Banks would face three major problems when they enter the stock market — competence, risk of losses and simple ethics. As regards competence, banks are traditionally deposit-takers and loan-givers. In such operations, they do have some time to examine and take a view. But in the stock market, their reaction has to be instantaneous and based more on expectations than on fundamentals of business.

One may ask whether banks are not active in foreign exchange markets, where also instantaneous decisions are made. While the stock and forex markets are somewhat similar, there are two crucial differences. One, the forex market is less volatile than the stock market. The Bell Weather index Sensex in India has moved up by 25 per cent in one year and has also gone down by the same extent earlier. Foreign exchange rates do not go on such roller-coaster rides. Two, in forex, banks always cover their positions and do not hold large value of any currency for more than a day or at best a few days. Banks observe scrupulously intra-day and overnight limits on holding currencies.

As the bubble in information technology companies the world over showed recently, the value of shares need not have any relationship to their intrinsic worth. In financial markets, one could trade for either hedging one's existing exposure or for speculative gains/losses or for pure and simple gambling. Hedging refers to a situation such as a forward contract where a bank buys or sells a foreign currency, say, the euro to be delivered after three months and to protect itself against fluctuation in the value during that period, sells or buys euro. That is, it covers the exposure. But, then, all operations in the stock market are either for speculation or for gambling, except in the rare case where the operator wants to hedge against a forward contract. Most, if not all, trading in shares by banks would come under speculation or gambling.

Risks in share trading could, thus, be enormous. For example, the high and low prices of shares during the last one year are quite revealing. Of the 50 shares that comprise the S&P Nifty index, a majority of 27 had a fluctuation of over 50 per cent and another 12 between 40 per cent and 50 per cent. Thus, if one had bought the shares at the high level and sold at the low level, the loss would easily be over 50 per cent in the 27 scrips. With such high quantum of loss in just one year, it is extremely risky for banks to enter the field. If at all banks enter, prudence dictates that:

a) they should fix a limit up to which they will invest in the secondary market; and

b) provide for at least 50 per cent of that limit for possible losses.

More than the likely large losses, it is the ethical dimension that is extremely disturbing. All major companies have banking (borrowing) arrangements with banks and the top two banks are likely to have lent to almost all the companies. And, by the very nature of the relationship, the companies are expected to share vital information of their operations, finances, and so on, with their bankers; such information is not usually available to the general public. If these banks were to trade in the shares of the borrowing companies, would they be using "price-sensitive" information available only to them in these trades?

Assuming that a company is having cash flow problems due to adverse market for their products and the banker comes to know of it, would the bank not sell the shares at the earliest opportunity? In other words, banks are susceptible to use insider information in their share trades.

In advanced countries, the problem is sought to be resolved in investment banks by creating "fire walls" or "Chinese walls" between the merchant banking division, which might get a lot of information and the broking arm; it is said that price sensitive information is not allowed to be passed on between these divisions by creating artificial barrier to the flow of information. True, such an arrangement could be put in place in banks also, but the effectiveness is extremely doubtful.

Both the loans and investment departments would report to one authority, say, executive director in public sector banks. In fact, having come to know of the problems of a particular company, if the executive director was a passive observer of the investment division holding on to the company's shares, he/she could even be hauled up for dereliction of duty by the vigilance authorities. The only way to ensure that banks do not abuse their privileges as `insiders' is to prevent them from trading in shares of companies which are borrowing from them. This could operate well for the smaller banks, but not for the bigger ones.

From ethical considerations, banks should not be allowed to trade in shares in the secondary market. However, if at all both SEBI and the RBI are able to put in place some effective systems to avoid insider trading by banks, each bank must be asked to set apart at least 50 per cent of the limit up to which it invests in the secondary market as assigned capital for this business.

Only the remaining amount of capital and reserves should be reckoned with for computing capital adequacy purposes. Will the RBI and SEBI initiate proactive action in this regard, before it is too late and a high-powered Parliamentary Committee forces them to do so?

(The author is former Deputy Managing Director, SBI.)

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