The Hindu Business Line : Redesign loans against shares

When the markets are gripped by panic, both lenders and borrowers tend to become jittery. Banks have neither the time nor the inclination to contact borrowers nor can the borrowers by any means bring in the cash at short notice to make good the margin.

— Paul Noronha

Banks generally play safe by pressing the sell button and dispose of the shares pledged against the loan.

Nelatur Syamasundaran

The past couple of years have seen several instances when the domestic stock indices have gone into a free fall. On May 18, 2006, the BSE Sensex fell by 6.76 per cent to close at 11,391 points. It further fell by 453 points on May 19, 2006, to close at 10,938 points. But the situation went out of control on May 22, 2006, when the Sensex fell by 10.2 per cent over the previous day’s close. There were two more such episodes — the Sensex fell by 10 per cent on January 21, 2008, and witnessed a similar fall on January 22, 2008, when trading on the BSE and the NSE had to be halted for an hour due to the index falling at the opening bell.

On these occasions, the shares were (at least on the screen) available at bargain prices but no one seems to have had the funds to indulge in buying. How much of this can be attributed to the panic selling by banks, without investors even realising that there is a funds shortfall? The magnitude of such episodes can be significantly reduced by certain measures. One suggested measure is the re-design of the bank lending mechanism against shares.

Need for review

Bank schemes on lending against shares need to be reviewed and realistic changes made. Banks, at present, lend funds amounting to 40-50 per cent of the market value of shares held in a Demat account, usually computed every weekend.

Given that markets have at times risen swiftly in the recent past (the Sensex which closed at 9397 points on December 31, 2005, went up to 12,612 by May 10, 2006, a jump of 3,215 points or 34 per cent over just four months). In such cases of unusual uptrend in the markets, the drawing power or the limit of the loans against shares is also automatically revised upwards by the banks. By using the additional money thus available in the loan account, investors are tempted to buy additional exposures. Under normal market conditions, any shortfalls in the margin on these loan accounts, due to fall in the value of the portfolio, is made good without much of a difficulty.

But if the markets are gripped by panic as happened recently, both lenders and borrowers tend to become jittery. Under such circumstances, banks have neither the time nor the inclination to contact borrowers nor can the borrowers by any means bring in the cash at short notice to make good the margin.

Banks thus play safe by pressing the sell button and dispose of the shares pledged against the loan. Though they earn interest on the same, it is not unusual for banks to make such sales unilaterally; this further worsens the market situation, with falling prices triggering more disposals.

It is therefore in the interests of both the parties to modify the lending scheme against shares. Should banks lend on the basis of market valuations of shares, which are clearly unsustainable? Here’s an alternative to arrive at fair value:

Suggested approach

1) On April 1 and October 1 every year, arrive at the average value of shares for the immediate preceding six months period.(that is, April 1 to September 30 and October 1 to March 31 of a year, as the case may be) based on the daily or weekly closing prices.

2) Compute the value of a share by assigning a multiple of 10 times the company’s EPS duly adjusted for extraordinary items; and

3) Compute the value of a share considering a multiple of two times the company’s book value after deducting unadjusted losses/expenses and revaluation reserves from the reserves and surplus.

The least of all the above can be considered as a fair value of the share.

For computing 2 and 3 above, one should consider the audited accounts of the company for the latest available period.

Changes may also be made to the lending schemes so that borrowers have a bigger time window to make good their margins. Even with new age banking, it takes anywhere between two and six days for transfer of funds from the West to India. One reason for this is that all the inward remittances pass through the Reserve Bank of India.

Within India, electronic funds transfer facilities are not available at a large number of branches; even in metros, they are restricted to select branches. Local cheques deposited for transfer through ECS are subject to normal clearing time lag of 1-2 days. Further, if the borrower were to pledge additional securities to make good the deficit in his account, it cannot be done electronically and it takes a minimum of two days under the present manual system.

Considering these practical aspects, banks should be required to give at least 72 hours notice to borrowers to make good any deficit in margin money either by payment of cash or additional securities. After all, banks, as lenders in business, cannot completely protect themselves from the vagaries of the stock market at the peril of borrowers and the capital market.

(The author is CEO, Right India Consultancy House (RICH). The views expressed are personal. Email: syam472001@yahoo.co.in)

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