Monday, December 23, 2019

Corporate governance and regulatory failures in pledged shares

Livemint has a very good article that shines light on the loans against shares (LAS) market in India. Indian promoters have routinely pledged shares to NBFCs and mutual funds to avail loans. 
The total amount of pledged promoter shares as on 9 December for 838 firms is about ₹2.25 trillion. While the sums involved have come down somewhat from a peak of ₹3.04 trillion in January 2018, a series of defaults could send ripples across the whole financial system. With NBFCs already under significant stress, if a big corporate does not service its interest, it could add to the stress. Interest rates on outstanding loans from non-banks are high, ranging from 9-15%. NBFCs also do not have any ceiling on the amount of loans they can sanction against shares. Several borrowers have also preferred to raise money through mutual funds, through an instrument called zero coupon bonds. It is essentially a debt instrument that does not pay interest, but instead trades at a deep discount, rendering a profit at maturity when the bond is redeemed for its full face value. The reason behind the new-found popularity of instruments like zero coupon bonds over the last few years is simple: while banks have several restrictions imposed by the Reserve Bank of India (RBI), mutual funds do not. The hassle of a regular interest payment is also absent...
The shares were either pledged to an NBFC at a 2:1 cover, or a mutual fund as collateral on their debt issuances at a cover of 1.5-1.7, and to banks as a part of corporate loans. Simply put, a cover means the value of securities against the quantum of loan extended. For instance, if the lenders extend ₹100, then a 2:1 cover entails that the lender will take securities worth ₹200 as collateral. As the stock price of some companies fell, the cover diminished, and anxious investors began calling in on the pledge.
Some observations 

1. What were the funds being used for? Given the poor quality of corporate governance among Indian companies, there should have been strong reasons to doubt the reasons for availing such loans.

The RBI had raised concerns about this as early as December 2013. In fact, one RBI report had even raised this possibility,
“In some instances, the shares pledged by unscrupulous promoters could go down in value and the promoters may not mind losing control of the company as there is a possibility of diversion of funds before the share prices collapse."
The reputations of at least some of the corporate groups are questionable enough to have raised concerns about the potential misuse of this less regulated credit channel.  

2. The liquidation of these shares by lenders, thereby stripping promoters of control over their companies is a welcome development. It is a rare example of capitalism with exit for Indian promoters. 

3. It is clear that LAS had become an important channel for fund raising by corporates in recent years. The volumes involved attest to the same. Now that it is exposed and regulatory limits have been tightened, this channel is likely to dry up as a source of funding. Further, a default by one of the larger corporate borrowers on LAS can add to the problems facing the credit markets. In any case, this is one more squeeze on the credit tap.

4. This raises questions about whether the regulators were behind the curve. The RBI Financial Stability reports going back to 2013 means that the regulators were aware of the issues.

What was the quality of LAS market surveillance? Were the profiles of the borrowers being monitored? Were the portfolios of the NBFCs for LAS exposure being monitored? Were the portfolios of the Fixed Maturity Plan mutual funds for LAS holdings being monitored? Were there at the least some reporting requirements on them? How were the promoters being allowed to pledge shares without disclosing them? Was the LAS issuance cover not being monitored and considered for raising based on the emergent trends that pointed to its being abused? What were the reasons for the delays in taking action on regulatory limits despite the early knowledge of the problems? Was the raising of issuance cover discussed by SEBI or RBI earlier, and if so, why was it not raised? Was it the reluctance to throw sand into the wheels of a credit source that was being used by the mainstream corporates and which appeared healthy?

1 comment:

KP said...

Dear Gulzar,

Thank You, for raising questions and shining a light that makes the modus operandi a little more obvious. There are three possibilities -

- one, of a disturbing absence of regulatory control, that had been exploited by politicians under the cover given by pliant bureaucrats (the institutionalized loot sharing mechanism)

- two, is what appears to be an absence of competence among the "economist / statistician " led RBI, that simply did not have sufficient knowledge of their operational domain and the real world. This becomes even more glaring because the RBI governor of that time suddenly starting waxing eloquent about the gaping NPA's after the monies had flown the coop.

It is time to separate the advisory capacity in the RBI (in the form of statisticians and economists, catering to their intellectual dogmas or the flavor of the season economic school - in this case inflation targeting) from the executive-operational capacity of the same(RBI)- which requires governors with a flair for more than just a statistical prognosis of an economy. I think we blundered by plonking for pedagogical/ideological purity and academic reputation rather than a combination of operational pragmatism and wider intellectual perspective. That we have now finally reversed.

One of the possible blunders we are paying for - is the outcome of the tight monetary policy of the Rajan led RBI that squeezed out the optimism of the 2014 election verdict, and that appears to be a last ditch attempt of trying to recoup reputation from what was banking blunders (willful and politically influenced or plain incompetence (?)) under the RBI watch upto then - which created an inflated asset bubble. We have to see how this damage to the economy plays out and if its gaming had political undertones, that we may see playing into the future - particularly since a lot of attempts at directing responsibility (for the economic (mis)management 08-14) had an underlying flavor of calculated misdirection.

The knee-jerk reaction in 2014 by the RBI to the profligacy of the banks in the years 08-14, seems to have been driven more by lopsided intellectual considerations and gaming for academic reputation (catering to the inflation targeting academia).

In hind-sight (the years 08-14) reflects a possible criminal nexus under the guise of fiscal policy - a political nexus that appears to have played its cards under the cover of plausible deniability and the legal/procedural facade of propriety. We will know, and never will we fully, and only when the courts rule on the cases at their disposal.

- The third case is one of dead-wood rising to the top of banks, who hardly have any incentive (particularly in the public sector) to either upgrade their knowledge a or resist political pressure - when playing along is a moral hazard with a lot private gains.

The economy has changed significantly, and as the VC game suggests, staying on top of both technology as well as domain issues in relevant industries (whether jewelry, manufacturing or platform based businesses) requires expertise that is beyond the capability of slothful, bureaucratic bankers who hardly have an incentive to upgrade their defunct knowledge base.

The systemic institutional issues apart - it is slightly circular to have a large part of the loans tied to pure financial assets, which is both bad design as well as ideally placed to be gamed by all the players involved, even under conditions of intelligent monitoring and control. This double balance sheet problem / recursive contagion if you can call it that, is a stark example of faulty recursive design that could only have spiraled inward during bad times. (that is despite any statistical risk measures that are given to justify the design of such a loan).

Do banks by design have such recursive risks ? What is the basis in theory for this sort of risk and what is the theoretical limit of such a risk allowed in the portfolio of lenders ?? any references ??

regards, KP.