Recently, Franklin Templeton Mutual Fund (MF) said that it is looking at invoking the pledge against shares offered as collateral by Reliance Big Entertainment and Essel Infraprojects against their bonds. This was done as the bonds were unable to repay the interest and principal, respectively. The episode brought to focus what the lender and borrower can do while dealing with loans against shares (LAS).
LAS is an easy way to tap funds. As these are secured, interest rates are also much lower than those on personal loans. But borrowers must be wary of the risks associated with such advances, as any sharp fall in share prices would trigger a ‘margin call.’
When the loan agreement is inked, the borrower and lender typically agree on what would constitute a margin call. If the share prices fall below a certain threshold, say by 25 per cent, the borrower must bring in additional funds or collateral to plug the gap. The threshold could vary with each lender.
When a margin call is triggered, the borrower must deposit more shares or cash with lender as additional collateral. If shares fall below the value agreed to by the lender and the borrower, the former can sell off the pledged shares in the market and recover the amount.
Here are a few basic things you should know before going for LAS.
Loan amount and interest
Banks and NBFCs (non-banking finance companies) provide loans for up to 50 per cent of the present value of equity shares. The minimum and maximum loan amounts vary—the minimum amount is Rs 50000 for LAS with State Bank of India (SBI), while it is higher for private sector lenders such as HDFC Bank and Kotak Mahindra Bank. The minimum sum is Rs 2 lakh and Rs 3 lakh, respectively for HDFC and Kotak respectively.
Most banks restrict the maximum loan amount to Rs 20 lakh. But NBFCs such as Tata Capital offer a maximum of Rs 20 crore. Interest rates also vary—SBI charges 9.75 per cent per annum, while private sector lenders and NBFCs levy 10.5-12.75 per cent. If the bank offers a loan amount worth 50 percent of the value of your shares, then you need to pledge shares worth Rs 1 lakh for a loan of Rs 50,000.
Individual borrowers can pledge their shares to avail loans to meet contingencies, personal needs or even for subscribing to rights or new issue of shares. Loans, however, are not sanctioned for speculative purposes and inter-corporate investments.
Some banks have restricted LAS to Rs 10 lakh if the purpose is for subscribing to IPOs (initial public offers). You can pledge your own shares, or those of your blood relatives (parents, spouse, children, and blood siblings only) above 18 years of age.
Banks keep a keen eye on your share prices
The value of your shares is crucial for your bank; in case their prices fall, they lose their relevance as the collateral. The portfolio will be revalued by lenders on a regular basis. While some NBFCs review it on a daily basis, several banks do it every week. However, in case of a sharp fall in market prices, an interim revaluation is done, which can happen any time. This is when the lender asks the borrower to make good the loss in value of pledged shares.
“It is not wise to borrow money against shares now as the market fundamentals are still bad,” says G Chokkalingam, founder and chief investment officer, Equinomics Research and Advisory. “If there is panic in the market, the borrower would give short deadlines (to pay) and would start dumping the shares if the money is not made available,” he says. “The underlying risk is always high in a volatile market. So, one has to be careful while doing the leveraging,” says Deven R Choksey, managing director, KR Choksey Investment Managers.
Can you borrow against partly paid-up shares?
Banks and NBFCs do not typically provide loans for partly paid-up shares, stocks that have already been locked-in (already pledged). Some banks also do not lend against shares held in the physical format.
Avoid loans as far as possible. If you’ve lost your job or faced an income cut, then dip into your emergency corpus as much as possible to meet your monthly expenses. If you do not have an emergency corpus, try selling some of your existing investments.
If you must pledge your shares and borrow, be prepared to face the possibility that in extremely volatile markets, you could be called upon to refill your pledge with more shares. Otherwise, your bank will forcefully sell your shares. This can result in a vicious cycle resulting in more pledging and more borrowing.