What is loan against shares and what is the RBI worried about

The RBI has barred JM Financial to stop giving loans against shares and loans for subscribing to IPOs.

Last week, the Reserve Bank of India asked non-banking financial company JM Financial to stop giving loans against shares and loans for subscribing to initial public offerings until further notice.

Through this explainer, we look at the process of loans against shares (LAS) and also what may have been the RBI’s concerns.

First up, what are loans against shares?

Investors who own shares in companies can pledge them with NBFCs, and borrow money against them.

What is the interest charged on these loans?

NBFCs charge anywhere between 10.5 and 13 percent, depending on the shares that have been pledged and the NBFC’s relationship with the client.

Who is the typical customer for LAS?

A majority of them are high net-worth individuals (HNIs) who invest in stocks and derivatives. They use the funds borrowed through this route to buy more shares or trade in derivatives.

Does the borrower have to disclose the end use of the funds to the NBFC?

Yes

How much money can an NBFC lend against the shares?

An NBFC cannot lend more than 50 percent of the market value of the shares — this is also known as Loan to Value (LTV).

How big is the market for loan against shares?

According to estimates by market players, this could be in the range of Rs 50,000-Rs 55,000 crore.

Do NBFCs lend money against all shares?

No, under RBI guidelines, they can lend only against group 1 shares on the NSE.

What are these group 1 stocks?

NSE defines them as stocks which traded at least 80 percent of the days for the previous six months. They also have mean impact cost of less than or equal to 1 percent.

What is impact cost?

It is the additional cost incurred by an investor while buying or selling a large quantity of shares. That is because the buying or selling itself can cause the price to move sharply. A low impact cost means large quantities can be bought or sold without the price getting affected much.

Why is this important?

Because in the event of the client defaulting on margin commitments, the NBFC has to sell the shares to recover its money.

If the impact cost is high, the selling can cause the price to fall sharply and the NBFC may not be able to recover its dues.

Do NBFCs lend to all the stocks in NSE’s group 1 list?

No. Within the group 1 list, every NBFC has its own set of stocks against which it will lend money.

Why is that?

Because some of the stocks on that list can be very volatile. There can be instances where the NBFC may have reservations about the promoter because of past issues. So they may not want to lend against those stocks or if they lend, they may demand more collateral or charge a higher interest rate.

How does an NBFC manage its risk in a loan- against-shares deal?

The value of the shares against which the loan has been given has to be maintained at 50 percent at all times.

Say, the stock price is Rs 100 and the client has borrowed Rs 50. If the price of the stock drops to Rs 80, then the client has to either put up another Rs 20 worth of shares or repay Rs 10. This in market parlance is termed “margin call”.

If the clients fails to do either, the NBFC can liquidate the stock.

Does the NBFC liquidate the shares immediately if the value of the stock falls?

Every NBFC has its own set of risk-management measures. If the price falls up to 10 percent, the client is given three days to bridge the gap but if the price falls more than over 20 percent, the margin call has to be met immediately.

What is RBI’s concern?

In its order against JM Financial, much of RBI’s concerns seems to be centred on financing of IPOs and non-convertible debenture offerings. It has not spelt out what the concerns over LAS were.

Market players say the central bank feels that the money borrowed through the LAS route across the industry is partly responsible for the bubble building up in the stock market.

Some of the NBFCs may not be following the rules for LAS and even be lending against stocks that are not part of the NSE group 1 list. In short, the RBI is trying to check the flow of funds into the stock market.