Loan Against Shares (LAS) – Appreciating the Risk to the Lender

Recently, there has been a lot of talk on the transactions in loan against shares (LAS). Many financial institutions (FIs), especially the mutual funds (MFs) and non-banking finance companies (NBFCs), have suffered losses on account of their LAS portfolios.

Let us try to understand where several FIs could have failed to correctly assess and manage a LAS product.

1. LAS is not a credit product

While the LAS is termed as a loan, it is actually not a loan, but a market security. Let us see how.

Consider a simple LAS transaction. A lender lends, at time 0, Rs 100 to a borrower against a security of a given initial value of XYZ shares. The loan is to be repaid by the borrower at time T. The interest is accumulated over the period of the loan and the repayment amount at T is Rs. 120.

Such a LAS transaction can be synthetically constructed with a mix of the following trades:

i. The lender buys a bond, at a price of Rs. 100, issued by the borrower. The bond has a maturity date of T and maturity value of Rs. 120.

ii. The borrower buys a bond Future from the lender. The Future is scheduled to be settled at time T at a price of Rs. 120.

iii. The borrower buys a put option written by the lender. The option is on underlying XYZ shares, has a strike price of Rs. 120, and expires at time T.

Note that while all three trades have happened at time 0, the settlement and delivery of the trade mentioned in (i) is on a spot basis, whereas the trades mentioned in (ii) and (iii) would be settled and delivered at time T.

Now, a rational borrower will act, at time T, with respect to the trades in (ii) and (iii), in the following manner.

A. If the price of XYZ shares is Rs. 120 or more, the borrower will settle the trade in (ii) and let the option in (iii) expire.

In simple words, the borrower will repay the loan. The lender does not lose any amount.

B. If the price of XYZ shares is less than Rs. 120, the borrower will exercise the option in (iii), thereby delivering the XYZ shares to the lender, and receiving Rs. 120 and then settling the trade in (ii).

In simple words, the borrower will default on the loan and relinquish the XYZ shares (the collateral) to the lender.  The lender loses an amount equal to the difference between the price of XYZ shares and Rs. 120.

Thus, it may be seen that the lender suffers a loss as a direct result of the price of XYZ shares falling below Rs 120 at time T. This makes the set of transactions, bundled as LAS, a market risk product. The loss to the lender has no direct relationship to the credit rating of the borrower.

In practice, the borrower would ascribe a value, higher than the market price of Rs. 120, to the collateral shares, to account for the value of significant management control, wherever applicable. So, the exercise by the borrower of the put option would actually happen at a price higher than Rs. 120. However, this is a finer point, and does not affect the fundamental structure of the LAS product, as explained above.  

Having understood that LAS is a market risk product, let us now see if the FIs are following the sound practices for such a product.

2. Analysis and Approval

LAS should not be housed in the credit portfolio or approved by the Credit Committee. It should be analysed by the Markets team and approved by the Investment Committee.

This also means that the methodology for analysis of LAS needs to be be appropriate for measuring market, rather than credit, risk. The volatility of the equity market and the underlying stock should be of prime concern in the analysis.

3. Monitoring and Reporting

Loans to borrowers are reviewed, usually, at monthly or quarterly intervals. However, LAS, being a market risk product needs continuous monitoring. The price of the collateral shares must be checked at least on a daily basis and tested for adequacy of loan cover.

The reporting of LAS should be included in the daily marked to market reports from the trading desk. It should clearly indicate the loan cover and the implied distance to default for the borrower.

4. Back office preparation

The back office responsible for the LAS portfolio should be aligned with the Treasury back office. It should always be prepared for supporting a quick sale of collateral shares, if required. This requires daily checking of stock in the dematerialised (demat) account, speedy internal approval process, and fast communication to external parties like the broker, share trustee, etc.

The call for additional collateral should be based on pre-decided thresholds of loan cover and delegated authority to the back office.

5. Measurement of market and liquidity risks

As mentioned earlier, the risk assessment of LAS should be based on the principles of measuring market and liquidity risks. The people and the models should be of appropriate skill and design to provide accurate and quick inputs to the front office.

An important point to consider here is the impact of correlation between the performance of the borrower and that of the collateral shares. If a borrower assigns its own shares as collateral, it leads to a wrong way risk. In other words, the collateral is of no use, when it is actually required at the time of distress of the borrower. A lender should therefore seek the shares of a separate (uncorrelated) issuer from the borrower. 

The assessment of risk on LAS should always be based on the analysis of the collateral shares, and not on the performance of the borrower.

6. Pricing

If we go back to the components of the synthetically constructed LAS, as mentioned earlier, it can be seen that lender has sold a put option to the borrower. A seller of a put option can lose up to 100% of the value of the underlying security, which is the loan value in this case. 

It is still common for FIs to be content with a moderately higher (say 300 bp) spread compared to that charged on a plain vanilla loan to the same borrower. However, the process to arrive at the spread should be scientific rather than ad-hoc, since even a moderately higher spread (than for senior loans) may not cover the risk adequately.

In case of a default by a borrower, a lender would rely on realisation of its outstanding dues by selling the collateral shares provided by the borrower. The price of the shares is volatile and prone to loss. The lender should estimate the maximum potential loss in the value of the collateral shares, at a desired confidence level, over the maturity period of the loan. The lender needs to ask for enough collateral shares to cover any such loss over the residual maturity. 

Additionally, the lender should consider the potential loss in value of the collateral, in case of a distress sale of the shares. The spread on LAS should be equivalent to the uncovered potential loss after sale of shares.  

7. Governance

The Board of a FI must keep a hawk's eye on products like LAS, since they are high risk products but not recognised as such.

Strict limits, regular monitoring, and effective reporting must be instituted by the Board and followed by the Management.

Summary

The FIs should look closely at the LAS product and understand its risk before underwriting it. LAS, being an equity linked product, is a highly risky product and should be dealt with, as such.

Finally, regulators also need to look closer at the appropriateness of LAS and any required special provisioning and capital requirements.