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What is Loan against Shares and Why RBI is worried about it?


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Last week, the Reserve Bank of India (RBI) directed non-banking financial company JM Financial to halt the provision of loans against shares and loans for subscribing to initial public offerings (IPOs). This move by the RBI has raised questions about the process of loans against shares (LAS) and the concerns that prompted the regulatory action.

Understanding Loans Against Shares

LAS allows investors who own shares in companies to pledge them with non-banking financial companies (NBFCs) and borrow money against the value of these shares. The interest rates charged by NBFCs for these loans typically range between 10.5% and 13%, depending on the shares being pledged and the relationship between the NBFC and the client.

This practice is primarily utilized by high net-worth individuals (HNIs) who invest in stocks and derivatives. The borrowed funds obtained through LAS are often used to purchase more shares or engage in derivative trading.

Loan to Value Ratio and Eligible Shares

There are certain limitations on LAS. NBFCs cannot lend more than 50% of the market value of the shares, which is commonly referred to as the Loan to Value (LTV) ratio. Additionally, according to RBI guidelines, NBFCs can only lend against “group 1” shares listed on the National Stock Exchange (NSE).

Group 1 shares, as defined by the NSE, are stocks that have been actively traded for at least 80% of the previous six months and have a mean impact cost of less than or equal to 1%. Impact cost refers to the additional cost incurred by an investor while buying or selling a large quantity of shares. A low impact cost indicates that large quantities of shares can be transacted without significantly affecting the stock price.

Risk Management and Margin Calls

When providing loans against shares, NBFCs must ensure that the value of the shares used as collateral remains at 50% of the loan value at all times. If the stock price falls and the value of the collateral drops below this threshold, a “margin call” is triggered. The client must then either contribute additional shares or repay a portion of the loan to maintain the required collateral value.

Each NBFC has its own risk-management measures. Typically, if the stock price falls by up to 10%, the client is given three days to bridge the gap. However, if the price drops by more than 20%, the margin call must be immediately addressed. Failure to meet the margin call allows the NBFC to liquidate the stock.

RBI’s Concerns and the Bubble in the Stock Market

While the RBI’s specific concerns regarding LAS have not been explicitly outlined, its action against JM Financial seems to focus on the financing of IPOs and non-convertible debenture offerings. Market players believe that the central bank is concerned about the money borrowed through LAS across the industry, as it may contribute to the building of a stock market bubble.

There are indications that some NBFCs may not be adhering to LAS regulations, potentially lending against stocks that are not part of the NSE group 1 list. The RBI’s intervention is likely aimed at curbing the flow of funds into the stock market and ensuring compliance with the rules governing LAS.

It’s important to note that the RBI’s actions are part of its ongoing efforts to maintain stability in the financial markets and protect investors.

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