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Did mutual funds overlook risks involved in pledging against shares?

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Lending to promoters has been on the rise in India. The estimated value of pledged sharesby promoters to various lenders in the current fiscal year is Rs. 1.2 lakh crore, an increase of around 60% over the last year. This indicates significant increase in leverage. Traditionally, promoters can pledge shares to banks as well as NBFCs.

Why do promoters pledge shares? To begin with, promoters (legally, a person with a controlling stake in a company) own most listed companies in India. When promoters need to raise funds, they can easily raise money by selling their shares in the company. However, this typically has a negative impact on the share price in the stock market. So, instead of selling shares, many promoters raise funds by pledging shares to a lender and borrow against them. In 2009, SEBI mandated public disclosure of promoters selling or pledging their shares.

Lending against securities is risky. That is why the Reserve Bank of India places certain restrictions on banks and NBFC’s for loans against shares. The rules relate to margin requirements that need to be maintained, as well as system wide exposure. The Reserve Bank of India actively monitors these loans. This is to maintain the stability of the financial system.

In the event of a market fall, a margin call would be triggered. If the promoters fail to fund the margin call, the creditor would need to sell shares. This can further trigger a decline in the share price, and the creditor may face a loss in this scenario.

This is where innovative structures have surfaced; several debt mutual funds have created structures to lend money to promoters against their equity shares. Debt mutual funds have extended loans to promoters, typically by purchasing bonds issued by the holding company controlled by the promoter.

Mutual Funds have been actively involved in backing promoter loans with shares/operational assets in their search of yields. Equity shares offer quick liquidity than other fixed assets, but they can be risky if the underlying price of the stock suddenly decreases. Usually, the collateral (equity shares) value is substantially higher than the loan amount to guard against any correction in the stock value.

The default by the IL&FS has turned the spotlight on the NBFC sector, as well as financing by pledging of shares. IL&FS Transport Networks, a listed company of the IL&FS Group, has seen its share price decline by 91% from its 52-week high. The promoters of the company had pledged 98% of their holding, which equalled 71.9% of total outstanding shares. IL&FS Transport Networks are among the IL&FS Group companies that have defaulted on debt.

Fears regarding lending against shares by mutual funds using the structure we have highlighted earlier arose when mutual funds sought a standstill agreement with lenders and did not sell pledged shares. It emerged that the holding companies had borrowed funds, pledging shares worth 59% of Zee Entertainment. The figure was 45.7% a year ago, indicating an increase in leverage. Aditya Birla Sun Life Mutual Fund, among other fund houses, had a large exposure.

The concerns are high for some other companies, too. For example, RelianceNSE 2.19 %Capital’s promoters had pledged 74.5% of their shares as on December 2018. Similarly, Bajaj Consumer Care’s promoters had pledged 70.5% of their holdings.

Pledging of shares is higher among promoters of mid- and small-cap companies, where pledging totals Rs 77,000 crore worth of shares in FY19, which is 62% of the total value of the promoter shares pledged in the same period. So far in 2019, more than Rs 16,000 crore worth of shares has been pledged by the promoters. Debt mutual funds have been active participants.

Because of these risks, SEBI is reportedly considering tightening disclosure norms. Mutual funds are essentially offering a loan against shares when they are buying commercial paper of the holding companies. The regulator is also reportedly considering framing rules for concentration risk as well. While the regulator has given some forbearance in the current crisis, this is a temporary measure we believe not to precipitate a crisis. In the coming months new regulations are likely. While Indian listed companies have made great progress in terms of regulatory driven improvement in transparency and timely disclosures, this event highlights that progress needs to be made in some other areas.

This is an also a near-term overhang on equity markets. We would be wary of investing in shares where promoters have a substantial pledge. This can be a systemic risk as well as outstanding loans against shares to promoters is roughly Rs 2 lakh crore. However, we believe that the right policy response along with liquidity assistance by RBI can prevent a crisis.

[“source=/economictimes.indiatimes.”]

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