By Okechukwu Onwuka
BANKS generate revenue by granting credit facilities to customers for a number of purposes from projects (project finance), purchase of manufacturing equipment, import, export, property (mortgage), acquisitions/mergers, buying of shares (margin facility) to business start-up or expansion. In simple terms, bank source for funds as cheap as possible and lend it to customers at highest possible rate of return. Thus, every credit facility represents an opportunity for profits. The same opportunity represents a risk potential for the lender as well as the borrower. Today, weâ€™ll focus on the risks that margin facilities pose to a financial institution (the lender).
Fundamental credit risk acceptance criteria for the lender will include the following: Security of the funds. It is of highest importance that the funds, either shareholder funds or depositorâ€™s funds are not put at an unacceptable level of recovery risk, particularly in the event of default; liquidity; earnings history of potential borrower; acceptable and available collateral (security) for loan by borrower; stability of provided collateral; projected future earnings potential of customer; credit history or rating of customer.
Regular customer equity contribution is around 30 per cent. In some cases, as low as 10 per cent equity have been accepted. Letâ€™s review the case where a 20/80 margin facility is used to purchase shares worth N100m with the borrower contributing only N20m in cash. The security is provided by the share certificate with a clause in the contract agreement that requires the borrower to provide additional collateral, cash or other acceptable instrument should the share price fall below say 80 per cent of purchase price. The risk of this profit opportunity is high on the side of the bank. The driver for approving this type of transaction is based on a number of assumptions that are fundamentally weak which may include but not limited to the following:
Share prices will always appreciate. History clearly shows that share price appreciation is never continuously upward. There are highs and lows. Market uncertainties, poor company performance, changes in government or regulators, bad publicity, are some contributors to price fluctuations.
In the recent stock market scenario, the relative ease for accessing these margin loans created a huge demand on just about any quoted company, with the result of prolonged periods of upward price movements. This unnatural push led to several shares trading at prices way beyond levels justified by market fundamentals calibrated by the companyâ€™s historical and near term performance. The immediate jumbo profits from these transactions dulled the sensitivity to the prevailing risks of a reverse trend.
Easy exit strategy. This is usually an important consideration for institutional investors. On a bullish market, itâ€™s easy to sell and recover investment plus profits. Deciding when to exit is a difficulty where clear policies for exit conditions are not explicitly spelt out. When stock traders are rewarded for profit generation, the probability of deciding to exit the market on a bullish run is low. With this situation, it indicates that only a bearish market scenario will induce a definite sell position.
Unfortunately, on a bearish market, there are more sellers than buyers. In less than five days of a maximum five per cent price depreciation, the borrower could have lost 100 per cent of his/her investment plus accrued interest. The lender issues a sell order but it may not happen. In a stock market crash, prices may fall to below 20 per cent of trading price before the onset of bearish trends i.e. a stock moves from N16 per share to say N3.20 per share.
The borrower is able to provide additional equity on demand. This is not usually easy in practice. Even if the borrower has sufficient capacity to provide additional equity, it may not be possible within the required time frame. What-If the borrower is unable to pay? This is the most likely scenario given the emotional trauma of having lost personal funds and may already be over-stretched. When this happens, as in the current market crash, a bank may find itself laden with an unacceptable high level of non-performing loans.
When financial institutions find themselves overexposed in non-performing loans, the consequences may include: Liquidity crunch. The institution may find it really difficult to meet regular day-to-day transactions. This may force them to borrow from other banks at exorbitant rates which would worsen an already bad situation. Loss of customer confidence and patronage. Unhealthy competition for rapid growth may lead to focus away from core customers to stock market and investment analysts who are constantly watching out for year-end profit numbers which become pivots for share price appreciation and public demonstration of profitability. Consequently, the risk management system for financial institutions that should be based on sound governance, stability, customer relations, transparent finances, security of customer and shareholder funds may become eroded. This further reduces the chances of attracting potential future investors and new customers. Customers will keep faith with a stable, customer friendly bank with moderate profits than a high risk institution with astronomical profits.
Potential intervention by regulatory agencies or shareholder rage. Reputation impairment for the leadership. Although this is not usually considered by many as a key consideration in risk management systems, major integrity damage situations may force new executives to include public reputation as a major risk area. Use of force to retrieve loans. Although this is a last resort mechanism, the impact might hurt more people in the long run.