Regulator tightens margin lending to cleanse market of negative equity

The new margin rules awaiting gazette notification are meant to keep both lenders and borrowers out of the negative equity trap.

Some vested quarters opposed them, but the regulator has stayed firm in its position to bring necessary changes in loan facilities for investment in the secondary market, said Md. Saifuddin, a commissioner of the Bangladesh Securities and Exchange Commission (BSEC), in an interview with The FE.

The new rules have already been approved to replace the existing ones, and a gazette notification is expected within a week.

Some crucial changes have been brought after analysing loopholes in the existing rules, lenders' imprudent practices and investors' behavioural weaknesses, Mr Saifuddin said.

For example, in the initial draft the regulator said only 'A' category stocks would be considered marginable. In the approved rules, however, 'B' category stocks may also be included as eligible for the credit facility, subject to the condition that the companies pay at least a 5 per cent annual dividend.

It is believed that this change will stop margin credits from facilitating rallies in stocks of poor-performing companies. Many weak companies with small paid-up capital have shown a tendency to retain marginable status by distributing dividends as low as 0.1 per cent.

Lenders will also not be allowed to disburse loans for investments in a company that has a free float of less than Tk 500 million, as per the new rules.

Wealth destroyed; trust eroded

Bangladesh's stock market has been carrying a persistently nagging, self-inflicted wound for nearly two decades owing to loopholes in the existing rules, said Mr Saifuddin.

Between 2007 and 2012, Bangladesh rode a wave of monetary ease. Credit was cheap, liquidity abundant, and speculative fervour high. The market soared - until its maximum elasticity.

When the market imploded in 2010, "retail investors, caught in a spiral of leverage, suffered losses far beyond their means."

Institutions stumbled upon a lack of market liquidity to enforce margin calls or absorb defaults. They quietly accumulated toxic assets and negative equity, with regulators allowing forbearance in the hope that time would heal what transparency could not.

When equity shrank by half, many of them doubled down instead of cutting losses. By the time forced sales were to be executed after 75 per cent erosion of equity, there was no scope for borrowers to recover anything from selling holdings after paying back loans with interest.

Now, overall negative equity stands at around Tk 150-200 billion. With a typical loan-to-equity ratio of 2:1, it can be said that investor equity worth up to Tk 330 billion has been wiped out over the last 15 years.

Investors who did not face negative equity lost up to 60 per cent or more of their equity.

"From this simple but realistic heuristic, we see the amount of investor wealth destroyed lies between Tk 500 billion and Tk 700 billion," said Mr Saifuddin.

That means roughly one-third of market capitalisation has been diminished because of the practices allowed by the existing margin rules. "That's why the market has failed to be stable in the last 15 years."

The BSEC commissioner said the deeper cost of those imprudent practices was psychological and has been passed down over generations.

"Thousands of first-time investors, many from middle-class families, saw their savings destroyed. The experience produced a cultural memory of pain and distrust."

This is the backdrop against which the regulator formulated the new margin rules to cleanse the market of the "poisonous system."

Traps laid by investors for investors

A group of large investors, including the directors of some lending companies, took huge amounts of margin loans and pumped such funds into listed companies, disregarding their fundamentals.

The aim was to drive stock rallies within a very short time, creating artificial demand. The unscrupulous large investors then sold off shares at high prices when retail investors joined the rallies to make perceived gains. The latter got puzzled when sell pressure from the former dragged down stocks, creating massive price erosion overnight.

On the other hand, lenders neither adjusted margin loans nor warned their clients, nor did they recommend selling stocks to avoid further losses. Rather, clients were assured that losses could be recovered.

Eventually, the burden of interest and price erosion intensified.

Changes for investors' safety

The existing margin rules require lenders to make a margin call when 50 per cent of an investor's equity is lost, and forced selling is executed only when 75 per cent of equity is gone.

As per the new rules, margin calls will be mandatory after 25 per cent erosion of clients' equity. Lenders will have to start portfolio adjustment through forced selling following 50 per cent erosion of client equity.

"This provision will help change investor behavior. They will remain alert, and unscrupulous groups will get no scope to park their holdings into the portfolios of borrowers," Mr Saifuddin said.

The sectoral performance will be taken into consideration before disbursing loans against a stock.

"Investors will get back at least 50 per cent of their money," said the BSEC commissioner, with the new rules in effect.

Safety of institutions

It is observed that a greater portion of the margin loans has been injected into a few stocks.

The regulator has also found that as much as Tk 2 billion went into only two or three stocks, said Mr Saifuddin, adding that the loans had been disbursed to the companies' directors and related parties.

Lenders could lend money surpassing their net worth under the existing rules.

Now, with the new rules brought into effect, a lender's total loan exposure will not be more than three times its net worth.

Also, the single loan exposure will be Tk 100 million or 15 per cent of the company's net worth, whichever is lower.

"The lenders will also have to submit a review report on margin accounts every three months," Mr Saifuddin said. This practice would save institutions from bankruptcy.

Negative equity to be written off

As many as 177 market intermediaries have an aggregate amount of negative equity worth more than Tk 150 billion.

Mr Saifuddin said the commission had received proposals, approved by the companies' boards, on how they would write off negative equity.

"They would face enforcement actions over their failure to do so within the timeframe mentioned in the proposals," he added.

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