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A tool for resolving temporary banking setbacks

Nironjan Roy | Published: October 01, 2019 21:39:13


As mentioned in the first installment of this write up, primary and secondary loan trading may take two different forms of which one is accrual loan trading and the other non-accrual loan trading. These are basically related to interest earnings on loans.

ACCRUAL VS NON-ACCRUAL LOAN TRADING: Loan when traded with the objective of making money through discount or premium disregarding interest income thereon is categorised as non-accrual loan trading. On the other hand, loan traded with the objective of earning interest thereon regardless of the price in the form of discount or premium, is termed accrual loan trading. Usually, superior quality credit facilities with good rating are traded on accrual basis while inferior quality loans are traded on non-accrual basis. Further, loans acquired through accrual loan trading are usually held for longer term.

LOAN TRADING AT DISCOUNT/PREMIUM: It is commonly known that any tradable financial instrument carries discount or premium when traded in the market, and loan trading is no exception as this product is also traded at either discount or premium. Loan can, however, be traded at par too. It may be mentioned here that premium or discount, whatever is agreed upon on each deal of loan trading, is technically associated with the commitment amount instead of the outstanding amount of loan. Loan when priced over commitment amount is traded at premium and conversely the loan traded below commitment amount is traded at discount. Similarly, the loan priced equal to the commitment amount is traded at par. Further, discount or premium is determined on the commitment amount and its price but adjusted with the outstanding loan in order to derive the net settlement amount. A hypothetical example may provide further clarity on the issue; say-- BDT 10 million committed loan with BDT 5 million outstanding is traded at 98 per cent price between ABC Bank and XYZ Bank as buyer and seller respectively. In this trade, discount is calculated at BDT 0.20m which will be adjusted from outstanding loan BDT 5m, so net settlement amount will stand at BDT 4.80m which ABC Bank will pay to XYZ Bank to purchase BDT 10m loan. In this example, other associated fees viz., delayed compensation, closing fee etc which are common in loan trading activity have been ignored for simplifying the topic. 

QUASI BOND MARKET: Loan trading sometimes satisfies the need of bond market because institutional investors can easily utilise their investable fund through participation in loan trading and generate some revenue. This opportunity provides good return on short-term investment, especially in the absence of institutional bond market. However, the only difference is that all intending investors including individuals can participate in the bond market, whereas only institutional investors, particularly banks and financial institutions which are active members of loan trading association, can participate in loan trading. Since loan trading is a kind of short-term investment with free trading options, it plays the role of quasi bond market in financial industry.    

ADVANTAGES OF LOAN TRADING: In the banking business, loan trading is the only product which has multiple advantages. Loan by nature is a static product where there is no further activity except disbursement and recovery, whereas loan trading makes this product an active instrument as loan can be traded multiple times even in a day. Sometimes, loan trading is identified as a derivative of loan originally sanctioned, and in this context, the derivative is more active than its original product. So, the entire credit market becomes very active and dynamic because of loan trading. Some tangible benefits commonly derived from loan trading business are briefly stated below.

MAINTAINING HEALTHY LOAN PORTFOLIO: Loan trading helps banks maintain their credit portfolio healthy. In order to determine the volume of loan portfolio for listing in the trading platform, banks are required to periodically evaluate and reassess each and every loan account. And based on the result derived from in-depth review and assessment, rating of each loan account is determined and accordingly loans are selected for sale. During this periodical evaluation of each loan account, weakness, if found in any borrower's credit facility, gets corrected. This is how bank's presence in loan trading market helps its loan portfolio to remain in good condition.

MAINTAINING ADR: ADR (Advance Deposit Ratio) can be well maintained using loan trading opportunity. Maintaining a certain ADR as determined from time to time is a regulatory requirement which each bank and financial institution has to adhere to. Breaching of ADR benchmark set by the central bank is not new at all. This frequently happens not only in our country but also elsewhere. This breach causes adverse impact in maintaining correspondent relationship with foreign banks who review this parametre seriously.

Usually, there are two common situations where ADR breach occurs. These are excess disbursement of loan or sudden excessive withdrawal by depositors. Once ADR breach occurs, it is very difficult for banks to reset it within a short time because banks have no control or influence on expediting loan recovery or deposit mobilisation. In this situation, loan trading opportunity can play an important role as banks will be able to sell required amount of loan in the trading market and can refill its portfolio later through purchase when situation improves. Therefore, if loan trading opportunity is available, banks are not required to pressurise their employees to hunt for additional deposits or press upon borrowers to repay loans in order to maintain ADR ratio.   

RESOLVING LIQUIDITY PROBLEM: Liquidity problem can be managed well using loan trading. Normal situation is that if a bank is in short supply of money, other banks may be in surplus supply. Because of this situation, call money market exists and this market is very active in our financial industry where deficit bank always relies on surplus bank-the latter sometime takes undue advantages by raising call money rate. This situation can easily be avoided and thus a very structured and competitive money market can be ensured if loan trading is introduced. Whenever any bank faces liquidity crisis, it can sell part of its loan portfolio which surplus bank can buy and this trade will be executed through established trading platform, so banks will not have to depend on call money market for meeting liquidity requirement. Similarly, bank's ALM (Asset Liability Management) committee will be able to better perform in managing balance between bank's assets and liability using loan trading option.     

KEEPING BUSINESS OPPORTUNITY ALIVE FOR MARKET PLAYERS:  All banks in the market may not avail the opportunity of acquiring loans in the new deal. When new attractive loan is offered in the market, many banks may not be able to capture the opportunity because of their tight situation in asset-liability ratio. At the same time, many banks in spite of having good liquidity situation cannot accept loan amount beyond their own investment limit because of portfolio cap, single borrower cap, degree of risk appetite etc. This situation can be amicably resolved if loan trading opportunity is available. At the request of the deficit bank, surplus bank may accept the portion of loan and can continue to hold it till the deficit bank is ready. When time comes, deficit bank will buy this loan from surplus bank using loan trading option. In this way surplus bank is able to make some money in the form of premium while deficit bank is also able to book quality assets in its loan portfolio.  This can be clarified by one hypothetical example. Say, one loan proposal for BDT 100 billion is offered in the market and twenty-five banks including Alpha Bank and Beta Bank participated in the deal for their share of BDT 4.0 billion each. Through industry analysis this deal is found a very attractive investment opportunity and therefore, many other banks including Gamma Bank is also equally interested to get into this deal for BDT 2.0 billion which, however, they cannot afford at the moment but will be able to do so within one year time. In this situation, Gamma Bank approaches Beta Bank to acquire additional BDT 2 billion and hold it for one year when Gamma Bank buys this BDT 2.0 billion from Beta Bank at 2.02 billion using loan trading option. From this loan trading, Beta Bank maintains its own portfolio cap by taking required amount of loan and earns extra BDT 0.02 billion as premium, while Gamma Bank is also able to acquire quality assets. This is how loan trading facility keeps business opportunity alive for intending market players or peer groups.  

 

The first part of the article was published on September 30, 2019.       

Nironjan Roy is a banker based in Toronto, Canada.

nironjankumar_roy@yahoo.com

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