Systemic risk at the bourse

By a Special Correspondent

Systemic risk may not be always due to negative traits of the market place. This articles attempts to weight the impact of positive sentiments, which in return become a systemic risk.

In the past few months many companies were listed by way of IPOs or introduction and raised capital by way of rights issues. As such the amount exceeding Rs. 34 billion as shown in the table has been absorbed by corporate firms. These proceeds will not come back to the share market according to their underlying projects.

Furthermore, due to introductions, investors have a wider number of companies to choose from. In both those instances, the secondary market gets dampened with less liquidity for investors to move around. Moreover, warrants issues and private placements are competing for the same limited resources.

We shall look at a situation where a country tries to import one whole year’s expected imports within a month. Exports are distributed throughout the year. What will happen to the balance of payment? In month in which the imports are made, a huge BOP deficit and imbalance in the economy will be created. But when you consider the whole year’s imports and exports activities, this could be viewed as a manageable situation. Can a country sustain its economy in this manner? I leave the answer to the economists.

It is a well known fact that money market liquidity (where the funds are ear marked for equity investments in this case) has a positive correlation to the wellbeing of a healthy equity market. Furthermore, even the banking industry interest rates will be pushed up due to the lack of liquidity, which is visible with the current AWPLR behaviour. Therefore, identification of investable funds in the equity market is a mandatory requirement. This could be achieved through historical data analysis and simulating findings for future outlook.

Adding fuel to the issue, margin trading facilitators are bound to keep their exposure at 50% at all times and the banks are also restricted in lending to this segment of equity investments (margin trading facilities) to 5% of its total lending book.

While it was celebrated that many companies are lined up for listing in year 2011, this should have been carefully planned in order to not create a sudden vacuum in the market place.

SEC has brought about many good rulings curbing the speculative aspects, but there has been little emphasis on a sustainable market place.

The current trend of strictly enforcing the 50% exposure on a single margin trading facility has created a spiral effect on the market, which will bring the market down further instead of stabilising or bottoming up in the near future.

As depicted in the pyramid, the lowest level of investors who had maintained healthy borrowing of less than 30% will be the only segment that will not get caught in the current situation at a backdrop of 15% decline in index from the highest point for 2011.

Hence, it is important to understand the real impact by filling the pyramid with number of clients at every level and the value involved. This will give a clear understanding of the spiral effect. What happens is that when the top layer is to be cleared; the second level customers will fall into the category of margin calls for exceeding 50% exposure. If the second tier is to be cleared, then the third tier will follow to the same category of margin calls.

It is noteworthy to mention that equity investors have converted their trading credit to permanent structured margin trading facilities by now. Hence, there was no real credit growth in this sector, but a shift in the method of financing.

Given below are some recommendations to be considered by SEC to give some relief to the investors immediately:

• Margin trading facilitators can be instructed that the lending be restricted to 50% always but to increase the tolerant level of an exposure to 70% in the event of a market downturn. This will create a stable marketplace where the margin calls will not be made immediately with a downturn. Otherwise, panic selling will set in and make matters worse. A 20% leeway will enable margin provider and the investor to come to an amicable settlement without disturbing the market place.
• Consider a 10% exposure level for commercial banks to lend to this segment, since there is no single sector concentration risk involved by investing in the equity market and the market as a whole is very well diversified and the value at risk will take care of the risk element of lending.

As a long term measure, SEC could consider the following suggestions:

• Analyse and understand the desired level of market liquidity and pace out events which contract the liquidity situation. Meaning the IPOs, rights issues and warrant issues must be limited for a month (quantified amount) on a first come, first served basis.
• In order to do the above, identify the potential private placements to take place as well, since the same investable funds are shared.
• SEC needs to closely liaise with Central Bank and the Monetary Board to understand their plans and give due consideration to equity market sustainability in their own decisions and vice versa.

Sustainability is key for any firm, industry, economy or the world for that matter, instead of short-term policy decisions. It is clear that the market collapse was due to liquidity constraints, forced selling and panic selling by investors due to the positive sentiments of firms raising capital as the predominant factor.

A systemic risk can prevail at a time of a positive sentiment if it is not properly planned.

(The author wishes to remain anonymous due to his/her employment terms and involvement in a related industry.)