Capital market relaxation - inopportune for now

Recent capital market relaxations might have been desirable over the long run. At the present juncture though they appear to be desperate acts to prop up the share market.

By C. R. L. Narasimhan

Very recently (on September 22) the Reserve Bank of India permitted banks to provide finance to brokers for margin trading in shares. The scheme, to be on an experimental basis for two months, will be reviewed thereafter. The RBI has also said that the aggregate quantum of finance to be extended through this route will not exceed the current aggregate ceiling of 5 per cent for banks' exposure to the capital market. By implementing one of the recommendations of the RBI-SEBI technical committee at this critical juncture - the share markets are at historical lows - the regulator hopes to influence market sentiment for the better. Other market friendly measures that were put in place recently include an enhancement in the investment limits for foreign institutional investors. They are now allowed to increase their investments in specific companies to levels that will be on a par with the relevant foreign direct investment (FDI) sectoral limits. There has also been a talk of permitting companies to buy back their shares, with a minimum of regulatory compliance.

Two points need to be considered before discussing the efficacy of these measures. One, the timing. Given the present context of stock market lows, some of these relaxations (that is how they can be called) might smack of desperation. A related question: Do they fit into the broad pattern of capital market reform, which again involves a proper sequencing? Second, will they have the intended effects on the stock market? At this juncture enhancing market liquidity and encouraging large players to stay invested are no doubt desirable goals. But it is doubtful whether these can be achieved immediately.

One reason for that of course is that the current depressed sentiment in the market has as much to do with the global uncertainty in the wake of the terror attacks as with the lacklustre performance of the Indian economy so far this year. One wonders whether market sentiment can be lifted by merely relaxing procedures and putting in place enabling measures such as margin trading. The FII relaxation has a limited significance in a context where some large investors were seen exiting from India. There has been a stock meltdown at the global level. Large investors have a wider canvas to operate than just India.

Moreover, at a policy level concerning international capital flows, the recent FII relaxation raises a few nagging questions. The RBI has recently been ranking the different types of capital flows - FDI, FII and portfolio flows - in terms of their liquidity index. Simply put, how stable these are for India's reserves? Obviously FDI qualifies more than FII and to give the same preferential treatment to both seems illogical. The other issue has to go with India's march towards full convertibility, which has been measured. At some stage FII relaxations, full repatriation facilities for many other categories and so on will come. But is the present juncture correct for bringing about any of those changes?

Margin trading as a concept is sound. It can allow more investors to participate. Investors can leverage better by only putting a relatively small amount upfront. In practice, its success will be judged mainly by the increased liquidity it brings into the system. But that might not happen just now for many reasons.

As is being introduced now, it is restrictive. There is a ceiling on the amount banks can lend to the capital market (5 per cent). Of which loans to brokers for margin trading cannot but be a small part. Right now, only actively traded stocks forming part of the NSE Nifty and the BSE Sensex are eligible. Procedurally, banks will have to keep a minimum margin of 40 per cent on funds lent for margin trading and keep the shares under their pledge. Since the shares will have to be in the demat mode, taking a charge over them looks theoretically easy. But in practice that might strain a bank's operating abilities utmost. Ensuring that the margin stays at 40 per cent is another thankless task as it involves constant monitoring. If the scheme is to be a success a large number of accounts will have to be opened.

By far the biggest obstacle to a successful implementation of margin trading will come from its very conceptualisation. It involves bank finance to brokers who in turn will fund investors' margins. For banks that is going to be a minefield if past experience is any guide. There will be psychological as well as practical blocks to a free funding of margins for shares. The RBI circular adds its bit to the prevailing inhibitions of banks. It says that bank boards should prescribe necessary safeguards to ensure that no nexus develops between interconnected stock broking entities/stock brokers and the banks. Second, margin trading should be spread over a large number of brokers. Three, stockbrokers availing of these facilities should be prohibited from lending to their own connected entities, relatives or business associates or those of the promoters/directors of the bank through this facility. Finally, banks should also ensure that the end use of funds is properly monitored.

It will be a while before all the above can be meaningfully implemented. In the meantime permission to banks to fund margin trading is unlikely to make a positive impact.

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