The history of lending has been at least 4,000 years in the making, when merchants fulfilled the role of banks by giving grain loans to farmers and traders. In Mesopotamia, Sumerian temples functioned as both places of worship and banks, and this was where the concept of interest rates first germinated. Temples in ancient Rome both took deposits and made loans; modern banking began in Italy. In the 17th century, the goldsmiths of London began issuing banknotes. And since 1971, when US President Nixon decoupled the dollar from gold, fiat money became the norm. Fast forward to the 1980s, Quicken Loans in the US pioneered online lending. Now, online peer-to-peer platforms let clients skip the traditional bank entirely.

The advantage of fiat currencies, which are not backed by a commodity such as gold, is that this gives governments flexibility to insulate their economies from the ups and downs of the business cycle. The problem is that this gives central banks too much control over how much money is printed. In the US, just before the onset of the 2008 financial crisis, the Federal Reserve had less than $1 trillion in assets. As the crisis deepened, stocks cratered and the economy nosedived, it expanded its balance sheet, which crested at $4.5 trillion in January 2015. Then, beginning in March last year, after Covid-19 hit, it once again injected massive liquidity into the system. The balance sheet has now ballooned to $7.7 trillion.

In today’s world, credit greases the wheels of economic activity. But it is the excesses that cause accidents. In the late 1980s in Japan, unrestrained expansion in credit and money supply led to a bubble in real estate and stocks that, once burst, inflicted pain for years to come. Two decades ago, as the tech and telecom bubble burst in 2000, the US Fed lowered its benchmark rate to one percent. Cheap money lit a fire under housing, and banks invented esoteric tools to prolong the good times. When the frenzy ended, the global crisis of 2008 ensued. Major central banks globally tried to stem the damage by lowering rates and expanding balance sheets. The practise continues to this day. This will exact a heavy price someday.

Lesson from Archegos

The world got a small glimpse into the brewing risk through Archegos Capital Management, a US family office that blew up in late March. Family offices are less regulated than hedge funds. The company was founded by Bill Hwang, who essentially lost $20 billion in a little over a week. He levered up five times in building a $100-billion concentrated portfolio. One of his stocks, ViacomCBS nearly tripled in three months before peaking mid-March; the surge in the share price itself was a rare occurrence considering the company was a well-established media conglomerate with billions in market cap. Hwang seemed to have a hot hand. Bankers were falling over each other to lend him money.

Then came a $3-billion equity offering by ViacomCBS, which apparently was taking advantage of the rally in its shares. The stock tumbled, down 60 percent in four sessions. Soon followed margin calls by prime brokers, who were obviously trying to cut their losses; some even weighed granting Hwang a margin holiday. In the end, a fire sale followed; this included other stocks in Hwang’s portfolio. One of the biggest margin calls of all time led to a swift collapse of Archegos. Credit Suisse, one of Hwang’s lenders, took a $4.7-billion write-down tied to this. Nomura is looking at a loss of about $2 billion. Credit Suisse’s chief risk officer was let go, and lending rules were tightened. But the damage was done.

This is what leverage does. Gains get multiplied, but so do losses.

Hindsight is always 20/20. Observers can now look back and say the Archegos disaster could have been prevented—or at least not have been as painful—if his lenders did more due diligence and limited Hwang’s leverage. But these entities are also motivated by the fees earned thereof. In a margin account, unlike a cash account in which clients pay the full amount for the stocks they buy, brokers lend money to buy stocks, using borrowers’ account as collateral. Interest is charged on the loaned amount. It can be a lucrative business in bull markets, as is the case now, globally. One feeds the other—until the trend reverses.

Regulators’ job not to let things get out of control

In Nepal, by mid-March this year, 66 banks and financial institutions (BFIs)—27 commercial banks, 19 development banks and 20 finance companies—held Rs81.4 billion in ‘margin nature loan’. These are loans issued against the value of the securities customers own. At the end of last fiscal year ended mid-July last year, these loans were Rs50.4 billion—meaning in the first eight months of the current fiscal, margin lending went up nearly 62 percent. The amount equalled 2.1 percent of these BFIs’ loan portfolio of Rs3,853 billion as well as of Rs3,820 billion in NEPSE’s record market cap reached this month. This level of leverage seems manageable. But as Archegos showed us, it does not take long before a tailwind turns into a headwind.

Thus far, leverage has paid off. From March 2019 when it bottomed at 1099 through the intraday high of 2760 on the 19th this month, NEPSE is up 151 percent—and up 140 percent in just the past 10 months. For margin borrowers, this more than takes care of the about eight to nine percent interest banks charge them. Even in a scenario in which NEPSE goes sideways, investor logic to use leverage goes like this: As the fiscal year ends mid-July, companies will begin to declare a dividend. Someone going long, let us say, a BFI paying 15 percent dividend will be earning 30 percent annualised if the stock is held for six months. Not a bad rationale to stay long, except it gets turned on its head if the price goes the other way.

Bull markets do not last forever. Brokers and banks are enablers of leverage and will get hurt if they do not have proper risk management measures in place. This is where the regulators come in; it is not their job to only wish for higher prices, rather make sure the seeds of instability are not sown. It is never popular to be a party pooper. Yet, it is necessary at times. Yubaraj Khatiwada, Nepal’s current ambassador to the US, was heavily criticised when he, as governor of Nepal Rastra Bank between 2010 and 2015, introduced measures that helped prick a real estate bubble. Banks were aggressively making these loans and speculation was rife. In hindsight, he probably acted before things really got out of hand. There is a lesson here somewhere.