Amid investor grievances that the Nepal Stock Exchange (NEPSE) has struggled to take off under the Balendra Shah administration, the latest unified directives from Nepal Rastra Bank (NRB) have eased margin lending rules by wrongly focusing on collateral rather than the debtor. As bulls saluted a Rastriya Swatantra Party (RSP) landslide victory in the March 5 polls, the index tagged 2,970 on March 25, having bottomed at 2,469 on October 26 last year; Prime Minister Shah assumed office on March 27. The NEPSE closed Tuesday at 2,697, rallying from a low of 2,547 on July 14; the unified directives were published on July 15. So far, so good. The change in margin rules has benefited the bulls thus far.

The NRB’s circular relates to the existing practice of banks and financial institutions (BFIs) offering margin loans of up to 70 percent of the lower of the last day’s closing price or the 180-day average. The BFIs, made up of 20 commercial banks, 17 development banks and 17 finance companies, now have the discretion to raise it to 80 percent by scoring the companies whose shares are used as collateral on paid-up capital, duration of public life, profitability and dividend history, credit rating, regulatory compliance, and timely conduct of general meetings. In essence, the loan-to-value ratio can be increased to 80 percent for companies the BFIs deem fundamentally sound.

The latest tweak to the margin rules is a continuation of the gradual loosening of policy over the last several years. The 2020-21 monetary policy upped the amount that BFIs could offer in margin loans from 65 percent to 70 percent. The 2021-22 monetary policy limited the amount an individual could borrow from one BFI to Rs40 million and a combined Rs120 million from multiple BFIs. That ceiling was first raised to Rs150 million and then to Rs250 million; last October, the lending limit was completely lifted. Additionally, last August, the risk weight for such loans was lowered from 125 percent to 100 percent, which reduced the amount that BFIs were required to set aside to extend such loans.

Restrictive margin policy no more

In a cash account, customers pay the full amount for their purchase. A margin account uses borrowed money to gain more bang for the buck. Someone, let us say, owns shares worth a million rupees, and using that as collateral can get additional buying power through margin loans of up to Rs800,000. Share-backed loans have grown significantly over the years. As of mid-June, BFIs, which charge interest on these loans, were sitting on Rs162.9 billion, up by just under 16 percent in the first 11 months of the last fiscal year, which ended in mid-July, and up from Rs76.5 billion as of mid-July 2023. BFIs’ latest tally makes up 2.7 percent of their total loan portfolio—not huge, but not negligible either.

NEPSE’s history goes back to January 1994. At Rs4,634 billion in market cap (versus Nepal’s nominal GDP of Rs6,600 billion), the size of the stock market has gotten big, yet sophisticated tools, such as derivatives, are still lacking. Shorting, in which borrowed shares are sold and bought back later as the price drops, is not allowed but is likely to be introduced soon. This does not let market participants with a bearish bias actively take part, other than to sell. Long investors naturally would want higher prices and routinely clamour for policy support, applying pressure on the concerned authorities. Bulls successfully lobbied for the steady dilution of the NRB’s restrictive margin policy.

There are two primary issues here. First, margin debt cuts both ways. Excess reliance on leverage can backfire. Just as it helps during market upswings, it hurts during downturns. For borrowers, the advantage is that the use of margin boosts purchasing power, enhancing profit in a rising market. The disadvantage is that the borrower’s pain gets amplified in a falling market. Since these are loans issued against the value of securities borrowers own, the lender will issue a margin call once the account equity drops below the safety limit. In such a case, the borrower is required to either add funds or sell the securities. Otherwise, the lender has the right to recover the loan by selling the securities.

The second issue is the eyebrow-raising idea of determining whether a stock qualifies for more margin lending based on the company’s capital base and profitability. When a bear market hits, stocks—big and small—are vulnerable. Speculative names might take a bigger hit, but that does not mean a blue-chip entity with a solid balance sheet and dividend history will be spared. When an equity index is down by 20 percent to 30 percent, margin calls occur, setting in motion a self-fulfilling prophecy. Once a BFI indulges in forced selling to recover its loan, there will be more downward pressure on prices and that, in turn, will trigger more forced selling elsewhere—regardless of whether the stocks are fundamentally strong or not.

The focus should instead be on the borrower, making sure they understand the importance of proper management of leveraged positions and creating guardrails around that. In bear markets, it is not uncommon to hear of leveraged accounts getting wiped out. BFIs, in this regard, would not mind extending credit using equities as collateral, which is considered relatively safe. They are currently sitting on tons of liquidity—a loan book of Rs5,915 billion against a deposit base of Rs8,268 billion as of July 21. Previously, these banks heavily relied on real estate but, because the sector is stagnant, are unable to sell off the collateral to recover non-performing loans, which stood at 5.6 percent mid-June.

Banks are enablers of leverage. But they are also a breed driven by profit. In this context, regulators need to watch over both the lender and the borrower, as it is not their job to only wish for higher prices. In central banking, there are times when a wink and a nod speak louder than the action itself. The latest NRB directive can be interpreted as a veiled message to the markets that the Biswo Nath Poudel-led bank has investors’ back. If the idea is to kickstart risk appetite and help the economy through the wealth effect of a ripping NEPSE, then this may work for a while, but that would sow the seeds of instability. An unpleasant hangover often follows a late-night party.