Things to know while lending to margin traders

March 29, 2018 | Posted by admin << back to blog

Great Laker Shiv Garg from PGPM 2018 shares the list of things to know and also the risks involved while lending in loans for margin trading. Scroll down to read in detail.

Let’s assume you are a bank employee and you have to approve a loan or credit line application received from a margin trader. You must know the consequences of granting a loan, especially if anything goes wrong.

Practically, you are lending money so you should only be facing credit risk as the trader may not repay the money. But the reality is that, often, this credit risk can lead to a crisis as it is a product of other risks to which the trader is exposed.

In fact, the risks are embedded into each other or, say, correlated with one another, and the extent of correlation varies from case to case or time to time (in a crisis situation, every risk is strongly correlated). So, from a top view perspective, it can be said that trader’s risk is your risk as a banker, even if you are not involved directly in trading.

A margin call situation

Simply, a trader may lose money when the market goes against his strategy; he may even lose money when the market is bullish and may gain when it’s bearish, or vice-versa. Ultimately, it depends on his open positions. But when he loses money, he has to meet the margin call and, to do that, he will ask you for more money.

A margin call is a situation when a trader gets a call from his broker to refill his account up to a certain percentage of the investment (say, 20 per cent of the original investment). Why does the trader get such a margin call? The answer is hidden in market risk, which is not as simple as it seems. It can also be made up of one or more of many risks, such as equity/commodity price risk, interest rate risk, foreign exchange rate or commodity price risk.

Equity/commodity price risk arises when securities are highly volatile and a trader may need to square up the margin calls quickly. Interest risk arises when you have lent money at a fixed rate or have borrowed money at a floating rate (say MIBOR + 2 per cent) and MIBOR shoots up. Foreign exchange rate risk arises when the lending and repayment currencies are different.

Liquidity risk

When a trader asks you for more money, you may end up giving it to him because of two reasons. One, you may be afraid that if you don’t give him the funds, he will move into a loss and will not be able to repay the loan to you. Second, you live in hope that, when the market does him a favour, you will get back the money, with interest. And this process (margin calls) may go on repetitively and the trader may lose more money than the initial investment, sometimes eventually becoming bankrupt.

There may be millions of positions similar to this, and every bank thinks it may face a crisis so each one starts to hoard cash and dry up the liquidity in market (liquidity risk), which will force traders to divest the portfolio below the market price because of not meeting the margin calls. It creates panic among investors and exerts more downwards pressure in the market and it goes on in spirals and crisis comes up.

In short; banks should deploy a robust risk management process to avoid scenarios where employees, unaware of the above facts, may approve a loan or credit line application that may lead to an eventual financial crisis.

The article was originally published by Business Line On Campus.

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