Regulatory overkill

Sebi must take a balanced view on capital adequacy

A recent statement by Securities and Exchange Board of India (Sebi) Chairman Ajay Tyagi suggests that brokerages might soon need more capital. It is cause for concern across the brokerage industry, which is already struggling to adjust to stiffer margin requirements, allied to harsh penalties. There are pros and cons to a possible upward revision of capital adequacy norms. These were last revised in 2012 and amount to anywhere between Rs 75 lakh and Rs 10 crore, depending on the specific segment covered by a broker. In addition, a very conservative formula is used to calculate capital adequacy — only the brokerages’ liquid assets are considered for this purpose, with fixed assets excluded from calculation. High levels of capital adequacy cushion defaults since the losses can be recouped from the broker’s own funds. Other things being equal, the norms could be revised upwards periodically, to reflect larger transaction volumes and larger lot sizes.

However, the other things are not equal. In the past few months, the regulator has severely restricted the offer of margin by a broker. Before a trade, the broker is supposed to collect a value at risk margin (VaR) and an extreme loss margin (ELM) from the client. December onwards, brokers cannot offer more than 25 per cent of the sum of the ELM and VaR, as margin to any client. Both margins are set in accordance with standard formulae. VaR covers losses that may arise under normal conditions, while the ELM covers potential loss if there is a sudden spike in volatility. These margins are to be collected even in secure transactions such as when a client is selling shares it possesses, and giving delivery. In effect, therefore, a brokerage will never be risking much of its own fund in a transaction. If there is a loss, the margin collected from the client should cover it. Moreover, rules regarding power of attorney on a client’s shares have been tightened. This is to plug a loophole that often led to fraudulent transactions without the client’s knowledge.

Under the current regulatory regime, it is hard to see a normal situation where higher capital adequacy will be required. If there is a black swan event, such as a massive default or outright fraud involving a major institution, no amount of capital adequacy would suffice to be a shield. A hike in capital adequacy norms would hit the smaller brokerages hard since they will struggle to meet new norms. The smaller brokers cater to the retail segment and this would make it more difficult for retail investors to directly access equity markets or to trade in derivatives. As it stands, few individuals hold equity, and reduced access would make it more difficult for them. Since 1994, when the National Stock Exchange started operations, there has never been a default of dimensions that led to a breakdown in the functioning of the exchanges. Even under global stress during the so-called subprime crisis in 2008, India’s financial markets continued to run smoothly. This speaks volumes for the efficiency of the exchanges and also for the prudence of the market regulator. It also implies there is relatively little need to tighten norms. Raising margins as well as raising capital adequacy norms may be overkill.