Navigating Risk Management in Loan Against Securities (LAS)
The conversation in the fintech circles has intensified in recent months: Secured lending is becoming increasingly prominent. The Reserve Bank of India (RBI) has also been signaling a shift by tightening regulations around unsecured lending options like personal loans, increasing the risk weights associated with them. In response, several financial institutions have introduced Loan Against Securities (LAS) to meet the sustained demand for loans.
Consumer interest in the markets has also been steadily increasing. From just 40 million demat accounts in 2020, India has about 140 million demat accounts today. This surge has expanded the pool of customers eligible for loan against securities.
And, customers have been warming up to the idea. Loan Against Securities (LAS) has increasingly become a popular financial product, enabling borrowers to pledge their investment securities—such as shares, bonds, mutual funds, and life insurance policies—as collateral for loans. This option has gained appeal due to its liquidity, flexibility, and typically lower interest rates.
In a previous edition of #FutureFinance, we explored the increasing digitisation efforts in this secured loan category and the factors driving consumer demand. Today, we delve into a critical aspect of LAS: risk and collateral management. Given the nature of these loans, risk management becomes crucial as value of the collaterals may undergo fluctuations over time. We decode this and more today!
Risk Management in Secured Loans
Unlike unsecured loans options like personal loans, where individual credit worthiness is all paramount, risk management in secured loans like LAS primarily focuses on the collateral, which is often subject to market fluctuations.
The value of securities (shares and mutual funds for example) can change rapidly and unpredictably. This market dependency necessitates a comprehensive and actively monitored risk and collateral management system.
The shift in underwriting models requires a fresh perspective on risk parameters and technology investment by financial institutions.
Decoding different types of Risks in LAS
While it may seem that risk is largely only on collateral, there are several data points that need to be factored in as well. Here are different types of risks in LAS that lenders end up keeping a tab on.
- Collateral Risk: The value of the securities pledged as collateral can fluctuate significantly due to market volatility. A sudden drop in value could lead to a breach of the Loan-to-Value (LTV) ratio (capped at 50% by RBI), requiring the lender to take action to protect their interests.
- Credit Risk: Although LAS is primarily secured against collateral, there is still a risk of borrower default. If the value of the collateral declines below the loan amount, the lender may face a shortfall which then needs to be addressed.
- Market Risk: The broader market environment can impact the value of the securities held as collateral. Economic downturns, political instability, or market crashes can lead to significant reductions in collateral value, exposing the lender to potential losses.
- Liquidity Risk: In the event of default, liquidating the collateral to recover the loan amount can be challenging, especially if the securities are not easily sellable or if the market is experiencing low liquidity. Also, liquidating the collateral is probably the last option a lender wants to consider.
So, what are some risk management strategies?
Managing these diverse risk factors would require a multi-faceted approach. For example, financial institutions continuously monitor the value of the pledged collateral. Lenders often maintain margins beyond the LTV limits set by the Reserve Bank of India to account for market volatility, preventing breaches of the LTV ratio.
Lenders also maintain a whitelist of mutual funds and shares that qualify as acceptable collateral, often based on parameters like Assets Under Management (AUM). To avoid concentration risk, lenders also limit the proportion of a portfolio dedicated to a single security or group of securities. For exposure management, lenders can consider capping certain sectors, such as travel during the COVID-19 pandemic, to limit exposure to volatile industries.
All of this needs to happen real-time to flag off risks to lenders so they can act.
Technology’s Role in Risk Management
Until recently, many aspects of LAS were managed manually, requiring customers to frequently visit their bank offices or physically sign/hand over documents to a bank representative. While it is still a work in progress, significant digitization efforts over the past few years have made the onboarding and servicing of these loans much easier.
Lenders are increasingly leveraging technology to enhance their risk management capabilities. Real-time monitoring systems have come in place tracking collateral value continuously, particularly for shares, where market fluctuations occur rapidly.
At SwiffyLabs, we have leveraged these industry insights to build our LAS solutions on a digital foundation, enabling seamless integration of risk management strategies.
Our platform has comprehensive risk management tools to manage drawing power of assets by ensuring active monitoring and management of exposure, Loan-To-Value ratio (LTV), Average daily trading volume (ADTV) and margins. It can also control liquidity of securities by actively monitoring the data which is extremely critical for the loan category.
There is also a multi-level (hierarchy management) limit management to control exposure and risk. It can further categorise securities and portfolios and apply risk rules to each of the categories giving lenders a comprehensive view of the portfolio.
What once required 10-15 manual steps can now be executed with a few clicks, enabling lenders to act quickly on data and effectively. These features are designed for easy integration into existing systems, allowing lenders to go live in a matter of hours.
Conclusion
As more customers take to investing in the markets, the pool for LAS is only going to increase in the coming years. Effective risk management is critical of a successful Loan Against Securities (LAS) strategy. By understanding the various risks involved and implementing robust management practices, financial institutions can safeguard their investments and offer competitive, secure lending products to their customers.
What do you think will significantly change the risk management aspects for LAS? Is India ready for a larger switch towards LAS with the increase in retail interest in the markets?
