In India, shares are offered as collateral to banks in exchange for loans. This is one of the many sources of borrowing money, especially in a volatile market with tight liquidity conditions.
Pledging of shares is common in companies where promoter holding is high. During share pledge, ownership is retained by promoters. In a rising interest rate scenario, promoters often use shares owned by them as collateral for loans. If the majority owner in your company has pledged a sizeable chunk of his or her equity, it could trigger a volatile price movement in a falling market.
Shares of companies with high pledging of promoter holding tend to witness volatility. The Reserve Bank of India, in its latest Financial Stability report, flagged a concern over share pledge. “Pledging of shares by promoters could pose as a concern in both, falling or rising market scenarios, when large scale pledging of promoter equity could pose concerns for retail investors’ wealth,” the RBI report said. As a result, investors need to look at pledging of shares by promoters before buying stocks.
Higher the pledging, greater could be the risk of volatility in the company’s share price. This is because, as share prices fall, the overall value of the pledged collateral falls. This would put pressure on the promoter to produce more assets as collateral. Sometimes, the lender may also be forced to sell some of the shares to ensure that the loan does not turn into a bad loan. If the promoter is unable to meet obligations of borrowing, the ownership of shares is transferred to the lender, who may then sell it to recover loans.
In India, out of the over 5000 listed companies, promoters of 4274 companies had pledged all or some of their shares, according to an analysis by Securities and Exchange Board of India. This was quoted in the recent RBI Financial Stability report. Of these, promoters of 286 companies had pledged more than 50% of their shareholding. Nearly 90% of these companies belong to the small-cap category.
Share pledging of promoter witnessed its highest quarterly jump in three years in June 2013 quarter. During an economic slowdown and rising interest rates, banks could put strict conditions on borrowing.
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