Democratizing asset based lending and how banks can protect themselves from systemic market risk

In this blog we investigate the potential risks linked to democratizing asset based lending to a larger retail and SME audience. In principle, when customers lend against their (liquid) investment assets at the bank, the scoring of the credit can be done on an objective basis, based on the valuation of the assets blocked by the bank. Therefore a big advantage of liquid asset based lending (LABL) is that customers can use the money for whatever purpose. This advantage for the customer can however also result in a big risk for the bank, when customers start using the money of the LABL to buy other assets, which are in their turn used as collateral for a next LABL loan. This is called investment leveraging and a valid usage of the LABL product.

In principle, the risk does not increase for the bank since each individual LABL credit request (by the customer) always contains coverage by liquid assets (the fact that he has bought those shares with a previous LABL credit does not matter). And everything remains fully transparent for the bank at all times: the customer has their global LABL credit opening with the bank, and the pool of covering liquid assets (blocked by the bank!) with a weighted collateral value that always needs to cover the full outstanding LABL credit amount.

There are multiple ways to avoid undesired leveraging.

First, the bank can set maximum amounts on the full asset based lending portfolio, for example limited to 50,000 EUR for Retail customers, limited to 150,000 EUR for Mass Affluent customers, and limited to 1,000,000 EUR for Private Banking customers.

Second, the bank can check on maximum market value of collaterals compared to total asset value deposited at the bank, i.e. the total market value of the blocked positions (blocked as LABL credit collateral) should be less than 50% of the total asset value deposited at the bank.

Third, the bank can use more conservative weightings. Let’s consider two scenarios with collateral weightings of respectively 70% (more risky) and 40% (more defensive) for a client with 10,000 EUR of initial stock. With an average collateral weighting of 70% (haircut -30%), a client with 10,000 EUR of initial stock can borrow up to ~21,000 EUR, i.e. the client obtains a potential leveraging effect of ~2.1. For the scenario with 40% collateral weighting (haircut -60%) the potential hedged LABL credit opening is reduced to ~6,600 EUR (as opposed to 21,000 EUR above). Be careful, this does not mean that the collateral weighting (or loan-to-asset ratio) was increased to 66% : Let’s not forget that each additional LABL loan is on its own covered by assets, hence the global risk and coverage level remain the same (i.e. 70% for scenario 1 and 40% for scenario 2).

Different algorithms exist for such weighting, depending on asset characteristics (asset type, sector, volatility, currency, etc.). Diversification of the asset portfolio also needs to be taken into account. Aforementioned leveraging is mainly increasing risk, if the loan amount is invested in same shares or in the same sector. The less diversified the total portfolio and total collateral portfolio, the higher the haircut percentage.

For both scenarios above, from the moment that the initial pledged asset portfolio goes below 10,000 EUR (e.g. 9,999 EUR) an alert is raised and the client is notified to take action within x days (below we will discuss the importance of these x days). Important: The same applies to all other assets that the client would have purchased with the released credit amount. Suppose that liquid assets actually drop -60% in x days (stock market crash), then the customer still has 4,000 EUR in initial shares, and 1,600 EUR in second tranche of shares he has bought, etc. and can still pay off the entire debt.

To answer the second question – “what in case of a systemic market crash?” – history shows that the stock market has never decreased by > 25% in one day with a maximum yearly percentage loss of 47% in 1931; a yearly loss of 38% was registered in the 2008 financial crisis. The S&P 500 lost approximately 50% of its value during the 2007-2009 period.

Largest daily and yearly percentage losses in the Dow Jones Industrial Average. Source: Sizzlers and Fizzlers. us.spindices.com.

The nature of the LABL product is indeed such that if the stock market systemically crashes within the x days (the period within which either the customer can take action or the bank automatically takes / may take action in accordance with the framework agreement) below the haircut (-60%) then there is a big risk for customers to default. In case of non-recourse asset based lending contracts, banks will have to write off the difference between the remaining loan amount (e.g. 40%) and the collateral value (30%); -10%. It is thus extremely important to conservatively define the haircuts and ideally keep the period of x days as short as possible to protect both banks and their customers.