Systemic risk in a stock market refers to the probability that default by one or more brokers would cause more defaults from other brokers, so much so, that the whole stock market would not be able to settle its trades. It is also referred to as settlement risk. The risk is present in the system because transaction and settlement do not happen simultaneously but with a time lag, which in a T+3 system is three days.

The consequences of a stock market not being able to settle its trades can be extremely damaging. A large number of people, brokers and their clients, are likely to loose their money. The confidence of equity investors would be shaken for times to come, which would dent the very ability of a stock exchange to work as an economic agent. This is why managing systemic risk is a fundamental responsibility of any stock exchange.

Exchanges use a variety of measures to manage systemic risk. These include margin deposits, limits on intra-day share price volatility, real time monitoring of trading activity, clearing house protection fund, capital adequacy for brokers etc. What we shall be focusing on here is the concept and implications of capital adequacy.

Capital adequacy means that the size of the business a brokerage house and risks assumed by it should be in accordance with its financial ability. Such financial discipline is necessary because the costs of default are borne by many other than the defaulter. Having a minimum base capital requirement also brings commitment to the business. If you want to do a lot of business and assume substantial risk, you should have the capital to ensure that you can fulfil your obligations.

The first and most important risk that a stockbroker faces is of adverse price movements. This is because most of the trading that brokers do is of very short term and speculative nature. The prices of securities are moving up and down all the time, and at times moving dramatically. The price risk is magnified if the position taken in a stock is large compared to the capital of the broker or the market of the stock. Second, there is the risk of termination of financing taken. Stock market financing is usually of very short nature and the financier would most likely either not renew the arrangement or demand his money back at the first sign of trouble. Third, there is this risk of allocation of losses due to default by some other broker in the guarantee-limited structure that our markets operate under.

Then there are other risks such as not having sufficient liquidity at the right time, risks of errors made in executing trades, etc. Often these risks tend to get realized at more or less the same time. It is in a quickly falling market that you are likely to suffer losses on your positions, where your clients are likely to default to you, where your financier would withdraw financing from you, and you might be called upon to pay your share of allocations of default of some other broker.

Measuring these risks and determining what is the adequate capital to cover for these risks is never easy. Techniques like “value at risk” can be used but they often turn out to be complex and costly. What is required is an optimal capital requirement, neither low, nor high because while low capital balances increase risk, high balances increase inefficiency. Empirical evidence, judgment, and market peculiarities play an important role in setting net capital balances.

Capital adequacy in stock markets: In our stock markets, the concept of minimum base capital was introduced in 2001 through an amendment to the Securities & Exchange Rule 1971. As a result, a broker at the Islamabad Stock Exchange (ISE) needs to have Rs0.75 million; a broker of the Lahore Stock Exchange (LSE) Rs 1.5 million; and a broker of the Karachi Stock Exchange (KSE) Rs 2.5 million as minimum net capital balance. The definition of net capital balance is given in the IV Schedule of these rules. Simply put, it is the excess of your current assets (cash, receivables, stocks, bonds, etc) over your current liabilities (trade payables, other liabilities). Securities are taken at a 5 to 15 per cent discount from their market value. Using market value and a discount factor are essential to avoid accumulation of unrealized losses and to keep a margin of safety.

Under the stock exchange regulations, the maximum exposure a broker is allowed is 25 times his net capital balance. That is, if your net capital balance is Rs 10 million then at any one point in time, your cumulative unsettled net-buy and net-sell positions can only be up to Rs 250 million. Brokers provide an auditor’s certificate of the net capital balance to the exchanges.

It is encouraging to note that LSE and ISE are implementing capital adequacy through the trading systems. The software allows a broker to take only as much exposure as is allowed. Once a brokerage house hits its exposure ceiling, the system allows execution of only those trades that reduce exposure.

Current approach: There are two key strengths of this approach. (i) It is simple to understand and implement, an essential in a developing market such as ours. You make some compromises on accuracy but have something feasible. (ii) By implementing capital adequacy through the trading system, human element is removed, and the margin of error and room for pressure from violators is substantially reduced. This is perhaps the best possible way of enforcing exposure ceilings.

There are two weakness of this approach. (i) It relies a lot on the auditor’s certificate of net capital balance. In an environment where price of stocks are changing every second, quarterly or six monthly capital balances are likely to contain stale information. It is also possible to window dress the financial statements to get a high net capital balance at the time of obtaining the certificates. Unfortunately, the integrity of the auditors certificate is not beyond doubt either. (ii) Some brokerage houses carry out a number of businesses other than stock broking.

For instance, investment banks, which are also stock exchange brokers, face obligations and risks stemming from sources other than those specific to the stock markets. Taking their net capital balance in full for stock broking without regard to other business activities and risks increases their permissible exposures to extraordinary levels.

International practices: In the USA, capital requirement was introduced for brokers through a net capital rule adopted back in 1975. The approach has become fairly sophisticated over time as it offers more than one treatment of equities for calculating net capital balance. It also tries to tailor the capital requirements for liquidity of securities, concentrated positions, hedged positions, short positions, arbitrage activity, etc. The UK requirements were introduced in 1988 and these offer even more ways of valuation compared to the US requirements. These capital requirements are too sophisticated to have direct relevance for our markets at the moment. It is the Indian practices, which seem to be more pertinent.

At the Stock Exchange Mumbai (BSE), which is India’s core stock market, all active brokers are required to maintain a base minimum capital of Rs1 million with the exchange. It should have at least 12.5 per cent cash, at least 12.5 per cent fixed deposit receipts, and approved securities or bank guarantees. All securities are taken at 85 per cent of their market value. The prescribed ceiling on a broker’s gross exposure is 20 times base minimum scrip-wise capital + additional capital deposited with BSE. Moreover, an additional intra-day trading limit is used under which gross purchases + gross sales cannot exceed 33.33 times base minimum capital + additional capital. Brokers are allowed to deposit additional capital above the base minimum capital with the BSE to use higher intra-day trading limit and gross exposure limit.

Improving capital adequacy: The current approach can be improved by taking the following measures: (i) Net capital balance should be deposited with the exchanges, with the option of additional deposits, as done at the BSE. (ii) The minimum net capital balance requirement should be reviewed in the light of high trading volumes these days. (iii) Brokers should be allowed to carry out business in excess of capital adequacy if they can deposit in advance 100 per cent cash against excess buy positions or provide securities against excess sale positions. (iv) Definition of net capital balance in the fourth schedule should be amended to make it more suited to the current T+3 trading cycle, with more emphasis on liquidity. (v) Brokers should be able to see their real time exposures with reference to capital adequacy at all times.