The long post-crisis bull run in equity markets has fuelled significant growth in the margin lending market. Margin loans are deals where financial institutions lend against security taken over strategic stakes in a listed company.
Now, the Prudential Regulatory Authority (“PRA”) in the UK has launched a consultation questioning the way regulated financial institutions allocate capital against these deals. More specifically, the PRA questions the eligibility of financial collateral as a credit risk mitigant in some secured financing transactions. For UK banks and investment firms advancing finance against strategic equity stakes, the outcome of the consultation could change the cost and structure of these loans.
The eligibility of listed share collateral for favourable treatment under the Capital Requirements Regulation rests in part on ensuring there is no material positive correlation between the value of the collateral and the credit quality of the borrower under a margin loan. The PRA considers that some banks need further guidance in applying that test and identifying such a correlation. Clearly, the PRA is concerned that some banks may have been giving some loans too favourable a capital treatment.
The PRA focusses on limited recourse margin loans as examples of deals where that correlation between collateral and credit quality occurs. Those deals could be limited recourse by virtue of legal structuring or the fact the borrower has no assets apart from the financed shares – both structures are common. But the consultation is not restricted to limited recourse deals. The scrutiny of the capital treatment afforded to any margin loan is increasing. Even where the lender has recourse to the borrower’s assets beyond the financed shares, depending on its past practices that lender may have to analyse its provision of capital in a more rigorous way unless it’s clear that there is no material positive risk correlation as referred to above.
For sponsors, family offices and corporates who have been heavy users of margin loans to finance listed stakes, the outcome of the consultation will bear close examination. Depending on how UK lenders have applied capital against these deals, changes to PRA’s supervisory guidance on capital treatment for margin loans following the consultation could increase the cost of this sort of financing. The alternative is that banks wish to structure these deals differently and potentially take security over a range of assets beyond merely the listed shares at the core of the transaction. That could be quite a different sort of deal.
Interested parties have until 10th April 2019 to respond to the consultation. Institutions regulated outside the UK but in competition with UK banks will no doubt be watching closely too.