Hazards of commercial papers in Bangladesh

Commercial paper (CP) has become very popular with investors in recent times because of limited financial products the market has. This instrument is becoming increasing popular among companies owing to its low cost, easy access and reduced dependency on bank loans. In brief, commercial paper is an unsecured promissory note with a maturity of not less than 30 days and not more than 270 days.
Companies issue commercial papers to raise funds from subscribers to meet their interim financing needs. Financial institutions act as arrangers and agents for the issuers and are often known as Issuing and Paying Agent (IPA). A scheduled bank, investment bank or non-banking financial institution (NBFI) can act as an IPA which will deliver the CP to investors against the proof of payment and at maturity, having received funds from the issuer. Repayment will be effected on receipt of the CP back from the investors. The bank, which purchases commercial paper, will receive the amount of loan from the IPA bank if the corporate group fails to repay the loan in due time. IPAs make it clear to the investors in the offering document that their investment is subject to credit and other risks inherent in such instruments and payment will be made to them only if the issuer has made the funds available to IPA. They inform the prospective investors that in case of default, the IPA will not be in a position to seek recovery from the issuer or initiate any action against the issuer either on its own or on behalf of the investors. In case of default by the issuer, it will be the responsibility of the bank/NBFI acting as IPA to notify promptly such default to the investors. In case of partial payment by the issuer, IPA will distribute the received funds as per terms of the underlying agreements. It looks fairly simple but there exists a question of moral hazard.
In the last few years, more than Tk 10 billion were raised through CPs and more issues are in the pipeline. Since 2013, this market is growing very fast in our country with its approximate growth of more than 500 per cent. But mere existence of a liquidity backstop raises concerns about moral hazard. This creates a risk that the facility will not be used when it is needed most, even in cases where the liquidity risk is broad-based rather than firm-specific. As this instrument has become common to the borrowers, it is about to be used in paying off existing debts. Some companies are only willing to raise funds through CP as there is not much control point on the use of this fund. The main drive for them is the rate of interest rate and easy access to fund. Most of the CPs issued recently range between an interest rate of 10 per cent-11 per cent whereas bank borrowing rate is hovering around 13 per cent. This is cheaper than bank borrowing. Hence investors are much more willing to go for this for short- term financing. Apart from this, some borrowers are willing to make arrangement to settle existing debt with a bank under the condition that a guarantee would be issued in their favour. This guarantee would be used for fund raisers through CP. The dark side of this arrangement is some banks are getting rid of their less credit-worthy customers but someone else would have to bear the risk.
Still there is no regulation in Bangladesh which can limit such fund raisers. In the developed countries, only corporations rated by recognised credit-rating agencies are usually allowed to issue commercial papers in accordance with the rules and regulations set by the financial regulators of the countries. Most of the CPs in our market are not backed by assets and as banks give loan against commercial papers without taking any collateral, a rampant use of the instrument for risky ventures would bring instability to the country's financial market.
The commercial papers played a role in fuelling the recent economic recession in North America and Europe as a number of conglomerate groups and banks became defaulters due to their failure in repaying the loans taken against the papers. In our country, a number of banks and non-bank financial institutions have already been involved in purchasing or issuing bank guarantee for the commercial paper and a few state-owned banks are also interested to act as IPA. This is an indication that our banking industry might run into a systemic risk if a couple of guarantees against CPs fail.
The financial sector would face debacle if the corporate groups rated low by the credit-rating agencies issue the commercial papers. In the developed countries, the corporate groups are now allowed to issue commercial papers if they hold no defaulted loan in last 10 years. They have to show healthy profits in the last few years to get approval for their commercial papers. The frequent issuance of CP is also hurting the economic growth of Bangladesh.
Fresh investment to set up new industrial units will also face crisis if banks give more attention to the short-term commercial paper instead of long-term financing. The long-term financing is usually made to set up fresh industrial units which boost up the GDP growth. If companies get more focused on short term borrowing, then capital and infrastructure investment would suffer in the future.
The rapidly growing market calls for proper regulations and guidelines. Our neighbouring countries like Pakistan and India have already issued guidelines on the commercial papers and they have set a number of conditions on the issuance on such instruments. Our central bank should also work out the amount of commercial papers enough for the country as a huge number of commercial papers usually create obstacles to achieving the expected GDP growth. Further consequences would be defaulted bank loans if commercial paper-issuing corporate groups lack credit worthiness and reputation. The major purpose of CP should be kept in mind which is to enable highly-rated corporate borrowers to diversify their sources of short-term borrowings and provide an additional instrument to investors. While underwriting the issue, banks/NBFIs will ensure that their total exposure including underwriting does not exceed their per party exposure limits. The banks/NBFIs are required to take due care to ensure that their per party limits are not breached. If so, then they could be allowed a time limit to sell CPs in excess of their per party limits and the company has been sanctioned working capital limit by bank/s or FIs. The allowable classification status of a borrower should not be less than 'standard' as per classification guideline of the Bangladesh Bank (BB).
All the commercial papers issued so far in Bangladesh are interest-bearing only. Generally, companies and financial institutions can issue commercial paper. Even though banks and NBFIs can act as arrangers for the issuers, only a scheduled bank can act as an issuing and paying agent for the issuance of CP. Banks, NBFIs and corporate bodies are the major investors in CP. The Bangladesh Bank needs to set a threshold on the fund raiser through CP or it can be limited to a certain percentage of paid-up capital or net worth of the borrower according to its last audited balance sheet. Asset-backed securities should be encouraged, CPs should be issued at a standalone basis and the credit rating of the borrower should be the consideration for pricing. Sanctioning any funded or non-funded facility against the security of commercial paper should be strictly restricted. Apart from that, purpose of the instrument should be clearly mentioned and any investment in fixed assets should be prohibited from the proceeds of CP. Maturity of CPs must not exceed the credit rating validity of the borrowers.
An identified reason for the decline in commercial paper in North America is that buyers of commercial paper, such as money market funds, learned during the financial crisis that  commercial  paper  was  riskier  than they initially thought and therefore they revised  upwards  their  expectations  about  the  likelihood  of  commercial paper's default.  For example, investors learned that asset-backed commercial paper was collateralised by assets for which liquidity in the secondary market could suddenly disappear. With Lehman's bankruptcy, investors in commercial paper learned that even large financial  institutions could  collapse  overnight,  causing  the  default  of supposedly  safe  CPs.  As a result, investors required higher return to compensate them for bearing more risk, which substantially raised the cost of  compensating them for bearing more risk. In Bangladesh, one major reason of why the interest rate on CP is lower than that of bank loan is the perceived market tradability. The investors bear an idea that investment can be liquidated prior to maturity by selling it in the secondary market. But the truth is secondary market for CPs does not exist in Bangladesh. Still, the rate remains at the lower level but as soon as investors realised the fact, expected return of this investment would shoot up for sure.
It is high time for the BB to come up with comprehensive guidelines on CP. It can consider selecting some eligibility criteria for investors to develop sustainable CP market. In the current capital market conditions, only banks, NBFIs and large corporations can be allowed to invest in CPs. Some special clauses could be included in the guideline for Domestic Systemically Important Banks (DSIBs) like higher credit rating and net worth of the borrower. DSIBs could be discouraged a bit to become issuer and guarantor compared to other financial institutions. CP is a relatively new instrument in the market and it could be more effective in the economy if regulated by proper guidelines.
The writer works at a foreign
commercial bank.
tanjib.eee@gmail.com