Thursday, June 30, 2011
Rights Shares: Wrong News
Issuing rights shares has become too common in Nepal now-a-days. Everest Finance, Birat Laxmi Bank and Bank of Asia published notices for rights shares on April 8. Malika Bikas Bank on April 10, and Royal Merchant Banking and Finance Limited on April 20 could not sell the rights shares issued to promoters, and had to start auctioning them. Kaski Finance Limited on April 13, Lord Buddha Finance Limited on April 18, Sunrise Bank Limited on April 20 announced opening for rights shares. There are more examples from the months before.
On the face of it, the concept of issuing rights shares seems harmless and innocuous. The shareholders buy more shares from their company, often at lower prices, and help raise capital for their company. And, that is all that the CEOs, Directors and promoters of these financial institutions think will happen when they announce rights shares. It is clear that they have not learnt any lessons from the history of rights shares issued by other financial institutions.
If you observe the share prices of the financial institutions that have issued rights shares in the past, a couple of patterns are immediately noticeable.
First, financial institutions, generally, tend to announce rights shares when the price of their shares starts falling. The falling share prices cause the institutions to come up with extra cash to balance their accounts. So, the institutions that tend to announce rights shares are usually the ones that seem to be in trouble.
Second, share prices tend to fall even further after the announcement of rights shares. So, announcing rights shares could help the institutions collect some capital, but it lowers the price of each unit of share in the market. Although the intention of announcing rights shares might have come out of necessity for generating more capital, the announcement actually ends up hurting the financial institutions’ standing in the market.
This trend holds true for almost all the financial institutions that have announced rights shares in the past. So, the evidence suggests that issuing rights shares does not help the financial institutions. Why, then, do Nepalese financial institutions keep issuing rights shares? Is it because the promoters don’t care about the share price stability? Or is it because they wish to raise large capital, flee with it, and leave the public shareholders hanging high and dry?
However, the worst feeling to come out of this is the realization that these institutions fail to apply the knowledge of basic economics into their equation. Issuing rights shares is a bad idea, and it will eventually result in a decline in share prices of the institution that issues such shares. How? Well, let’s look at the first thing that every introductory Economics course teaches us about demand and supply.
The theory of demand and supply states that price of a share is determined by how much shares are available in the market and how much demand is for those shares. Initially, the supply of shares is given by S1 and demand is given by D1. The market price and total quantity traded is determined at the point where suppliers and buyers agree on the price and quantity of the shares to be traded. Demand and supply of shares become equal at point E1. Therefore, the total shares bought and sold in the market is q1, and the price paid and received for each share is p1. This is what introductory Economics teaches us about market price and quantity determination of any product, whether it is a packet of Wai-Wai noodles or a share of a bank.
When financial institutions issue rights shares, there occurs an increase in the total number of shares available for trade in the market. This causes the supply of shares to shift from S1 to S2. Since demand is still D1, a new equilibrium is created at E2 where total number of shares traded is q2, and the price of a share is p2. Therefore, when supply of shares increases in the market, the price that each share fetches decreases. It does not matter whether all the rights shares that were announced get sold or not. The basic economic theory suggests that the mere existence of an increased supply of shares will drive the price of a unit of share downwards.
Now, those in charge of managing the financial institutions might argue that all is not bad with a lower price if they can generate a large amount of capital. However, they should realize that raising large amount of cash is not their only job. They are responsible for austerity and fiscal stability of their institutions in the long run. A decline in their share prices helps neither their austerity nor the long run fiscal stability.
Also, there is another half to this story that makes the situation even worse. Psychologists have studied human behavior for years, and have concluded that when it comes to handling stress from risks and confrontations, humans have two natural instincts: fight or flight. They have observed that very few fight, and that most choose to flee. This fleeing-from-danger element of human psyche causes a cascading effect in the market price when the rights shares are announced.
Once the price of a share falls from p1 to p2, the general public, that owns the shares of that institution, starts panicking. The dominant natural instinct of “flight” kicks in. Realizing that the price of a unit of share has fallen, the shareholders sell their shares to avoid incurring any more losses on their investment due to any further decline in share prices. Thus, a perfectly logical human reaction results in a lower demand for shares of this institution. The demand curve shifts from D1 to D2. And, a new equilibrium occurs at E3 where q1 number of shares is traded at a price p3.
So, the number of shares traded in the market, which is q1, is the same as before the announcement of rights shares. However, the new price p3, which a unit of share now fetches, is much lower than the initial price of share, p1. And, this is why issuing rights shares is a bad idea. The financial institutions are not doing anyone any favors by pursuing this approach of capital generation. It hurts the shareholders, it hurts the financial institutions themselves, and it hurts the overall financial market of Nepal. Last decade’s data of share market prices of financial institutions before and after the announcement of rights shares shows the pattern repeating itself again and again.
This opinion piece was published in The Republica daily on May 1, 2011.
Labels: banks, financial institutions, rights shares, share market
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