Gold Loan Business: A Canary in the Coal Mine?

The recent move by the Reserve Bank of India to impose additional provisioning requirements for gold loans companies is timely. The gold loan business is fraught with risks. The business model is increasingly risky and seems to thrive on its ability to lend to customers who are already financial stressed. While the companies do not lend without collateral (usually physical bullion or jewellery), the risks arise from the lack of prudent practices including risk management practices and the increasing risks of a steep price correction. The problems in the business are manifold and it is clear that most of the analysts and the companies themselves seem to underestimate the risks. Luckily, the regulator (the RBI) has think otherwise and has decided to play cautious. Critics of the RBI seem to gloss over the everyday dynamics of the gold loan business, which are essentially nothing more than a good starting point. The operational dynamics of the business have emerged as another classic case of non-existence of prudent lending practices. India has a history of financial sector being either economic with the truth or seems to a memory that does not look beyond the next one quarter (or at best a six month horizon).  

The gold loan business has been estimated at nearly Rs.300,000 crores, of which only about Rs.80,000 crores comprises of the formal companies. ICRA, estimates the organised sector gold loan market at about Rs.40,000 crores at the end of 2010. The business was estimated to have grown at a compounded rate of 40% from 2002 to 2010. 

The growth has been exponential with the gold loan companies expanding in the very small towns. A town with a population of about 50,000 invariably houses at least 4, if not more gold loan companies. The picture below is one such case. It is from a small town, Jedcherla, in Mahabubnagar District of Andhra Pradesh,  where five gold loan companies operate and all the banks advertise their gold loans. There are at least 10 banks that operate in the town with a population of about 75,000.

The companies have publicly put on a brave face, for now. However, it is clear that their excesses have reached the regulator and the RBI has decided that it would be better to crack the whip. As in most of the financial sector, the business thrives only when there is no regulation. The public claims are in variance with the actual business practices. One such instance is the Loan-to-Value Ratio (LTV). The companies claim that they usually lend only about 50-60% of the actual market value of the gold pledged. Companies like Mannapuram claim that their Loan to value ratio is about 66%. The gold loan companies claim that they lend a maximum of about 70% of the value of the jewellery or gold. Muthoot Fincorp claims that they lend less than 60% of the value of the gold pledged. Analysts tracking these companies claim that the LTV is 73-75%. The reality seems to be different. All one needs to do is talk to a cross section of borrowers and the reality should worry any policy maker. It is mostly as high as 90-95%.

Borrowers however have a different version. Talking to a number of borrowers gives the impression that either the companies are indifferent to the risks (or they have poor risk management systems where the branches can hide the details, or the business is run like a major Ponzi scheme). None of these are good for the business and the broader lending/borrowing business considering the volumes and importance of the business.

The loans are mostly above 90% LTV (Loan to Value Ratio). The companies have different ‘options’ for borrowers and the interest rates chargeable are dependent on the period of the loan. Borrowers can pay interest on a monthly basis, at the end of three months, six months or other intervals. The maximum duration of most of the loans is often one year. One borrower in Hyderabad city pointed out that he accessed 95% of the Rs.30,000 worth of jewellery he pledged at a interest rate of 16%, payable at the end of three months. The interest rate is 12% per annum if the interest is paid every month. Each delayed payment leads to a penal interest of 10% of the outstanding interest. In the case of a second month of default it is 20% of the outstanding interest. A large number of borrowers usually access Rs.25,000 to Rs.50,000 worth of loans, indicating that they are either from the lower middle classes.

The risk is not only the high LTV for a commodity. It is pertinent to note that commodity prices are volatile and considering the huge run up in gold price, high LTV only add to the risks. The last one year has seen a number of weeks where the price of gold has moved more than 5%. An additional risk is the very nature of borrowers who approach a gold loan company. The profile of the borrowers dictates that the companies should be more cautious. In a country like India, where gold has innumerable socio-cultural connotations, borrowing money by pledging gold is an option only when the borrower is extremely financial stressed. Lending large amounts to financially stressed borrowers with low margin for error in a volatile environment is definitely a receipe for disaster in the medium to long-term: remember the aqua boom and the NBFC boom in the 1990s and the microfinance excesses a few years back! 

Historically, businesses tend to make outsized returns only when the regulatory environment is either non-existent or lax. Gold loan business is probably the latest in the long list of such businesses. The Central Bank may have done the country a favour by cracking the whip before it gets out of hand. The last time this happened in India was in 2007-08 when the RBI cracked the whip on real estate speculation.

Deja Vu all over again! The only difference is that we never learn from History, that after all may be the relevance of history.