Will RBI regulation prevent a gold loan bubble?

Given the scale at which the business of lending money at usurious rates against the collateral of gold is growing, RBI now seems to be worried about the possibility of a gold loan bubble building up in the system and is contemplating tighter regulation for the sector.

The regulation could be in the form of limits on the loan that a gold loan firm can give as a percentage of the value of mortgage. The central bank may also restrict the maximum interest that a gold loan firm can charge its customers, and also the penalties that gold loan firms can impose.

As Firstpost reported earlier, the apex bank last year removed the priority sector lending tag for bank loans to non-bank finance companies given against the collateral of gold. What this means is that these firms will no longer get a concessional rate but will have to pay the market rate to avail bank loans.

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However, even as RBI steps in to introduce some prudential rules and customer protection guidelines, it is posed with two major challenges- first, it is difficult for the RBI to monitor customer practices across the country and second, to ensure that that these very guidelines don’t kill the industry.

In a CNBC TV-18 special, Indianomics,Latha Venkatesh discusses if the exponential growth of gold-loan firms have already made the sector a bubble.

[caption id=“attachment_211086” align=“alignleft” width=“380” caption="‘We are in the business of lending money against used household jewellery’ Unnikrishnan, MD, Manappuram Finance. Reuters"]  [/caption]

Though the gold loan industry has grown from an unorganised ‘rural pawn broker’ situation to a Rs 80,000 crore corporate business, the pace at which it has grown is a major cause for concern, points out Prithvi Haldea from Prime Database. Corporatising has its own ills and putting prudential norms in place is important for the industry to survive, said Haldea.

Moreover, the central bank is also concerned about the end use of the money lent out against loan. Unlike other loans where one is buying a house or a car or any other asset, loans against gold is a " cash-for-cash" situation, argued Haldea. And in case where borrowers do not pay up the loan on time, gold loan companies have the right to auction the asset within group companies without a proper notice to the borrower!

Hence there are various concerns over the kind of protection offered to borrowers, supervision systems and proper training and this is where the RBI should step in and define consumer rights and a standard practice for all gold loan companies.

However, Unnikrishnan, the Managing director of Manappuram Finance, which was barred by the RBI last week from accepting public deposits, is not in favour of a regulatory arbitrage. He argues that the risk of default is negligible because the loan size is given to household borrowers and not not jewellers or retailers who may speculate in the market. Hence buyers are most likely to repay the loan even if gold prices drop because " we are in the business of lending money against used household jewellery and not bullion", said Unnikrishnan.

In an earlier interview with Firstpost, VP Nandakumar, Executive Chairman, Manappuram Finance, has said that defaults for the company are very rare as it maintain a capital adequacy ratio of 30 percent instead of the 15 percent that the RBI mandates." As for a fall in gold prices, such a risk remains in any commodity business. We have been doing this business for decades and the family gold sentiment guards us against defaults if gold prices crash," he had said.

However, since much of the loan is collaterised against one’s possessions, a sharp drop in gold prices is likely to set off a chain of events that may wreck havoc on the financial structure of gold loan companies.

Watch the full report on CNBC TV 18: