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Gold loans: "Free-market" Rajan shows his true colours

The Austrian school of economists has always viewed the supposed Chicago school of "free market" economists with suspicion. While the latter talk a lot about the benefits of free markets and advocate the same in principle, for all practical purposes, they are as interventionist - at least in aspects of monetary policy, banking, etc. - as the Keynesians.

RBI Governor Raghuram Rajan has demonstrated why this deep-rooted suspicion is not misplaced. His latest decision - on regulations for gold loan companies - comes just a few weeks after he spoke eloquently of the need for "zero regulations". If that's his goal, he should get a zero for his latest efforts.

The regulations pertain to how much loan can be given in terms of the value of the underlying collateral, the storage facilities for this collateral, about opening of new branches and some rules pertaining to auctions. Let's see as to why free markets would work much better than any regulation the RBI can come up with.

An employee receives payment from a customer inside a gold jewellery showroom in Mumbai. Reuters

An employee receives payment from a customer inside a gold jewellery showroom in Mumbai. Reuters

Loan to value: Firstly, loans against gold are voluntary transactions that happen between two consenting parties and there's no reason why the RBI should even prescribe a limit of how much should be lent. If a company wants to lend upto 100 percent of the current value of the collateral, or, for that matter, even upto 200 percent, then it shouldn't be the concern of the RBI. This should worry the lenders more than the borrowers.

If at all the RBI should do something, it can to encourage these gold loan companies to disclose their lending practices in their annual reports. And even this ought to be a "best practices" kind of recommendation rather than a regulatory requirement. If the RBI feels this is not sufficient, then it can rate these companies in terms of what they disclose and the other market participants can make their decisions about these companies.

If gold loan companies indulge in practices that expose their bond/equity holders to undue risks, then these companies will fail/go bankrupt. That is the job of "free markets" - to weed out the incompetent players and that's how a system gets better and better with time.

It's certainly is not the job of the RBI to create regulations against stupidity/undue risk-taking.

Norms for storage Facilities: This is a nanny-state attitude that the RBI has displayed in these regulations. How does it concern the RBI as to where this collateral is kept? If somebody should be concerned, it should be the person borrowing against the jewels he pledges and the company providing a loan against the same. Let the borrowers decide between competing players and the storage mechanism ought to be a form of "competitive differentiation". Providing regulations on these ensures that borrowers will take more risks than they should by presuming that all gold companies are safe. They will presume that since "regulations exist", there will be no problem.

All that the RBI should do is to ensure that if the collateral is lost for whatever reason, then the gold loan company should adequately compensate the owner. That would be in line with the spirit of private property and protecting the same. Speedy disposal of private property violations is one of the legitimate goals of the RBI/government. They should focus on that and not on regulating storage facilities.

Free markets automatically ensure that borrowers gravitate towards players who have the best of storage facilities. Companies that expose their collateral to theft would automatically be bankrupted by the markets as long as the players do not use the hand of the government to escape the consequences of their misdeeds.

Opening of new branches: Just days after doing away with regulations for opening new branches for regular commercial banks (an eminently sensible move), the RBI has imposed rules on the opening of new branches by gold loan companies. Again, these are voluntary transactions that happen between the companies and the customers and there's no reason for the RBI to impose its judgment on what's right for the markets. It doesn't make sense for the RBI to impose these restrictions on the smaller companies, let alone the larger ones that are already listed and have enough market regulations governing their operations.

Allow the free markets to work. If these big loan companies fail, it's even more important to allow the markets to work, instead of propping them up under the guise of too-big-to-fail. Success and failure is just part-and-parcel of a capitalistic system and imposing individual judgments on what's too big only creates distortions in the market place.

Auction rules for sale: This is one of those seemingly good regulations that seek to protect consumer interests, but stems from the faulty assumption that companies exist to milk the consumer. I am not arguing that most men/businesses are honest - but just that consumers would gravitate to companies that provide them with the best deal - and in the absence of governmental regulations that create special privileges to a select few, companies that are the most innovative and customer-focused would thrive and succeed.

So, under the new regulations, auctions are supposed to happen in the same taluka as to where the loan originated. What happens in a situation where the best price is obtained in a different taluka? Or just a case of scale efficiencies lending themselves to centralised auctions being more productive for the customer? How does the RBI know which is the best way out in each case? What happens if there's only one item to be auctioned in a taluka and the overheads of that auction are substantially higher than the collateral value?

These are judgments best left to the free market and the government-knows-best and government-cares-the-most attitude is certainly a throwback to the days of YV Reddy and D Subbarao.

Conclusion: It's not usual for me to praise a central banker. Like all economists from the Austrian school, I certainly believe that the world would be a better place with a free market monetary system rather than one individual (or even a committee of individuals) deciding as what the appropriate interest rate and money supply should be. In fact, the boom-bust cycles that we have witnessed over the last 100 years can be attributed to the Federal Reserve toying with interest rates (Google "Austrian Business Cycle Theory" to understand this better).

Despite my reservations on central banking, I was actually impressed with the contents of Rajan's day zero speech. But in a very short span, the lofty standards of free markets and market regulation have descended to a situation of I-know-what's-right. But as any Austrian school economist would say, "what else do you expect from a Chicago monetarist?"

Shanmuganathan "Shan" Nagasundaramis the founding director of Benchmark Advisory Services - an economic consulting firm. He is also the India Economist for the World Money Analyst. He can be contacted

Updated Date: Dec 20, 2014 23:08 PM

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