Need for flexibility in regulations
In March 2012, the Reserve Bank of India (RBI) introduced new regulations rules to contain the rapid growth of the gold loan companies which was perceived as posing a risk to the stability of the financial system in India. The major change brought about was that gold loan NBFCs were required to observe a cap of 60 percent on the maximum loan to value ratio (LTV) for gold loans. Until this point of time, there were no restrictions on the maximum loan to value ratio and some particularly aggressive gold loan NBFCs were known to go beyond even 90 percent LTV ratio.
Following the imposition of this regulation, the very next year, i.e. in April 2013, there was a sharp correction in the price of gold in the international market that appeared to vindicate RBI’s position. With the benefit of hindsight, RBI’s measure in capping LTV proved timely. It is even likely that they averted a serious crisis for some of the gold loan NBFCs that were, hitherto, lending at very high LTV ratios.
Around this time, a widely held view was that gold loan NBFCs were able to grow their business at a rapid pace only because they were not shy of taking undue risks (i.e. lending at high LTV ratios). The impression was that gold loan NBFCs were reckless and taking huge risks in the pursuit of rapid growth unmindful of the larger consequences for the stability of the financial system. In reality, this was not correct as the following episode would illustrate.
In 2010, the management of Manappuram Finance had considered the risks arising from a sharp fall in price of gold and examined the option of hedging against a potential fall in gold price as a way of minimizing the price risk. The company got in touch with a foreign agency that was willing to enter into an appropriate option contract. Now, it’s true that hedging has a cost involved, but the idea was cost effective for us because we would only have to hedge for that portion of gold in custody that was likely to go into final default and auction.
Accordingly, it was calculated that about 5 or 6 percent of the total gold in the company’s custody would have to be hedged against the risk of a substantial fall in gold price. In a worst case scenario, it was estimated that this figure would go up for sure but not beyond the 10 percent levels. Therefore, by hedging against the risk of sharp fall in the price of gold of less than 10 percent of total gold in its custody, the company would be able to significantly de-risk its business.
At this point, we approached the Reserve Bank of India for necessary approvals. But then, after much back and forth, the idea had to be shelved. For the Reserve Bank, the two sticking points were:
a) Manappuram was not the owner of the gold in its custody because ownership continued to vest with the borrowers. Despite Manappuram’s clarification that the company was to be treated as the beneficial owner of this gold, RBI did not budge.
b) RBI had reservations about the fact that premium for the hedging contract would be remitted in foreign currency.
I recall this episode only to demonstrate that contrary to popular impression, many of the gold loan players were conscious of the price risk angle even before the RBI stepped in. It also points to the need for regulators to shed rigidity when dealing with entities under their regulatory control, particularly NBFCs.
A flexible and constructive approach would not only have addressed the risks in the system, it would have also fostered growth of the sector. As it happened, the overnight announcement of stringent new regulations did have the desired impact of curbing the growth of gold loan NBFCs but it came at a high cost. These costs were borne by the gold loan companies that lost business and market share to the unorganised sector where the writ of the RBI does not run. The wider economy was a loser too as the process of monetizing India’s vast reserves of privately held gold suffered a setback.
Today, after two years of declining fortunes, the gold loan industry is finally beginning to look up. The revival has come about after the Reserve Bank revised the cap on LTV ratio (in January, 2014) to a more customer friendly 75 percent. Clearly, having studied the workings of the gold loan industry in detail over the last couple of years, there is greater clarity and comfort in the policy making establishment. And that is a welcome development.