Borrowing against gold is becoming more popular as the yellow metal’s price reaches for the stratosphere and Indians lose their inhibitions over pledging their family heirlooms as collateral. Is it safe to do business with these gold-loan companies? 

In the previous part of this two-part series, we examined how loans against gold gained popularity (http://www.moneylife.in/article/78/9891.html). We now examine the revenue models of these gold-loan companies.

The biggest advantages for a gold-loan company are the following:

1) The hefty interest they can charge on these loans. The illiterate farmer has no other place to go and it was an opportunity for these companies.
2) They operate at huge margins - sometimes as high as 20%.
3) They offer very short terms of lending and they can ask the borrower to repay/give more assets or auction the securities (and in auctioning also there are so many fraudulent activities like not giving proper notices to the borrower/imposing very high penalty rates/taking the pledged ornaments in auction through people known to them, the list goes on).
4) No elaborate documentation involved. Just a promissory note and an application form.
5) Safe custody of documents/securities was easier (as they were just bundled in a cloth bag and kept with the name of the borrower tagged to it inside their strong room. And today a share broking company has to keep its shares and clients' shares separately - these gold loan companies have no such norms).
6) Normally, there are huge increases in market rates of assets pledged resulting in heavy gain for lenders due to the high margins while granting a loan.
7) These companies adopted intricate networks for easy reach, coming across as a "saviour" for the local people.

While banks thrived well and succeded in banking as they started other loans like cash credits, term loans by lending to industrial and trading activities, the small NBFCs (non-banking financial companies) and gold financing companies could not do it in the organised sectors. They still continued lending against ornaments to their existing client base and survived. When the liberalisation process started in India, these companies could see a silver lining for survival and waited patiently for the banks to diversify. Along with the banking reforms that were implemented due to the intervention of the Reserve Bank of India (RBI), these companies providing loans against gold started an active campaign for their comeback not in any traditional growth areas, but for the same old "loan against gold ornaments" category. These companies confined their operations to local districts (or maximum to their states) to float in the turbulent market, so that they would be well-poised to reap the benefits of any possible recovery in the market.

And now we see some of the companies trying to reach out to a pan-India audience, with branches at key centres. It can be seen that all these centers will be middle- and lower middle-class dominated areas. They are coming up with massive advertisements to attract customers. These companies are trying to raise money from the public both by way of debt and equity.

Some of them want to come out with initial public offerings (IPOs) to ride the current market highs and some are raising funds through private equity placements. 

Even compared to sectors like real estate, these gold loan companies are finding it easier to attract entities for equity participation or equity lending.

Ultimately these lenders are in it for short-term returns and are not long-term players in this market. Gold loan companies are sure that none of their FDs or bonds will be rated. And same is the case with their deposits. Hence they are taking deposits from the public through the same way they used to collect earlier. As the cost of deposits has fallen down over a period of 20 years today, they are able to garner deposits @ 15% pa (as against the earlier 24%) and are lending at 24% to 30% pa. These costs may not be transparent as they will have appraising charges, processing fees on a quarterly/half-yearly basis, safe custody charges and so on.

These monies are taken for a term of 1 to 5 years and they also borrow from private moneylenders and from some banks against securities. The pooled money is lent against ornaments at exorbitant rates where they have at least 10% gross margin. Their operating cost is very low as they operate from ordinary places; thereby saving on overheads and the staff cost is not at the market level. The people employed are not qualified professionals. Thus they are able to get a huge profit margin and have started approaching the urban/metro sector population, using the latter's greed for retail assets and up-market living style.

Is it safe to deposit money with these companies?

No, for the following reasons:

1) They have no regulator. Though they say that they are regulated by the RBI, the grip on these companies by RBI is too weak. They are under the ambit of NBFCs; depositors should not forget the tough time they had during the days when NBFCs were giving out very huge rates of interest and incentives for mopping up deposits and all of a sudden the bubble burst. Anyone paying more than 200bps (around 10 % now) is to be avoided.
2) These companies have no asset backing. They do not have any fixed assets to floating assets like raw materials and work in process. They have only the money raised from you and from other sources and at any time of downfall there is no asset base cushioning for them.
3) They do not have a long-term plan to diversify into other areas of business and unless there is diversification in related areas in a financial service company, growth cannot come about. Hence they are short-sighted and want to make use of the sunshine now.
4) Their business model is just dependent on a single metal and the vagaries in price of this single asset, gold, will affect them both ways to a larger extent.
5) The deposit guarantee schemes given by the government will not apply to the deposits made with these gold loan companies.
6) Due to cost constraints, they operate from tiny residential areas; keeping a watch on them will be difficult.
7) There is no transparency in their deployment of funds raised as many are not listed companies or fall under the purview of any regulator like SEBI or IRDA.

And what about using them for raising loans?

Invariably, you will be requested to deposit some money or pay a rate of interest based on the amount funded. The usual margin they have is from 25% to 40%. And the amount you get in hand plus the interest you are going to pay will be a huge burden on you. Since these are considered as short-term loans, you need to close them on time or otherwise again pay through your nose to get them rolled over. The EMIs are structured in such a way that the main portion of it goes to interest in the initial period (though they are short-term loans). As a result you will be in a position to lose the ornament and the replacement cost will be higher for you with the cost of the yellow metal going up.

Hence investors are advised to exercise utmost caution while dealing with these companies. It is time that they are screened properly by the regulator and their dealings are made more transparent.

(The author is a management and financial consultant and can be reached at [email protected])