The KUB Rao Working Group has come out with tougher guidelines and asked for better documentation, standardization of interest rates, stricter KYC guidelines and more transparency from gold NBFCs. But the market has interpreted it as being good for gold loan companies

A Reserve Bank of India (RBI) panel has said that the growth of gold loan non banking financial companies (NBFCs) business warrants that their operations may be closely monitored. The RBI Working Group headed by KUB Rao also expressed concern on some gold loan NBFCs which have been raising public deposits surreptitiously through unincorporated bodies. However, the stock market has interpreted the recommendations as very good for gold loan companies. At close today, Manappuram Finance soared 19.94% to close at Rs40.60 and Muthoot Finace jumped 9.51% to settle at Rs229.80 on the NSE.

The RBI, in its monetary policy statement on 17 April 2012, had raised regulatory concerns over the large rise in the gold loan business, the branch network of gold loan NBFCs, volume of loans disbursed and the quantum of bank borrowings. It also constituted a working group under KUB Rao, advisor in Department of Economic and Policy Research at the RBI.

The report said, NBFCs, predominantly engaged in lending against the collateral of gold jewellery had recorded exponential growth in recent years both in terms of size of their balance sheet and physical presence. “Based on the number of complaints received against such companies, it is apparent that the mammoth expansion had taken place at the cost of sound internal controls. Several undesirable features such as poor Know Your Customer (KYC) compliance, poor storage facilities for gold accepted as collateral, increased incidences of frauds and robberies, opaque auction procedures, all pointed towards rising operational risk as well as consumer protection issues in such companies,” it said.

Calling for monitoring transactions between gold loan NBFCs and unincorporated bodies, the panel said there is a need to bring the sister concerns floated by gold loan NBFCs under the ambit of monitoring and regulation for ensuring domestic financial stability. “There are also interlinkages within the gold loan NBFC segment in the form of gold loan NBFCs floating unincorporated sister concerns to undertake financial activities, which are not permitted by the financial regulator. Such activities primarily involve raising public deposits and diverting these funds towards registered gold loan NBFC. Raising public deposits by such illegitimate means can have implications for public confidence in the concerned NBFCs and non-banking financial sector as a whole. If such activities are not curbed in time, they can threaten the stability of financial system,” the reports said.

According to the Rao panel, since large numbers of complaints are being received against the NBFCs, there is a need for an ombudsman to hear the grievances. “This will be a no-cost service to the customers and will go a long way in disciplining the NBFCs as well,” it added.

The report said sources of funds of gold loan NBFCs do not appear to be an immediate cause of concern giving rise to concentration credit risk. “Going by the past trends, a sharp sudden drop in gold price by 30 to 40% is a remote possibility causing financial distress to the gold loan NBFCs and the extant loan to value (LTV) ratio should provide a reasonable risk cover in case the gold prices fall by 10%. Asset quality, NPAs as percent of total credit exposure and capital adequacy of gold loan NBFCs are not a cause for concern at present,” the report said.

“The committee has come out with tougher guidelines and asked for better documentation, standardization of interest rates, stricter KYC and more transparency from the companies; on the positive side it has also asked for an increase in the LTV from 60% to 75%. Hence, in our opinion although the document itself may not be extraordinarily positive for gold loan NBFCs, clarity around regulations should ease much needed funding for the sector and uncertainty amongst investors about the sector's future prospects," said Espirito Santo Investment Bank Research in a note.

The Rao Committee has said that there is a case for review of the LTV of 60% and it could be increased to 75%. However, it has also clarified that calculation of LTV should be standardised and fixed at potentially prevailing prices of 22 carat gold in the Mumbai bullion market. Currently companies are using scrap value of gold and adding to it other costs associated with the jewellery to derive the value of jewellery. The companies have formed an association called the Association of Gold Loan Companies (AGLOC) which is providing the price of gold jewellery and the available LTV. "The combined impact of these two regulations will mean that the loan per gram may not change from what is being currently offered by the gold loan companies," the brokerage said.

Loan per gram of gold (in Rs)

Source: Company fillings, Espirito Santo Investment Bank, *as per www.agloc.org, **as per illustration shown in the working group report

As the demand for gold loans increased at a scorching pace in recent years, gold loans NBFCs have started expanding their operations at a hurried pace through opening of their branches rapidly across the length and breadth of the country. To accommodate the large demand for such loans, these NBFCs have also increased their reliance on bank and other borrowings on a massive scale, the report said.

The RBI panel has also recommended imposing restrictions on borrowings from retail customers. On the positive side the report has clearly specified that as of now gold loan NBFCs do not pose any systemic risk to the banking system, which should ease funding from the banking system. Given the same clarity around regulations, funding from the commercial paper (CP) route should restart which was a major source of funding for many gold loan NBFCs like Manappuram historically and has totally dried up in post regulatory issues, Espirito Santo added.

The Rao panel suggested host of measures, including introduction of tax sops for instruments used to impound idle gold, and higher customs duty to discourage import of the precious metal. The RBI draft report also favours imposing value and volume limits on import of gold by banks and other agencies.

Noting that large gold imports are adversely impacting the current account deficit (CAD), the report said there is a need to moderate the demand for gold imports, as ensuring external sector’s stability is critical. “Fiscal measures to reduce the gold imports may be revisited,” said the report.

Gold import is a major constituent of India's rising CAD. The CAD widened to a record high of 5.4% of gross domestic product (GDP), or $22.3 billion, in the July-September quarter.

The report also said banks need to design innovative financial instruments that can provide real returns to investors. Recommending “introduction of tax incentives on instruments that can impound idle gold may be considered,” the report said that there is a need to convert both rural and urban demand for gold into investment in gold-backed financial instruments through dematerialisation of gold.

“Limits on the volume and value of gold to be imported by banks may be considered, if required under extreme situation” is also one the recommendations in the draft report, on which comments can be given till 18th January.

Earlier, finance minister P Chidambaram said the government is considering steps to make import of the precious metal more expensive.

The report has concluded that gold loans have a causal impact on gold imports substantiating the emergence of a liquidity motive for holding gold. Also, international gold prices and exchange rate “significantly and positively” affect the gold prices in India.

Commenting on the Rao Committee report, George Alexander Muthoot, managing director, Muthoot Finance, said, “The report has also outlined that there is no systemic implications in the financial system because of gold loan NBFCs. The recommendation of the Committee for prescribing the appropriate loan to value ratio is found suitable, while its recommendation that there is no case for conceding level playing field for the gold loan NBFC with the bank is highly appreciated.”