RBI’s order to prohibit Manappuram from accepting/renewing deposits comes 14 months after Moneylife discovered flaws in the business model of gold-loan companies

The Reserve Bank of India (RBI) has prohibited Manappuram Finance (Manappuram), a Thrissur-based non-banking finance company (NBFC), from accepting/renewing deposits but has this action come a little too late? The RBI has advised that “Manappuram Finance, Thrissur, Kerala, is not permitted under the Reserve Bank of India Act, 1934, to accept/renew deposits from the public,” the central bank said in a statement. In the light of this event, the company has decided to convene a board meeting to discuss RBI’s statement today (10th February), as well as improve corporate governance practices.

The order comes after RBI is reportedly worried about the pace at which gold has grown over the years and feels that the business model of Manappuram might not be sound, after all. Moneylife had argued more than a year ago that that the business model of gold loan companies have several holes. We ran an exclusive series on gold-loan companies on our website.

The first part of the series (click here) talked about the facilities, or lack thereof, in some the branches of Manappuram and Muthoot (there are two groups and several companies under each with the same name, Muthoot). The second part of our series (click here) had highlighted the shakiness that is the business model of Manappuram—at that time the only gold-loan listed entity—by delving deeply into its numbers. We questioned the sources of finance, since it cannot accept ‘deposits’. It is quite obvious that the company had to rely on non-convertible deposits (NCDs), which is basically public money and fundamentally no different from “public deposits”. The only difference is in its technicality. However, the RBI had found out that Manappuram Agro Farms (MAGRO), a sole-proprietorship of VP Nandakumar, the chairman of Manappuram, had been accepting public deposits, and has Rs134 crore worth of it as of 8 February 2012. Therefore, it is safe to assume that Manappuram has been dipping into the funds of MAGRO for running its business. It clearly violated 45S of the RBI Act, 1934, which states NBFCs cannot take ‘deposits’ and the same is punishable.

The fact that it took RBI so long to detect this after our article pointed out the shaky model of gold loan companies is lamentable. According to BSE website, the company has issued a rejoinder stating that it does not accept “public deposits”. This is sort of a misleading statement because, technically speaking, Manappuram doesn’t accept deposits, but had used MAGRO as a front for the same.

What is most pertinent is that ratings agency ICRA has rated Manappuram’s credit as ‘A+’ and is yet to re-classify it, in the light of the above event. According to ICRA’s grading scale, ‘A+’ means “instruments with this rating are considered to have adequate degree of safety regarding timely servicing of financial obligations. Such instruments carry low credit risk.” It is another way of saying that the company is in good standing. The fact that ICRA cannot decide whether the business model of the firm is solid is shaky is not a surprise. Rating agencies in India and all over the world have a business model that makes them hard to act in the best interest of the investors and consumers.

Last year when we wrote the gold loan series, the chairman of Manappuram told us via an email that “we believe that unlike the common man, banks are fully capable of appreciating these risks and that this is a question best left to the banks and their qualified risk analysts who have made it their business to assess these kinds of risks.” One must not forget that risks analysts, similar to ones from ICRA, deliberately misread the sub-prime crisis in the United States and the rest of the developed world which led to drastic circumstances. What happens if ICRA misreads this one?

According to its 2011 annual report, Manappuram states that “Cash credit, overdrafts and working capital loan accounts have been availed from various banks and are secured by Gold Loan receivables.” In other words, borrowings are pledged against the very gold possession you pawn off. Manappuram’s chairman told us that the company securitises your gold loan by engaging in something known as Bilateral Agreements, in which “the bank advances money by taking over a specific portion of the loan book and control over the security related to the loans is also passed on to the bank by way of a bi-partite agreement. Thus, for every instance of assignment, there will be a different set of receivables (and related security) governed by independent agreements.” While securitisation is certainly an innovative way of doing business and diversifying risks, is it stable as it claims to be, by diversifying risks across different individual parties? What happens if ICRA actually downgrades its credit, for some reason? What happens to all these agreements when the price of gold falls?

This brings us to the third part of the series we had covered (click here and here). We had explained in detail the various scenarios possible and that the company’s survival depends on gold prices rising upwards (and possibly good credit standing of the company). Anything besides that would spell trouble for not only the company but also all the depositors. Since much of the loan is collaterised against your 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.

A bank might ask the company to put up extra assets/cash, possibly more of your gold, for collateral, when prices fall steeply. The clauses in the bipartite agreements usually come into force when such an event takes place. If and when there is a run on the gold-loan company, there might not be enough physical gold to repay the customers. Securitising customers’ gold possessions is like pawning off a friend’s watch you had accepted as a collateral to give him cash because he needed money even though it doesn’t ‘belong’ to you. It might be legal, but not exactly a stable way of doing business. While this possibly hasn’t happened yet, we cannot rule it out.

To make the business of gold-loans more lucrative, the company needs woo more gold owners. This way, they would securitise it further and sanction more loans, or use the money for other means, such as investments and branch expansion. For this purpose, Manappuram had roped in five high-profile brand ambassadors—Akshay Kumar, Vikram, Mohanlal, Venkatesh, and Puneet Rajkumar—to endorse its products. Having high-profile stars like Akshay Kumar, whose endorsement has been widely viewed on television, makes depositors more likely to pawn off their gold, without doing any serious homework. It shows how easy it is to trap consumers and investors alike, right under RBI’s nose. The Securities and Exchange Board of India (SEBI) does not allow companies and mutual funds to use models when they raise money but the banking regulator has no issues with this.

Following the three-part article, Moneylife had written to Dr KC Chakrabarty, deputy governor, RBI, questioning the business model of gold-loan companies and the need for tighter regulations. We did not get a reply. Some 14 months late, the RBI has "cautioned members of public that those who deposit money with Manappuram Finance or MAGRO, do so at their own risk". The warning should have come much earlier. The fate of MAGRO is unknown as is the fate of its customers. Manappuram will now have to fight for its name and regain trust of the shareholders and more importantly, its customers—the gold owners.

What does this lesson hold for all of us? The same as before: Regulators and ratings agencies are often late to act the investor/depositor will have to do all the homework herself.