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? 

Of late, we see a number of advertisements from many gold financing companies, including listed companies, informing the public to keep their gold ornaments with them "for safe custody" and also enjoy loans/returns. These advertisements are deceptive with some notable cinematic personality advocating them. All what these gold finance companies want to convey is that they have the facility for 'safe custody' of your gold or ornaments; but they want the public to pledge them and avail of a loan. Companies like Muthoot, Manappuram etc have become popular over the past few years with lots of publicity, trying to woo the attention of middle- and lower-middle class people. Is it safe to deposit your hard-earned money with these companies? How have these companies been operating?

A gold loan is not a new phenomenon to Indians. It has been the main source of lending and raising money from the earliest days of financing. The origin goes back to a few centuries when it was the main item of barter and trade. And India was, and is, the highest user of gold ornaments in the world with states like Kerala and Tamil Nadu holding top rankings among the Indian states. In every south Indian TV channel you will see scores of advertisements from various retail jewelers who vie with each other to extend lots of discounts to buyers under the name of 'making charges', etc.

These companies have roped in the most popular cine stars as brand ambassadors, making many start-struck investors to sign on the dotted line for a loan.

The origins of gold loans are from the southern part of the country. Moneylenders - like the Chettiars of Tamil Nadu, the Shroffs and Marwaris from other parts of India and landowners from all over the country have traditionally lent villagers money against their gold for special occasions like marriage. The lenders accepted gold as collateral because the borrowers invariably worked for them. For an individual, it was an easier way to raise loans in a very short time, and with minimum hassle while borrowing.

Looking at these advantages, banks in coastal Karnataka (like Syndicate Bank and Canara Bank); Kerala (Federal Bank, South Indian Bank, Catholic Syrian Bank and Dhanalakshmi Bank) and in Tamil Nadu (Indian Bank, Indian Overseas Bank, Karur Vysya Bank and Lakshmi Vilas Bank, among others) entered the gold-loan fray during the 60s in a grand manner.
Most private sector banks in southern states extended loans against gold ornaments because:

1) It was easier to reach the retail masses for these banks as they were not widely spread then
2) Other advances required assessment techniques and small banks did not posses the same
3) The profit margins were huge
4) The security was adequate (margins as high as 50% were also charged)

These banks grew their loan books and ticket sizes mainly through these types of loans and also introduced 'pigmy payments' and daily collections from borrowers to repay the loan and interest. Their service was impeccable during those days and the banks registered a good name with increase in customer base and increased profits and developed very fast. The problems started surfacing when interest rates and market rates of gold started increasing. Very few banks allowed re-pledging of these borrowings. The borrower, who had placed his ornaments (not for safe custody - but for actual need) was not able to repay the loans.

Interest rates were even as high as 24%-36% p.a (with processing fees, etc thrown in) without taking into note the penal rate of interest. Banks did not need any specialised people. Only an appraiser was necessary, a man who would check the ornaments after rubbing it on a testing stone and dipping the scratched portion of the gold on the stone in nitric acid/sulfuric acid and testify and certify the genuineness of the gold contents in any ornament.

The repayment was not very prompt as people who used these facilities were poor people and farmers and the banks were comfortably able to square off the loans along with the huge interest cost mainly because of the increase in gold prices, and more because of the hefty margins they had.

These loans were considered as short-term borrowings and there were no interest-leveraging activities, back then. The ornaments were stored in the strong rooms of various banks. When the finance companies (who were also accepting deposits and running chit funds in Kerala and Tamil Nadu - they were referred to as 'Blade companies') collapsed in the early 80s, many of the depositors lost their money.

But I would like to reiterate here that a few banks brought in some discipline in the whole process of gold loaning and established some norms. Even today it is better to take a gold loan from a bank than from any of these gold loan companies.
 
These companies face stiff competition from banks and were not able to win customers when banks were active in this business. Gold loan companies were also accepting deposits from the public and many were local societies and had a few individuals who controlled how and to whom the loans should be given. The rate of interest was variable depending upon the decision of these people. These companies started to get into problems due to the wrong management style that they adopted back then. And at these times, some of the better companies saw this position as an opportunity for them to grab the pledged assets (gold) at reasonably lower prices by auctioning them through known persons, whenever the gold loans became non-performing assets (NPAs).

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

(In the next and last part of this series, we will look at the functioning of these companies and whether it is safe to invest money in them).