Friday, May 27, 2011

Should you invest in gold loan firms?

It's hard to miss the gold loan advertisements that have sprung up lately on billboards and television. If the demand for gold loans is growing sharply, a natural question is whether the companies are offering good opportunities to equity investors.

If one likes to cash in on the momentum of rapid growth in the early stages of a business and is willing to take on risks like a venture capitalist, the answer is yes. If, however, one is looking for a long-term play, perhaps the answer is no.

Such loans help pledge the gold that is traditionally held by households in order to realise cash. The risk to lenders is low due to the asset-backed nature of the loan and the ease with which gold can be sold in case of a default.

Gold loan companies have been growing rapidly as restrictions on branch expansion (unlike banks) do not apply to them. The product structures are also attractive.

Interest rates are high, but depend on the value of the pledged gold that is being taken as loan, with lower rates offered for a lower loan-to-value ratio. Loans are offered with bulleted payments at the end of the term, which can be as short as one month.

Processing time is fast (some claim just one hour), there is low or no administrative fee, and these loans are beyond the ambit of Cibil's credit scoring mechanism, which is used by banks. While all these factors contribute to market expansion, they also point to high-risk borrowers turning to gold loans.

The key operating cost for a lender depends on the availability and cost of funds. The RBI had allowed funding to non-banking financial companies (NBFCs) for lending against gold as an indirect priority sector activity. This meant that banks preferred indirect participation in this market by lending to NBFCs at low rates and claiming credit under priority sector lending.

The spurt in gold loans by NBFCs between July 2010 and February 2011 can be attributed almost entirely to this gap in the RBI circular. NBFCs not only borrowed from banks to offer gold loans, but also sold securitised paper backed by gold loans to banks. Funding the NBFCs and earning the much-needed priority sector credit score was a better option for banks than trying to offer gold loans directly.


The RBI clamped down on this gap in February this year by explicitly excluding gold loans and securitised loans backed by gold offered by NBFCs from the definition of priority sector lending. So the revenue projections of gold loan companies will have to be tempered under the changed circumstances with respect to funding. 
Their cost of funding is likely to rise at least by 2-3% due to this change, provided banks continue to lend to them. If they have to seek alternate sources of funding, the cost could be higher.

The profitability of gold loan companies depends on two key factors-low default rate of borrowers and rising price of gold. According to popular conjecture, since borrowers would not like to part with their gold, they are likely to repay. However, gold loans disbursed across the counter without a credit score do not conjure up images of low-risk borrowers.

The confidence to disburse speedy loans to unknown borrowers comes primarily from the possession of the gold being pledged. The high margin offers some protection against fluctuation in gold prices, but any sharp correction poses a risk to the lenders. There is also a flip side to the story. If defaulters lose their gold to the lender, popular backlash can bring tighter regulatory focus on this sector. Think micro-finance. An aggressively growing lending operation will also face threats from competition.

As more players come in, they are likely to improve the terms. It is only a question of time before banks ask for a slice of the pie and the RBI modifies capital norms and lending requirements for banks. NBFCs will not be able to match banks as far as cost of funding is concerned.

The business strategy of gold loan companies is based on rapid expansion to capture the market. This comes with a high fixed cost that is spent on branches, personnel and technology. It can be absorbed when gold prices are rising, the market has few players, cost of funding is low, and the product is new.

However, it will be difficult to sustain this growth in the long run. To investors, there is surely a short-term opportunity from a new business growing at a rapid pace. However, long-term gains are not visible in this business, at least not at the current juncture.  
Source : ET

1 comment:

Unknown said...

Gold is best investment option these days. Because loss in gold is very less when compared to other investment. In emergencies, one can use gold to take gold loan for instant cash.

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