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Gold Loan Market in India

Gold has not been a great performer as an asset class over the last 5 years. However, not only have gold loan companies maintained their profitability but the stock prices of these gold loan companies have also performed exceedingly well. Consider this chart below to get an idea..



The above chart is an interesting comparison of how the two major gold financing companies in India viz. Mannapuram and Muthoot Finance have performed in the stock markets over the last 5 years. The comparison throws up some interesting contrasts. During the last 5 years, Mannapuram returned 141.63% while Muthoot Finance returned 163.10% during the same period. Even if you were to reduce this to a CAGR growth, it quite impressive compared to the Nifty. But during the same period, gold as a metal has given negative returns of (-28.43%). This is slightly paradoxical as normally we see the financer of any asset grow along with the asset. So what explains this paradox? For that you need to understand 4 features about the business model of gold loan companies..


1.  They operate on gold funding and spread arbitrage..

This is perhaps the most important aspect of the gold loan business. If you approach a gold loan company with your jewellery, they will finance you to the extent of 60-70% of the value of the gold (RBI restricts LTV at 75%). Even this gold value is adjusted lower so the actual margin is much higher. This gold is then pledged by these gold finance companies with large banks where the funding is to the tune of over 80% of the value of the gold. There is a margin that the gold finance company retains. Secondly, there is a huge divergence in the rates. The PSU banks normally refinance the gold loan companies at 11-13% as it is fully secured. However, the gold loan companies, in turn, charge anywhere from 18% to 32% annualized based on the credit risk perception of the borrower. It is this huge margin that keeps the gold loan companies going.


2.  There is a very low degree of asset price risk with the hypothecated gold..

This is the second reason the gold loan companies are able to make money. Gold is rarely as volatile as equities. As stated earlier, the gold loan only finances you to the extent of 60% of the value of your gold. If you look at the last 5 years, which has been a bad period for gold, the negative returns have been around 28%. That means you are still profitable on your hypothecated asset. Effectively, it means that the gold loan company charges you a hefty interest on a loan that is fully secured and the risk of asset price default is very negligible. Like in case of the MFIs, the gold loan business is not full regulated and that gives them enough leeway.


3.  Gold loan companies manage distributed low-cost networks..

Low cost is one of the big advantages that gold loan companies enjoy. There is a huge demand for these gold loans in semi-urban and rural areas where the gold loan company can effectively operate through a network of franchises and brokers. This reduces their establishment cost substantially with only a variable payout entailed. Secondly, rural and semi-urban folks prefer to approach the gold loan companies as the documentation requirement is much simpler and is just limited to a promissory note and a simple form. Running operations in rural and semi-urban areas is much cheaper for these gold loan companies and that is what has stood them in good stead.


4.  What if your asset value appreciates substantially..?
Most of the gold loan companies will actually earn their alpha if the price of gold starts going up. Obviously, the gold loan company does not increase your loan limit proportionately with the rising price of gold. However, higher price of gold enables these gold loan companies to get higher funding from the refinancing banks, ensuring a better spread and margin for them. Most of the gold loan customers being dispersed and uneducated do not have the bargaining power for demanding better funding terms and hence in a rising gold price scenario, the situation really works in the favour of these gold loan companies.
Apart from these factors, it needs to be remembered that these gold loan companies also raise funds through deposits which are essentially long term money. By raising long term funds at lower rates and deploying them into short term gold loans, these gold loan companies earn an above-market spread. Of course, one can argue that this will create a maturity mismatch risk, but that is a different debate altogether. The crux of the matter is that the unique nature of gold and the huge arbitrage that the gold loan companies enjoy in terms of margins and spreads gives them the advantage. That is the reason despite tepid gold prices, these gold loan companies continue to remain profitable and enjoy higher stock market returns!

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