RBI's gold loan norms welcome, but NBFC-bank parity is essential

The Reserve Bank of India (RBI) has issued draft guidelines on gold loans and sought comments. Given the overall size and speed of growth of gold loans (76 per cent growth in the last year), the regulator paying attention to this segment is welcome. In this article, I argue that while the RBI’s efforts to standardise loan terms and prevent evergreening are in the right direction, treating banks more favourably than non-banks is likely to be counterproductive. 

 

To appreciate the spirit of RBI guidelines, it is important to understand the profile of typical gold loan borrowers. These are likely to be new-to-credit, with little understanding of business, finance, or their rights under a contract. Such borrowers are vulnerable to manipulation by sophisticated lenders. In this regard, the first set of proposed measures that aim to standardise lending, valuation, storage, and auctioning are timely and relevant. For instance, a proposed regulation requires the lenders to return the gold held as security to the borrowers within a period of seven days after loan repayment. Another proposal in the same spirit requires the lender to pay a fine of ₹5,000 per day for any delay in returning gold.

 

The second set of proposals relates to safeguarding the health of lenders. One important proposal in this regard requires the lenders to renew loans or extend additional loans “only on the basis of a formal request from a borrower and based on a fresh credit appraisal.” The requirement of fresh appraisal is an important antidote to evergreening of loans — the practice of using proceeds from new loans to repay older loans that are on the verge of default. In a research paper titled “Identifying evergreening: Evidence using loan-level data” published in the Journal of Banking and Finance, I show that bank loan officers regularly issue new loans to cover up the likely default of existing loans issued by them. Eventually, the evergreened loans are nearly 30 per cent more likely to default than normal loans. I also find that the practice of evergreening is most rampant in gold loans.

 

If the new proposals are implemented, it will be difficult to extend fresh loans to borrowers in poor health automatically. Thus, the tendency to evergreen loans is likely to reduce. Given that the gold loan market is reaching a critical size — close to ₹10 trillion (ICRA estimates) this year — a sudden increase in defaults could cause systemic issues. Therefore, the proposal to curb evergreening is timely.

 

However, there is one proposal that, in my view, requires reconsideration. According to the draft guidelines, the total loan value should not exceed 75 per cent of the value of the gold for all loans issued by non-banking financial companies (NBFCs). However, for banks, this restriction applies only to consumption loans. Gold loans issued by banks for the purpose of income generation can exceed the above threshold.

 

There are two issues here. First, tracking the end use of funds is extremely hard. We know from the 2008-2015 Indian banking crisis that the central bank cannot monitor the end use of funds even when the borrower is a large corporation. Given this, it is unrealistic to assume that the regulator will be able to monitor the end use of small loans of gold loan borrowers. This will likely lead to large-scale misclassification of loans by banks, potentially triggering a future crisis.

 

The second issue relates to the regulators’ approach of imposing more stringent conditions on NBFCs than banks. A possible argument in favour of such an approach could be that banks have the strength to absorb more losses than NBFCs. This is not true. Banks have significantly lower levels of capital than NBFCs. More importantly, a large fraction of banks’ liability structure comprises savings and current deposits that can be demanded at any time and hence have the potential to cause a run. Finally, as we know from previous crisis episodes in India and abroad, it is also not true that banks lend more carefully than NBFCs when given lenient regulatory treatment.

 

It is essential to understand that the very purpose of the existence of NBFCs is to issue loans that banks, with their fragile capital structure, cannot issue. Lending to first-time and poor borrowers falls in this category. Banks neither have the expertise nor the risk appetite to lend to this category. Incentivising banks to lend directly to this category may end up increasing systemic risk rather than decreasing it. Higher default rates are usually followed by more stringent regulations and restrictions on lending. Thus, the differential treatment of banks eventually hurt access to credit for the poor.

 

It is not my case that NBFCs should not be regulated. However, imposing rules on them that are more stringent than banks defeats the very purpose of their existence. Finally, if the intention of the regulator is to promote cash flow-based lending, it is better to take it up separately and not mix it with gold loans. I hope that in the final version, the regulator will treat banks and NBFCs similarly with respect to gold loans. Overall, the guidelines are a step in the right direction.

 

The writer teaches at Indian School of Business