Our country needs a new type of financial intermediary. This need arises for two reasons. First, many persons buy gold over the years to use at a later date (say, for a daughter or son’s marriage, which may take place many years later). Second, many persons possess jewellery but do not have access to personal finance at reasonable interest rates.
The Reserve Bank of India (RBI) Report of the Technical Group to Review Legislations on Money Lending (2007) says that across various states the rate of interest charged by informal creditors “ranged from 12 per cent to 150 per cent per annum although the average rate of interest ranged from 18 per cent to 36 per cent per annum”. The report of the Planning Commission’s committee on financial sector reforms (2008) says: “The single most frequently used source of loans for the median Indian household is still the moneylender.” Let us call this proposed financial intermediary a “Gold Bank”. As an example, let us say Mohan belongs to the first category of persons. One day, he deposits 100g of gold with Gold Bank for one-year at an interest rate of 1% per annum. Thus, Gold Bank is required to repay 101g of gold to Mohan after one year. Please note that Gold Bank calculates the interest in grams of gold and not rupees.
Say Vivek belongs to the second category of persons. Vivek has 120g of gold jewellery and urgently needs cash on that same day. Vivek takes the 120g jewellery to Gold Bank and offers it as collateral. Gold Bank gives Vivek cash (equal to the value of 100g of gold on that day) and will charge an interest rate of 3% per annum. Gold Bank had raised this cash by selling Mohan’s gold in the market. Thus, Vivek should repay cash (equal to 103g of gold’s value one year from today).
One year later, Gold Bank earns an interest spread of 2g of gold. In case Vivek does not seek a rollover of his loan and if he defaults on the loan, Gold Bank will return the collateral after taking 103g of pure gold from it. Thus, Gold Bank does not face any unmitigated credit risk. Now, Gold Bank could have thousands of customers (depositors as well as borrowers) spread across the country in its first year of operation. And Gold Bank could have many more new customers in later years. These large numbers will make it possible for Gold Bank to allow Vivek, if he so desires, to roll over the loan for another year—since with a diverse portfolio of customers, in general some depositors may opt to roll over too. Vivek will pay interest at the new one-year interest rate prevailing on the date of the rollover.
Gold Bank will always consider the effective collateral after considering the purity of Vivek’s collateral.
Thus, Gold Bank will earn an interest spread of 2% by taking some risks related to asset/liability tenor mismatches—but without taking any unmitigated credits risks. Gold Bank is allowed to use gold as its reporting currency and so its reported profits are relatively stable.
The borrower could be adversely affected by a rise in gold prices. For a higher interest rate of, say, 6%, the borrower could be offered a cap on his liability in rupees. The strike rate of the embedded commodity option would effectively cap the interest rate in rupees at, say, 25% per annum.
The same RBI report says “Moneylenders provide 24/7 service and maintain confidentiality.” But, unlike the moneylender, Gold Bank incurs financing costs and earns returns in the same currency as the collateral, namely, gold. Also, the Gold Bank employs economies of scale. If Gold Bank has a commitment to serve customers, it can easily outperform the moneylender—assuming regulatory reforms allow Gold Bank to exist!
A.M. Godbole is an adviser with AV Rajwade and Co. Pvt. Ltd, a risk management consulting firm. These are his personal views. Comment at firstname.lastname@example.org