Background:
Gold is one of the best performing commodities witnessing the highest gain. Gold prices have gained lot of appreciation in years ranging from Rupees 18500 per 10 gram in 2010 to around Rupees 55000 per 10 gram in 2020.
Currently Gold prices have dropped steeply since beginning of the year. It has dropped to around Rupees 44800 per 10 gram as on today with correction of more than 10 percent. Gold prices have reached at the highest to around Rupees 55000 per 10 gram in the month of August 2020.
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Loan to Value (LTV) in case of gold loans:
LTV means maximum amount lender will consider loaning to borrower as percentage of market value of the loan. For example, if LTV is 75%, in case borrower pledges gold of market value Rupees 1 lakh, he may avail loan of maximum of Rupees 75000. In August 2020, Reserve Bank of India increased the permissible Loan to Value ratio from 75% to 90% till 31st March 2021. It has been done with the view to mitigate the impact of Covid-19 on households and to allow them to take higher loans against their gold
Explanation:
Reasons of reduction in Gold prices:
There are few reasons of falling of gold prices. Same is summarized below:
1. First reason is reduction in customs duty of gold in the Union budget 2021-22. Custom duty of gold reduced from 12.5% to 7.5%. Agricultural and infrastructural cess has been imposed on gold making the total levy to 10%.
2. Second reason is appreciation of Indian Rupee against the US Dollar. Gold price tends to drop when the rupee gains since US dollar to buy it from abroad is lower.
3. Third reason is increase in US bond yields. As bond yield increases opportunity cost of hold gold increases. This increases in change in portfolio of investors from gold to bonds.
4. Fourth reason is investor find it lucrative to opt for equities than other assets like gold. Stock market has gained on bullish economic outlook. Last year investors moved to gold market due to gloomy economic outlook given on spread of novel Coronavirus (Covid-19) pandemic.
Impact on such reduction on Gold Financing institutions:
Gold loans are linked to gold prices and these are highly fluctuating. When gold prices are high, people fetch higher amount of the loan. When the prices of gold fall or correct, the loan amount that person can borrow reduces. For existing borrowers substantial reduction in gold prices may result in lending institutions asking them to pledge more gold or make part prepayment to adjust the shortfall. This is because when gold prices fall Loan to Value (LTV) ratio goes up and to bring LTV to the required level, gold financing institutions may ask the borrower to provide additional collateral. In case of extraordinary correction, lenders may ask for additional collateral or prepayments putting extra burden on the borrower. In a nutshell if there is no substantial correction of gold prices, lender may not ask for cash call or additional gold. In case of substantial drop in gold prices, borrower may have to arrange for additional collateral or prepayments depending on lender policies. Failing to do so can lead to loss of precious assets as lender may sell borrower gold to recover its dues.
Credit Risks which may be faced by companies due to fall in gold prices:
A fall in gold prices not only lowers the amount that can be lent but may also increase the risk of default. If the prices of gold increases it is beneficial for the companies, however if prices of gold decreases drastically, it is negative as the probability of borrowers defaulting rises further may result in addition of Non-Performing Assets (NPA). Gold loan companies also find it difficult to meet short term obligations towards banks, creditors. Decline of gold prices may have an impact on cash flows and balance sheets. Also there is possibility of temporary Asset Liability Mismatch in company books.
How lending institutions overcome such issues?
Normally loans are secured against family jewellery, and it carries lot of sentimental attachment. Most of the borrowers choose to prepay the loans and chances of default are not likely. In India gold is not commodity for common man, it is Lakshmi (Goddess of Wealth). Common man would think of losing only if he is in severe difficulty.
In case of such issues, adequate Capital Adequacy Ratio (CAR) is maintained by the lending institutions which is needed to deal in case of liquidity crunch. CAR is the ratio of lending institutions capital in relation to risk weighted assets and liabilities. CAR set standards for lending institutions by looking at its ability to pay liabilities and respond to credit risks and operational risks. Also institutions may comply with lower LTV cap which gives a big safety margin against fall in gold prices during the tenure.
Conclusion:
Gold prices are highly fluctuating. In order to safeguard interests of borrowers, they may keep loan amount lower so that in case of steep fall of gold prices, above mentioned difficulties could be managed in better and efficient way, if they arise.
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