RBI’s Move to Increase Risk Weight for Lending

Context:

The Reserve Bank of India (RBI) has directed banks and non-banking financial companies (NBFCs) to reserve more capital for risk weights.

Relevance:

GS III: Indian Economy

Dimensions of the Article:

1. Background
2. Understanding ‘Risk Weights’
3. Reasons for Regulatory Changes
4. Chief Concerns
5. Impact on Consumers
6. Conclusion

Background:

• RBI’s Risk Weight Adjustments:
  • RBI has increased the risk weight for consumer loan, credit card exposures, and loans to NBFCs by 25%, reaching a total of 125%.
• Application Scope:
  • Applies to personal loans, excluding housing loans, education loans, vehicle loans, and loans secured by gold and gold jewellery.
• Concerns Raised by RBI:
  • RBI expresses concerns about the rapid expansion of consumer loans, prompting this regulatory move.
  • Anticipates potential risks associated with the increasing volume of these types of loans.
• Impact on Costs:
  • Adjustment leads to higher costs for both banks and non-banking lenders engaged in consumer lending.

Understanding ‘Risk Weights’:

• Concept of ‘Credit Risk’:
  • Core focus of RBI’s action is to address ‘credit risk.’
  • Refers to the risk linked with a borrower’s inability to fulfill obligations, leading to defaults.
• Role of ‘Risk Weights’:
  • Essential tool for banks to manage credit risk.
  • Presented in percentage factors, it adjusts for the risk associated with a specific type of asset.
• Indicator for Risk Management:
  • Indicates the ideal holding percentage that a lender should have to appropriately adjust for the associated risk.
  • RBI has directed an increase in this indicator to align with the perceived rise in risk in consumer lending.

Reasons for Regulatory Changes:

• Governor’s Concerns:
  • Governor Shaktikanta Das, in October’s monetary policy statement, expressed worries about the “high growth” in specific components of consumer credit.
  • Advised banks and NBFCs to strengthen internal surveillance, address risks, and institute safeguards.
• Monitoring by RBI:
  • The apex banking regulator closely monitored signs of potential stress in the consumer credit segment.
• Moody’s Assessment:
  • Higher risk weights aim to curb lenders’ enthusiasm for consumer loan growth.
  • Rapid growth in the unsecured segment exposes financial institutions to elevated credit costs during economic or interest rate shocks.
• Data on Personal Loans:
  • RBI’s latest figures indicate a 23% YoY increase in unsecured personal loans as of September 22.
  • Outstanding loans from credit cards rose by about 30% during the same period.
• Concerns for Small Loans:
  • Loans below Rs 50,000 carry high default risk, with delinquencies at 5.4% as of June.
• Shift in NBFC Focus:
  • Some NBFCs, traditionally focused on secured lending, have shifted to riskier segments.

Chief Concerns:

• Impact on Capital Adequacy:
  • Primary concerns revolve around the impact on capital adequacy and overall profitability for banks.
  • Capital adequacy ensures banks have sufficient capital to absorb losses from unforeseen events or risks.
• Asset Quality and Profitability:
  • S&P’s report suggests that slower loan growth and increased risk management could support better asset quality.
  • Estimates a decline of about 60 basis points in Tier-1 capital adequacy.
• Tier-1 Capital Adequacy:
  • Tier-1 capital adequacy represents banks’ highest-quality capital to absorb losses immediately.
• Potential Capital Raising:
  • Drop in capital adequacy may prompt lenders with weaker positions to raise capital.
  • Public sector banks generally have lower capital adequacy compared to large private sector banks.
• Impact on Finance Companies:
  • Finance companies might be worst-affected, facing a surge in incremental bank borrowing and impacting their capital adequacy, according to S&P.

Impact on Consumers:

• Caution in Credit Extension:
  • With increased risk weightage, banks may exercise caution in extending credit, especially to those with higher perceived risk.
  • Some individuals might find it challenging to obtain credit cards or personal loans.
• Stricter Terms and Conditions:
  • Eligible consumers may face stricter terms and conditions when availing credit.
  • Lenders could implement more stringent criteria for loan approval.
• Objective of RBI:
  • RBI’s move to raise risk weightage aims to manage growing defaults and risks associated with unsecured loans.
  • Lenders must account for higher credit risk, leading to pricier lending.
• Higher Costs for Borrowers:
  • Adjustment in risk weightage will result in higher costs for borrowers taking out unsecured loans.
  • Interest rates in this loan category may see an increase.

Conclusion:

• Growing Unsecured Loans:
  • Unsecured loans, including personal loans and credit card dues, are experiencing rapid growth.
• Cost Implications:
  • Due to higher risk provisioning, these loans may become marginally more expensive.
  • Impact on interest rates will vary among lenders.
• Fundraising Challenges:
  • Both banks and NBFCs need to raise funds while recalibrating priorities based on new risk weights.
  • Balancing profit margins and managing risks from non-performing assets (NPAs) becomes crucial.

-Source: The Hindu