Why is it in the News?

Context:

• The Reserve Bank of India (RBI) recently issued regulatory measures to banks and NBFCs to increase risk weights associated with consumer credit and bank credit by an additional 25 percentage points.
• Currently, at 100% risk weight, loans to consumers will see an increase to 125%, excluding loans for housing, education, vehicles, and against gold.
• This would be applicable to unsecured personal loans, credit cards, and lending to NBFCs.
• The directions are expected to result in higher capital requirements for lenders and thereby, an increase in lending rates for consumers.

What is ‘Risk Weights'?

• Risk weight is capital required to be set aside, stipulated by the Reserve Bank of India for Banks, or National Housing Bank for housing finance companies, that has to be made by banks for giving the loan.
• In other words, it is the amount (depicted as a percentage of loan disbursed) that institutions need to set aside for assets.
• The risk weight is a function of the risk perception the apex bank has on loans for different sectors.
• It is applicable to all categories of retail (personal, home, car, and education loans) as well as corporate lending.
• The one that often impacts borrowers directly, and the most, is the risk weight on home loans.
• It is an essential tool for banks to manage this risk.

Why do risk weights matter?

• Risk weights are pivotal in banking regulation, as they dictate the capital set aside for different loan types, reflecting their risk profiles.
• Unsecured loans, perceived as riskier, have higher weights, thus requiring more capital.
• Home loans, for instance, attract a risk weight of 35-50%, depending on the size of the loan.
• In comparison, personal loans will now have a risk weight of 125%.

Why were the Changes by RBI Deemed Necessary?

• Governor Shaktikanta Das had flagged concerns about the “high growth” in “certain components of consumer credit.” while presenting the monetary policy statement in October this year.
• He advised banks and NBFCs to “strengthen their internal surveillance mechanisms, address the build-up of risks, if any, and institute suitable safeguards, in their own interest.”
• The governor said these were being closely monitored by the apex banking regulator for “any signs of incipient stress.”
• Rating agency Moody’s also put forth that higher risk weights are intended to “dampen lenders’ consumer loan growth appetite.”
• The unsecured segment, it adds, has grown rapidly in the past few years, exposing financial institutions to a potential spike in credit costs in the event of a sudden economic or interest rate shock.
• RBI’s latest figures stipulate that unsecured personal loans have increased approximately 23% on a year-over-year basis, as of September 22 this year.
• Outstanding loans from credit cards increased by about 30% during the same period.
• Major concerns emerge for loans below Rs 50,000 – these carry the utmost default risk.
• Delinquencies in this segment stood at 5.4% as of June this year.
• Ratings agency S&P in their assessment held that borrowers in this segment are often highly leveraged and may have other lending products.
• According to Moody’s, several NBFCs that until now focused on secured lending categories (such as infrastructure, real estate, and vehicle loans) have pivoted to riskier segments.

What are the main concerns?

• The primary concerns are about how these changes might affect the amount of money banks have and how well they can make a profit.
• Having enough money, called capital adequacy, is crucial for banks.
• It helps them handle unexpected problems or risks in their business without losing too much money.
• A recent report from S&P, which is a group that studies these things, says that if banks are more careful and focus on managing risks, it could make their loans safer.
• However, it predicts that a measure called Tier-1 capital adequacy, which is like the best kind of money banks have, might go down a bit—about 60 basis points.
• This is important because Tier-1 capital helps banks deal with losses right away.
• S&P thinks that this might make banks that don't have a lot of this kind of money think about getting more.
• Also, it noticed that government-owned banks generally have less of this important money than big private banks.
• But, the report says that finance companies might face the biggest impact because they could end up borrowing more from banks, and it might affect how much good money they have.

How It will affect Consumers?

• As the risk weightage goes up, banks may become more careful about giving loans to consumers, especially those seen as having a higher risk.
• This could make it harder for some people to get credit cards or personal loans.
• Even those who still qualify for credit might face stricter terms and conditions.
• Experts suggest that by increasing the risk weightage, the RBI is trying to handle the increasing number of people not repaying their loans and the risks connected to unsecured loans.
• Lenders will now have to consider the higher credit risk in this type of loan, which could make lending more expensive.
• As a result, borrowers taking out these loans may face higher costs.

Way Forward

Banks and NBFCs may need to review their approaches to risk and lending specifically for unsecured loans. This could involve placing greater emphasis on evaluating creditworthiness and exploring alternative strategies to effectively handle risk while still providing loans. Financial institutions might also consider diversifying their loan portfolios by placing more emphasis on secured lending or exploring other creditworthy segments. This approach aims to balance the effects of the heightened risk-weighting associated with unsecured loans.

What is the Capital Adequacy Ratio (CAR)?

• The Capital Adequacy Ratio (CAR) is a financial metric used to evaluate a bank's stability and risk management.
• Calculated as a percentage, it compares a bank's capital—comprising Tier-1 and Tier-2 capital—to its risk-weighted assets.
• Tier-1 capital includes core elements like common equity
• Tier-2 capital consists of supplementary items.
• Regulatory authorities, such as the RBI, establish minimum CAR requirements to ensure banks can absorb potential losses.
• A higher CAR reflects greater financial resilience, emphasizing a bank's ability to navigate economic challenges and adhere to regulatory standards.