Why is it in the News?

Spooked by the strong growth in unsecured loans to consumers, the Reserve Bank of India (RBI) has increased the cost of funds for banks and non-bank financial companies (NBFCs), by increasing the risk weight of such loans.

What are Risk Weights?

• Every rupee lent by the bank is a cost or has an implication on its capital position.
• Depending on the nature of the loan and the inherent risk associated with it, risk weights are attributed.
• Banks have to ensure that their capital is enough to cover these risk-weighted assets.
• Total assets as disclosed in the financials and total risk-weighted assets are different things.
• Each asset class has varying risk weights.
• For instance, risk weights for home loans could range from 50 percent to 75 percent, for gold loans it is 75 percent.
• Corporate loans are charged 100 percent given the risk they carry.

How do they affect borrowers?

• Lower the risk weight, and lower the rate of interest. This is the thumb rule.
• Therefore, risk weights impact borrowers indirectly and are felt through the pricing of loans.
• For instance, home loans have the lowest interest rate among retail products because lower risk weights allow banks to pass on the advantage of capital consumption.
• Personal loans and credit cards have the highest interest rate because of their tenure and charge on capital.