Measures to address concerns over the growth of unsecured retail loans

  • November 17, 2023
  • Posted by: OptimizeIAS Team
  • Category: DPN Topics
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Measures to address concerns over the growth of unsecured retail loans

Subject :Economy

Section: Monetary policy 

The Reserve Bank of India (RBI) has taken measures to address concerns over rising systemic risks associated with the growth of unsecured retail loans.

  1. Increased Risk Weights:
    • Risk weights on unsecured consumer loans, including credit cards, have been raised by 25 basis points (bps) for banks and Non-Banking Financial Companies (NBFCs).
    • Outstanding and new consumer credit exposure, excluding specific loans, will now attract risk weights of 125%, up from the current 100%.
  2. Exclusions and Inclusions:
    • For NBFCs, microfinance and Self-Help Group (SHG) loans are excluded from the higher risk weights.
    • Credit card receivables for commercial banks will now have a risk weight of 150%, up from the current 125%, while NBFCs will continue with 100%.
  3. Impact on Capital Requirements:
    • The move is expected to increase capital requirements for lenders, acting as a proactive step to enhance guardrails and strengthen internal resilience.
    • Higher capital buffers will provide lenders with better cushioning against potential increases in Non-Performing Assets (NPAs).
  4. NBFC Exposure:
    • Banks will need to set aside a 25-percentage point higher risk weight for loans to NBFCs, excluding core investment companies.
    • This applies if the current risk weight falls below 100%, based on the external credit rating assigned to the NBFC.
  5. Top-Up Loans and Sectoral Exposure:
    • All top-up loans against movable assets will be treated as ‘unsecured loans’ for credit appraisal, prudential limits, and exposure purposes.
    • Lenders are directed to review and establish board-approved limits for sectoral exposure in consumer credit, with implementation by February 29, 2024.
  6. Expected Impact:
    • The measures are anticipated to result in higher capital requirements, potentially leading to increased lending rates for borrowers.

 About Capital to Risk-Weighted Asset Ratio (CRAR):

 Definition:

  • CRAR is a financial ratio used to measure a bank’s capital in relation to its risk exposure.
  • It indicates the amount of capital a bank holds as a buffer to cover potential losses on its loans and other assets.

Calculation:

  • The CRAR ratio is calculated by dividing a bank’s capital (Tier 1 and Tier 2 capital) by its risk-weighted assets.
  • CRAR = (Tier 1 Capital + Tier 2 Capital) / Risk-Weighted Assets.

Components of Capital:

  • Tier 1 Capital (Core Capital): This includes equity capital, ordinary share capital, intangible assets, and audited revenue reserves.
  • Tier 2 Capital: This comprises unaudited retained earnings, unaudited reserves, and general loss reserves.

Importance of CRAR:

  • CRAR is a critical tool for assessing a bank’s financial health.
  • It ensures that banks have sufficient capital to absorb potential losses and continue lending safely.
  • It protects depositors and provides assurance of a bank’s ability to sustain its operations.

Benefits of CRAR:

  • Risk Management: CRAR helps banks manage and mitigate risks effectively.
  • Depositor Protection: It safeguards depositors’ funds by ensuring banks have enough capital to cover losses.
  • Sustainability: It contributes to the stability and sustainability of banks’ operations.
  • Lending Capacity:Maintaining a healthy CRAR allows banks to continue lending money to businesses and individuals.

In summary, CRAR is a key financial metric that provides insights into a bank’s financial strength and its ability to withstand financial challenges and risks.

About Capital Adequacy Ratio (CAR)

The Capital Adequacy Ratio (CAR) is a key financial metric that measures a bank’s capital adequacy and its ability to absorb potential losses arising from various risks.

It is a crucial component of the regulatory framework designed to ensure the stability and soundness of financial institutions. The CAR is expressed as a percentage and is calculated by dividing a bank’s capital by its risk-weighted assets.

The formula for calculating the Capital Adequacy Ratio is as follows:

CAR=(Tier 1 Capital + Tier 2 Capital/Risk-Weighted Assets)×100

  1. Tier 1 Capital:
    • Tier 1 capital, also known as the “core capital,” includes the most reliable and liquid forms of capital. Common elements of Tier 1 capital include common equity, retained earnings, and certain qualifying preferred stock.
  2. Tier 2 Capital:
    • Tier 2 capital consists of subordinated debt, undisclosed reserves, and other less liquid forms of capital. It serves as a supplementary layer of protection for depositors and creditors in case of a bank’s financial distress.
  3. Risk-Weighted Assets (RWA):
    • Risk-weighted assets represent a bank’s total assets adjusted for risk.
    • Different categories of assets carry different risk weights, reflecting the varying degrees of risk associated with each type of asset. The risk weights are determined by regulatory authorities based on the perceived riskiness of the assets.
  4. Calculation Basis:
    • The numerator (Tier 1 Capital + Tier 2 Capital) represents the bank’s total capital, while the denominator (Risk-Weighted Assets) adjusts this total for the riskiness of the bank’s asset portfolio. The resulting ratio is expressed as a percentage.
  5. Regulatory Requirement:
    • Regulatory authorities, such as central banks and banking regulators, set minimum capital adequacy requirements that banks must meet. Common international standards, such as those outlined in the Basel Accords (Basel I, II, and III), provide guidelines for calculating and maintaining the Capital Adequacy Ratio.
  6. Minimum Requirement:
    • The minimum acceptable level of CAR is specified by regulators to ensure that banks have a sufficient cushion to absorb potential losses and withstand financial shocks.

Core Investment Companies (CICs) – A Quick Overview

  1. Specialized NBFCs: CICs are specialized Non-Banking Financial Companies (NBFCs) with a specific focus.
  2. Asset Size Requirement: To be registered with the RBI as a CIC, a company needs to have an asset size exceeding Rs 100 crore.
  3. Primary Business: The main business of CICs is the acquisition of shares and securities. However, specific conditions apply to their investment portfolio.
  4. Investment Conditions: CICs are required to have at least 90% of their net assets invested in equity shares, preference shares, bonds, debentures, debt, or loans in group companies.
  5. Group Companies: Group companies are defined as entities related through various relationships such as subsidiaries, joint ventures, associates, promoter-promotee relationships (for listed companies), related parties, common brand names, and investments in equity shares of 20% and above.

In summary, Core Investment Companies are specialized NBFCs with a significant asset size that primarily engage in acquiring shares and securities, subject to specific investment conditions primarily related to group companies.

economy Measures to address concerns over the growth of unsecured retail loans