RBI’s Move to Increase Risk Weight for Lending

RBI’s Move to Increase Risk Weight for Lending

Subject : Economy

Section: Monetary policy

Context:

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

Background:

• The RBI has raised the risk weight for consumer loan, credit card exposures, and loans to NBFCs by 25 per cent (now standing at 125 per cent).
• This would apply to personal loans, excluding housing loans, education loans, vehicle loans and loans secured by gold and gold jewellery.
• The central bank has expressed worries about the rapid expansion of these types of consumer loans.
• This adjustment will result in higher costs for both banks and non-banking lenders engaged in consumer lending.

What are ‘Risk Weights’?

• The central idea behind the RBI’s action is to address the notion of ‘credit risk.’
• It refers to the risk entailed by a borrower being unable to meet their obligations or defaulting on commitments.
• ‘Risk weights’ are an essential tool for banks to manage this risk.
• This metric, in percentage factors, adjusts for the risk associated with a certain asset type.
• In other words, it is an indicator of the essential holding the lender should ideally have to adjust the associated risk. This is what the RBI has directed be increased.

Why were the Changes Deemed Necessary?

• While presenting the monetary policy statement in October this year, Governor Shaktikanta Das had flagged concerns about the “high growth” in “certain components of consumer credit.”
• 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.”
• Ratings 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 on 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 Chief Concerns?

• The primary concerns relate to the impact on capital adequacy and the bank’s overall profitability.
• The latter ensures that banks have sufficient capital to absorb losses arising out of unanticipated events or risks within the business.
• S&P’s latest report states that slower loan growth and an increased emphasis on risk management will likely support better asset quality in the Indian banking system.
• It estimates that Tier-1 capital adequacy will decline by about 60 basis points.
• Tier-1 capital adequacy represents banks’ highest quality of capital as it helps banks absorb losses immediately as and when they occur.
• According to S&P, the drop may prompt lenders with weaker capital adequacy to raise capital.
• Unrelatedly, it observed that public sector banks generally have lower capital adequacy than large private sector banks.
• However, the worst-affected might be finance companies, as their incremental bank borrowing might surge, besides the impact on their capital adequacy, S&P states.

How Will It Impact Consumers?

• As risk weightage increases, banks may become more cautious in extending credit to consumers, especially those with a higher perceived risk.
• This could result in some individuals finding it more challenging to obtain credit cards or personal loans.
• Those who are still eligible for credit might face stricter terms and conditions.
• According to experts, by increasing risk weightage, the RBI aims to manage the growing defaults and risks linked to unsecured loans.
• Lenders will now need to account for higher credit risk in this loan category, thus making lending pricier.
• This adjustment will also result in higher costs for borrowers taking out these loans.