Risk Weights in Banking
- November 18, 2023
- Posted by: OptimizeIAS Team
- Category: DPN Topics
Risk Weights in Banking
Section: monetary policy
Risk weights in banking refer to the assigned measure of risk associated with various assets held by banks.
These weights are used in the calculation of regulatory capital requirements, determining how much capital a bank needs to hold based on the riskiness of its assets.
The higher the risk weight assigned to an asset, the more capital the bank must set aside to cover potential losses.
- Regulatory Requirement: Risk weights are a crucial component of the Basel III regulatory framework, which establishes international standards for bank capital adequacy.
- Asset Risk Assessment: Different types of assets carry different levels of risk. For example, unsecured consumer loans, including credit cards, are often considered riskier than secured loans. The risk weight reflects this difference.
- Calculation of Capital Requirements: The calculation involves multiplying the risk weight assigned to each category of assets by the total amount of assets in that category. The sum of these weighted assets determines the minimum capital a bank must maintain.
- Impact on Capital Adequacy Ratio (CAR): Changes in risk weights can impact a bank’s Capital Adequacy Ratio (CAR), which is the ratio of a bank’s capital to its risk-weighted assets. An increase in risk weights may necessitate a higher capital buffer.
Recent Example: In the provided context, the Reserve Bank of India (RBI) increased the risk weights on unsecured consumer loans, including credit cards, by 25 percentage points for banks and Non-Banking Financial Companies (NBFCs), bringing the risk weight to 125 percent.
This move is expected to increase the capital requirements for banks and may lead to a decline in the Common Equity Tier-I (CET1) capital levels.
Impact on Banks:
- The increase in risk weights is expected to result in a 5 percent increase in capital requirements for banks, amounting to ₹84,000 crores.
- CET1 capital levels are anticipated to decline by 35-100 basis points (bps) for various banks.
- Banks may pass on the impact through higher lending rates to maintain risk-adjusted returns.
- The move could moderate credit growth in segments affected by the risk weight hike.
- Consumer credit has been growing at a significant rate.
- The impact is estimated to be around 9.8 percent of total outstanding loans.
- Sectors like unsecured lending, credit cards, and personal loans are likely to be affected.
- Shares of banks and financial companies declined following the announcement.
- There may be an impact on the Return on Equity (ROE) of lenders.
- The cost of borrowing for NBFCs is expected to increase, leading to a rise in the cost of funds.
Impact of the increase in risk weights on unsecured consumer loans
The impact of the increase in risk weights on unsecured consumer loans, including credit cards, by the Reserve Bank of India (RBI) has several potential implications for the Indian economy:
- Credit Growth Moderation:
- The move is expected to lead to a moderation in the growth of unsecured lending, particularly in segments like personal loans and credit cards.
- Higher risk weights mean that banks will have to set aside more capital for these types of loans, potentially making them less attractive for lenders.
- Interest Rate Increase:
- Banks may respond to the increased capital requirements by raising interest rates on unsecured consumer loans to maintain their return on capital.
- Higher interest rates on consumer loans could impact borrowing costs for individuals, leading to reduced consumer spending.
- Impact on Consumer Spending:
- The cost of borrowing for consumers, especially those relying on unsecured credit, may increase.
- This could impact consumer spending patterns, as individuals may cut back on discretionary spending due to higher interest rates.
- Banks’ Capital Adequacy and Profitability:
- Banks will need to ensure that they meet the higher capital requirements, which could impact their capital adequacy ratios.
- The decline in the Common Equity Tier-I (CET1) capital levels for banks may affect their profitability and lending capacity.
- Sectoral Impact:
- Sectors heavily reliant on consumer credit, such as retail and consumer goods, may experience a slowdown in demand.
- Financial institutions, particularly those with a significant portfolio of unsecured consumer loans, may see a temporary impact on their financial performance.
- Market Dynamics:
- The stock prices of banks and financial companies may be influenced by the market’s perception of the impact on their profitability and growth prospects.
- Investors may re-evaluate their positions in financial stocks based on the anticipated changes in the lending environment.
- Risks Mitigation:
- The regulatory measure is aimed at mitigating risks associated with the rapid growth of unsecured consumer loans. It reflects a proactive approach by the RBI to address concerns related to asset quality and systemic risks.
- Competitive Landscape:
- The changes in risk weights could influence the competitive dynamics among financial institutions, with some players more affected than others.
- Institutions with a higher share of unsecured consumer loans may face greater challenges in maintaining growth.
- Overall Economic Growth:
- The impact on consumer spending and lending activities can have broader implications for economic growth.
- A slowdown in credit growth and consumer spending may contribute to a more cautious economic environment.
It’s important to note that the full extent of the impact will depend on various factors, including how banks adjust their lending practices, consumer behaviour, and the overall economic context.
Basel III Norms:
Basel III refers to a set of international regulatory standards developed by the Basel Committee on Banking Supervision (BCBS) to strengthen regulation, supervision, and risk management within the banking sector.
The framework was introduced in response to the global financial crisis of 2007-08 with the aim of enhancing the resilience of banks and reducing the likelihood of future financial crises.
Here are key components and objectives of Basel III:
- Capital Adequacy:
- Basel III introduces more stringent capital adequacy requirements, aiming to improve the ability of banks to absorb losses during economic downturns or financial crises.
- Common Equity Tier 1 (CET1) Capital:
- One of the central elements of Basel III is the emphasis on Common Equity Tier 1 (CET1) capital, which represents a bank’s core equity capital. CET1 capital includes common equity, retained earnings, and certain regulatory adjustments.
- Capital to Risk-Weighted Assets Ratio (CRAR):
- Basel III mandates banks to maintain a minimum Capital to Risk-Weighted Assets Ratio (CRAR) of at least 8%. CRAR is a ratio that compares a bank’s capital to the risk-weighted value of its assets, where assets are assigned different weights based on their risk.
- Leverage Ratio:
- Basel III introduces a leverage ratio, which is a measure of a bank’s capital to its total exposure. This ratio is designed to mitigate the risk of excessive leverage and acts as a backstop to the risk-weighted capital requirements.
- Liquidity Standards:
- The framework includes new liquidity standards to ensure that banks maintain an adequate level of high-quality liquid assets to meet short-term liquidity needs.
- Systemically Important Banks:
- Basel III identifies systemically important banks and imposes additional capital requirements on these institutions to mitigate the risks they pose to the broader financial system.
About Additional Tier-1 (AT1) bonds
Additional Tier-1 (AT1) bonds are a type of financial instrument issued by banks to strengthen their core capital base and meet regulatory requirements, particularly under the Basel III framework.
Here are key features and characteristics of AT1 bonds:
- Nature of AT1 Bonds:
- AT1 bonds are unsecured, perpetual bonds, meaning they have no maturity date and do not need to be redeemed by the issuing bank.
- These bonds are a form of hybrid instrument, combining features of both debt and equity.
- Purpose of Issuance:
- Banks issue AT1 bonds to enhance their capital structure and fulfill regulatory capital requirements, particularly the Common Equity Tier 1 (CET1) capital ratio mandated by Basel III.
- Coupon Payments:
- AT1 bonds pay a fixed or floating coupon to investors. However, the issuing bank has the discretion to skip coupon payments if it incurs losses, and it can only make payments from profits or revenue reserves.
- Yield and Risk:
- AT1 bonds typically offer higher yields compared to other types of bonds issued by the same bank, reflecting the higher risk associated with these instruments.
- Investors are attracted to AT1 bonds for the potential of earning a higher yield, but they also bear the risk of non-payment of coupons and potential write-downs.
- Call Option:
- The issuing bank has the option to call back the AT1 bonds or repay the principal after a specified period, usually five years. This gives the bank flexibility in managing its capital structure.
- Risk of Write-Down:
- In the event of severe financial distress, if the bank’s Common Equity Tier 1 (CET1) capital ratio falls below a certain threshold (Point of Non-Viability Trigger or PONV), the AT1 bonds can be written down or converted into equity.
- The risk of write-down or conversion into equity is a unique feature of AT1 bonds and reflects their role as a form of contingent capital.
- AT1 bonds typically receive credit ratings that are lower than those of secured bonds issued by the same bank. The lower rating reflects the higher risk associated with these instruments.
In summary, AT1 bonds play a crucial role in a bank’s capital structure, providing a source of contingent capital that can absorb losses during periods of financial stress.
Investors in AT1 bonds accept higher risks in exchange for potentially higher yields, and the regulatory framework ensures the stability and resilience of the banking system.
About Common Equity Tier 1 (CET1) capital
Common Equity Tier 1 (CET1) capital is a key component of a bank’s regulatory capital and is considered the highest quality of capital. It represents the core capital that provides a financial institution with a substantial cushion against potential losses.
CET1 capital is a measure of a bank’s financial strength and its ability to absorb losses without jeopardizing the stability of the financial system.
Here are key features and characteristics of CET1 capital:
- Core Capital:
- CET1 capital is part of the Basel III regulatory framework, which sets international standards for bank capital adequacy.
- It is considered the most reliable form of capital as it consists mainly of common equity, which includes common shares and retained earnings.
- Common Equity Tier 1 capital includes common equity elements such as common shares and retained earnings.
- It may also include other comprehensive income and certain regulatory adjustments.
- Quality of Capital:
- CET1 capital is classified as “going concern” capital, meaning that it is available to absorb losses while the bank continues its normal operations.
- It is meant to provide resilience to a bank during economic downturns and financial stress.
- Regulatory Requirements:
- Regulatory authorities, such as central banks and banking regulators, set minimum CET1 capital requirements that banks are required to maintain.
- These requirements are part of the broader capital adequacy standards aimed at ensuring the stability and solvency of financial institutions.
- Risk-Based Capital Ratio:
- CET1 capital is expressed as a ratio to risk-weighted assets (RWA). The CET1 capital ratio is calculated by dividing CET1 capital by the risk-weighted assets.
- The formula is CET1 Capital Ratio = CET1 Capital / Risk-Weighted Assets.
Maintaining an adequate level of CET1 capital is essential for banks to meet regulatory requirements, support sustainable business operations, and instill confidence in depositors, investors, and other stakeholders.
About ‘Point of Non-Viability Trigger’ (PONV)
The ‘Point of Non-Viability Trigger’ (PONV) is a regulatory mechanism that allows a regulatory authority, such as a central bank, to take over the management and operations of a distressed or failing bank.
This trigger is particularly relevant in the context of Additional Tier-1 (AT1) bonds issued by banks.
Here’s how the PONV mechanism works:
- Identification of Non-Viability:
- If a bank reaches a point where it is no longer considered viable due to severe financial losses, regulatory authorities, such as the central bank, may determine that the bank has reached the “Point of Non-Viability.”
- Activation of PONV Trigger:
- Once the regulatory authority determines that the bank is non-viable, it can activate the Point of Non-Viability Trigger. This triggers a set of actions and measures aimed at addressing the distressed situation of the bank.
The PONV mechanism is designed to ensure that regulatory authorities have the tools and powers needed to intervene in a timely manner when a bank is facing severe financial distress. By activating the PONV trigger, the regulatory authority can take swift actions to prevent the failure of the bank and protect the interests of depositors, creditors, and the broader financial system. This mechanism is part of the broader regulatory framework, such as the Basel III norms, aimed at enhancing the stability of the banking sector.
About Capital to Risk-Weighted Asset Ratio (CRAR):
- 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.
- 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.
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
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.