Introduction

In the intricate world of finance, where Risk lurks in the shadows and rewards beckon from the horizon, the Reserve Bank of India (RBI) assumes the role of a vigilant maestro, orchestrating a delicate balance between the thrill of financial endeavours and the necessity of safeguarding economic stability. As the custodian of monetary policies, the RBI crafts a melody that harmonizes risk and rewards for banks, ensuring a dynamic equilibrium in the ever-evolving world of finance. It’s a dance where caution spins with ambition, and the consequences of each move echo through the corridors of the financial realm. Yet again, RBI has made a very small change, however, its impact will be felt by the entire economy.

The Reserve Bank of India (RBI) has a proactive stance on consumer loans and credit cards due to concerns about the aggressive lending behaviour of banks and the rising levels of defaults in these segments. The central bank has observed a significant increase in unsecured loans, especially in the range of INR 10,000 to INR 50,000, with a staggering 48% growth. Simultaneously, defaults in the personal Loan category have risen to 8.1%, surpassing the overall bad loan ratio in the retail segment. The RBI is worried that such rapid growth in unsecured loans, which lack collateral, could pose a risk to the stability of the banking sector. To curb this trend and encourage responsible lending practices, the RBI has recently directed banks to increase the risk weight for certain types of loans. Unsecured personal loans and loans provided to non-banking financial companies (NBFCs) now carry higher risk weights of 125%, up from the previous 100%. Additionally, the risk weight for credit cards has been elevated to 150%. Essentially, the RBI’s move is a preemptive measure to address potential financial risks arising from the exponential growth in consumer loans and credit cards, promoting a healthier and more sustainable banking environment. However, for the bank, it means more idle funds that wouldn’t generate returns for the company.

What are the capital adequacy norms?

Imagine you’re running a lemonade stand. You’ve invested your money in buying lemons, sugar, and a stand, and you’re making a profit by selling lemonade. Now, think about what might happen if something unexpected occurs, like a sudden rainstorm ruining your lemons or a group of customers not paying for their drinks. In the world of banking, similar unexpected events can happen. Banks lend money to people and businesses, invest in various things, and operate with the expectation of making a profit. However, banks too are exposed to several risks, including credit risk (default by borrowers), market risk (fluctuations in interest rates, exchange rates, and other financial markets), operational risk (risks associated with internal processes, systems, and external events), and liquidity risk (inability to meet short-term obligations). Banks, in their essence, operate by accepting deposits and redistributing these funds through loans. The difference between the rate of interest is the earnings of the bank. However, if any borrower defaults on their loan, or the investments of the bank do not fetch positive returns, the bank will run out of money. Adequate capital acts as a safety net to absorb losses that may arise from these risks.

Suppose a bank has assets as follows – INR 100 crore as loans to customers, INR 30 crore as investments, INR 20 crore as cash and reserves, and therefore, in total INR 150 crore assets. At the same time, the bank also has the following liabilities – INR 120 crore customer deposits, INR 10 crore borrowings from other banks and therefore, in total, INR 130 crore liabilities. In this case, the difference between assets and liabilities is INR 20 crore which is the capital of the bank. This also means that the bank can suffer losses of up to INR 20 crore on its assets and still pay back its liabilities. Now, if customers default on their loans to the tune of INR 30 crores, the assets of the company would fall short of the total liabilities and therefore, the bank would run out of money to pay its customers. In today’s complex financial world, there can be several reasons that can lead the bank to such a situation. In such cases, the depositors lose their confidence in the bank and the banking system. To avoid such situations, the Reserve Bank of India (RBI) specifies the minimum capital that each bank must maintain to avoid such situations.

Capital adequacy refers to the amount of capital that financial institutions, such as banks, need to maintain to cover potential losses arising from various risks they face in their operations. This capital acts as a financial cushion that can absorb losses. In the event of unexpected financial setbacks, such as a high level of loan defaults or a significant decline in the value of investments, a well-capitalized bank can absorb these losses without jeopardizing its solvency. Various norms surround the capital adequacy requirements which are specified by the RBI and also monitored regularly. The capital adequacy ratio (CAR) is one of the key components of this requirement. The CAR is calculated as follows – (Tier 1 Capital + Tier 2 Capital) / Risk-weighted assets.

What are risk-weighted assets?

The RBI mandates a minimum capital requirement, typically set at 9% of the total loans disbursed. However, the complexity deepens with the introduction of risk-weighting. This regulatory approach acknowledges that not all loans carry the same level of risk. For instance, a home loan, secured by collateral, is deemed less risky than an unsecured personal loan. To reflect this, the RBI assigns risk weights to different loan types, influencing the amount of capital banks need to set aside. These weights are assigned to various categories of loans based on their perceived risk levels, reflecting the likelihood of default and the potential impact on the financial institution if the borrower fails to repay. By assigning different weights to different types of loans, regulators aim to incentivize banks to engage in prudent lending practices and discourage excessive risk-taking. Risk weights also encourage diversification in lending portfolios. Banks are motivated to distribute their lending across various sectors and types of loans to maintain a balanced risk profile.

Before the latest announcement, the risk weights were as follows – 1) Tier 1 Capital – 0%, 2) Tier 2 Capital – 50%, 3) Government bonds – 0%, 4) Corporate bonds – 20%, 5) Retail loans – 75%, 6) Business loans – 100%, 7) Unsecured loans – 125% and 8) Securitized assets 100% – 125%. However, in its latest announcement, the RBI has increased this risk-weighted capital requirement on loans to consumers to 125%, and on loans given to NBFCs to 150%. This means banks would now have to maintain higher capital to provide the same amount of loan. Suppose, a bank has INR 50 crore as consumer loans in assets which are funded by INR 10 crore Tier 1 capital, and balance through customer deposits. According to the earlier rules, the bank would have a capital adequacy ratio equal to Tier 1 capital INR 4 crore + Tier 2 capital Nil, divided by risk-weighted assets i.e. consumer loan of INR 50 crore x 75% risk weight. This means the bank has a CAR of 10.66% which meets the requirement of 8-9% mandated by RBI. However, after the latest changes, this CAR would become ( 4 + 0 ) / ( 50 x 125% ) = 6.4%. This means the bank will have to introduce more capital on its balance sheet to meet the mandatory legal requirement, even though the bank has neither issued any new loans nor suffered any loans.

For banks, this translates into idle money, as the set-aside capital doesn’t generate any returns. To compensate, banks might resort to charging higher interest rates on new personal loans. This adjustment, however, isn’t limited to traditional banks. NBFCs and fintech partners, integral players in the lending ecosystem, will also find themselves grappling with a double whammy. NBFCs, reliant on borrowing from banks, now face higher interest rates due to increased risk weights. Simultaneously, when these entities disburse loans, they must set aside more capital, adding an extra layer of financial burden. Ultimately, the end borrower bears the brunt, facing higher interest rates as a consequence of the intricate web of regulatory changes. In essence, the RBI’s strategic move aims to make borrowing more expensive. By forcing banks to reconsider their lending practices and introducing measures that trickle down to borrowers, the central bank hopes to curb the demand for loans. It’s a nuanced approach, a way of indirectly hiking interest rates without the need for a conventional rate hike.

The way forward

Banks are now expected to become more cautious in extending unsecured loans, as the higher RWAs make these loans more capital-intensive. This could slow down the growth of unsecured lending, which could have a ripple effect on consumer spending and economic growth. NBFCs will be subject to even higher capital requirements than banks for their unsecured lending. This could put a strain on their profitability and make it more difficult for them to raise capital. The higher RWAs could make NBFCs less competitive with banks in the unsecured lending market. This could also lead to a loss of market share for NBFCs and a consolidation of the industry. Meanwhile, existing borrowers will have to face higher interest rates on unsecured loans, as banks and NBFCs pass on the increased cost of capital to their customers. New borrowers will find it more difficult to qualify for unsecured loans, as banks and NBFCs become more risk-averse. This could disproportionately affect lower-income borrowers who may have limited access to secured credit. The ultimate impact of the changes will depend on how banks, NBFCs, and borrowers respond to the new regulatory environment.

References

1. RBI risk weight: Larger banks to face impact of 80 bps on capital adequacy, NBFCs’ cost of funds to rise by 20 bps
2. What RBI’s increase in risk weights mean to the borrower?
3. Why RBI raising risk weights for consumer loan is significant?

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