Risk Weights for Lending

Risk Weights for Lending

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

What are Risk Weights?
• The main focus of RBI’s action is to address ‘credit risk.’ It refers to the risk linked with a borrower’s inability to fulfill obligations, leading to defaults.
• Risk weights are an essential tool for banks to manage this risk. It is a percentage indicating how much capital a lender should ideally hold to cover the associated risk.
•  Risk weights are assigned based on the associated risk of default. For example, higher risk weights for unsecured personal loans.

What is RBI’s plan?
• Increase in Risk Weight for Consumer Credit: RBI has increased it by 25 percentage points, from 100% to 125% for commercial banks and NBFCs. This applies to personal loans (and retail loans for NBFCs), excluding housing, education, vehicle loans, and loans secured by gold.
• Credit Card Loans: Currently, scheduled commercial banks have a risk weight of 125% for credit card loans while NBFCs have 100%. The RBI plans to increase this to 150% and 125%, respectively.
• Bank Credit to NBFCs: The risk weight for bank credit to NBFCs is being increased by 25 percentage points. However, this does not apply to housing finance companies and loans to NBFCs classified into the priority sector.

Why is RBI resorting to the plan?
• RBI’s move to raise risk weightage aims to manage growing defaults and risks associated with unsecured loans.

What will be the impact of the move?
• With increased risk weightage, banks may exercise caution in extending credit, especially to those with higher perceived risk. Some individuals might find it challenging to obtain credit cards or personal loans.
• It is quite certain that eligible consumers may face stricter terms and conditions when availing credit. Lenders could implement more stringent criteria for loan approval.
• It will lead to higher interest rates for borrowers, slower loan growth for lenders, reduced capital adequacy (as the loan growth slows down, they will have to maintain lesser capital to meet the capital adequacy requirement) and it will take a hit on profits of banks.
• Lenders must account for higher credit risk, leading to pricier lending. Adjustment in risk weightage will result in higher costs for borrowers taking out unsecured loans. Interest rates in this loan category may see an increase.
• NBFCs will face the most impact because of higher risk weights on their unsecured loans and on account of the bank lending mandates to NBFCs.