FinTechUncategorizedHike in risk weight for Financial Institutions: A balancing act between economic growth and high risk loans

INTRODUCTION

The Reserve Bank of India (“RBI”) issued a notification to all commercial banks and non-banking financial institutions (“NBFC’s”) titled ‘Regulatory measures towards consumer credit and bank credit to NBFCs’ to counter skyrocketing consumer credit by advising banks and NBFCs to strengthen their internal surveillance mechanisms and address the build-up of risks.

Banking and financial institutions are an integral part of the business ecosystem, and one of the most important functions of banks and NBFCs is providing loans to prudent individuals and corporations, which can help boost not just the borrower’s enterprise but may also lead to creating trickle-down benefits in the way of jobs, High Net worth Individuals (“HNWIs”), etc.

In this article, we take a look at the reasons behind this notification and the implications of the same in the Indian financial sector.

WHAT IS RISK WEIGHT?

Risk weight determines the amount of capital that the banks are required to keep as reserves in case of default in payment by the borrowers. The risk weight assigned to different categories of assets determines the amount of capital that a bank is required to hold against those assets. These risk-weighted assets (“RWA”) are subsequently used in the calculation of the Capital Adequacy Ratio (“CAR”).

Thus, a higher risk weight means a higher standard of obligations and interest on unsecured or higher-risk, regular individual borrowers. As an illustration, if a bank is lending money to the Food Corporation of India, the risk weight would be less as the borrower is a government department and thus there is little chance of default in payment, even in which case there are avenues to recover the same, such as the sale of assets or government bailout, etc.

Whereas, lending to a private business would be considered a high-risk activity. As a result banks are required to keep a higher quantum of capital reserves in ratio to the lent amount as a failsafe against possible default, which could affect the rest of the bank’s customers ability to withdraw their deposited money.

An increase in the risk weights for lenders directly impacts their capital adequacy ratio, as they have to set aside higher capital against such loans. This will likely make the loans more expensive for borrowers.

The Capital Adequacy Ratio (CAR) is a key regulatory requirement in the banking sector. It is a measure of a bank’s capital strength and its ability to absorb potential losses arising from its lending and investment activities. The capital adequacy Ratio is expressed as a percentage and is calculated by dividing a bank’s capital (mainly Tier 1 and Tier 2 capital) by its risk-weighted assets.

There are two main components of the capital adequacy ratio:

• Tier 1 Capital: This includes the core capital of the bank, such as common equity Tier 1 capital, which consists mainly of common shares and retained earnings.

• Tier 2 Capital: This includes supplementary capital, which provides additional loss absorption capacity. It includes items like subordinated debt and other instruments that are less permanent than Tier 1 capital.

In the context of lending laws in India, the CAR plays a crucial role in ensuring the financial stability and solvency of banks. The Reserve Bank of India (RBI), which is the central banking authority in India, sets guidelines and regulations regarding the minimum capital requirements that banks must maintain.

DIRECTIONS UNDER THE NOTIFICATION

RBI’s latest notification advises banks and NBFC’s to increase the risk weight across the board as a measure to reduce the potential exposure to the overall banking sector from bad loans.

In furtherance to the above, the RBI directed all noticee Banks and NBFC’s to take the following measures as under –

Consumer Credit changes for Commercial Banks

• Increase the risk weight from 100% to 125% in respect of consumer credit exposure of commercial banks, including personal loans.
• This change shall not affect the following kinds of loans:
  • housing loans;
  • vehicle loans;
  • loans against gold jewellery; and

 Consumer Credit changes for NBFC’s

• The consumer credit exposure of NBFCs categorized as retail loans, shall attract a risk weight of 125%.
• This increase shall be operable for new as well as outstanding loans.
• This change shall not affect the following kinds of loans:
  • housing loans;
  • educational loans;
  • vehicle loans;
  • loans against gold jewellery; and
  • microfinance loans.

Credit Card receivables from Scheduled Commercial Banks (hereinafter, SCB)

• The earlier risk weight on credit card receivables for SCB’s and NBFC’s of 100% and 125% each has been increased across the board to 125% and 150%, respectively.

• All top-up loans extended by regulatory entities against movable assets that are inherently depreciating in nature, such as vehicles, shall be treated as unsecured loans for credit appraisal, prudential limits, and exposure purposes.

In terms of existing norms, exposures of SCBs to NBFCs, excluding core investment companies, are risk-weighted as per the ratings assigned by accredited external credit assessment institutions (ECAI). Upon review, it has been decided to increase the risk weights on such exposures of SCBs by 25% points (over and above the risk weight associated with the given external rating) in all cases where the extant risk weight as per external rating of NBFCs is below 100%.

For this purpose, loans to HFCs and loans to NBFCs that are eligible for classification as priority sectors in terms of the existing instructions shall be excluded.

STRENGTHENING CREDIT STANDARDS

• REs shall review their existing sectoral exposure limits for consumer credit and put in place, if not already there, Board-approved limits in respect of various subsegments under consumer credit as may be considered necessary by the Boards as part of prudent risk management. In particular, limits shall be prescribed for all unsecured consumer credit exposures.

• The limits so fixed shall be strictly adhered to and monitored on an ongoing basis by the Risk Management Committee.

• The RBI, in prudence, recognized the difficulty in implementing such widespread internal evaluation and provided time until 29th February, 2024 to implement the said board-approved limits.

• All top-up loans extended by REs against movable assets which are inherently depreciating in nature, such as vehicles, shall be treated as unsecured loans for credit appraisal, prudential limits and exposure purposes

The said measures are issued by the RBI as a consequence of the growth seen in consumer credit and the increasing dependency of NBFCs on bank borrowings. This step is taken by the RBI in order to secure the capital reserve, especially while advancing unsecured loans. This is an indication by RBI to the commercial banks to be more cautious while giving unsecured loans.

ANALYSIS AND INDUSTRY RESPONSE

This measure taken by RBI will directly affect the existing borrowers as they have to pay more interest on the same amount of loan, which will ultimately result in increase in total cost of borrowing.

Although the changes are quite recent they have already caused a stir in the industry. Recently the Finance Industry Development Council (“FIDC”), a representative body of NFBCs requested the RBI to re-evaluate the sharp increase in risk weights assigned to bank loans to NBFCs, according to a letter sent to the regulator.

The FIDC stated that they welcome the positive step to reduce exposure in consumer lending but the step by the RBI “has the potential to sharply reduce flow of credit to MSMEs, self-employed and other sectors which rely upon credit from NBFCs”

AMLEGALS REMARKS

The move by the RBI is a prudent regulatory practice aimed at enhancing financial stability by curbing the issuing of loans against riskier assets, which has been on the rise since the Fintech revolution in online, mobile-based, instant lending.  The increased risk weights will serve as a safeguard, compelling SCBs and NBFC’s to allocate more capital to cover potential losses, thereby minimizing systemic risks. This move also indirectly encourages stable businesses to take out loans, as lenders will always prefer to do business with borrowers who have stable incomes and high credit scores.

However, this strategy may have drawbacks as well, especially in relation to the ease of doing business and the prospects of small-scale entrepreneurs. Elevated risk weights can, in turn, impede the accessibility of credit for small businesses and entrepreneurs, limiting their ability to invest, expand, and contribute to economic growth.

With this measure, it has become clear that the banks are intending to advance money to those with stable incomes, who have high credit worthiness, and those who can show that they are eligible for the loans by giving records of timely payments.

For any query or feedback, please feel free to get in touch with tanmay.banthia@amlegals.com or jason.james@amlegals.com