RBI raises risk weights: Impact to be felt on consumer borrowing

To tighten credit control, the Reserve Bank of India (RBI) raised risk weights for unsecured consumer credits, including personal loans and credit card dues, by 25 percentage points, from 100 per cent to 125 per cent. This regulatory response addresses concerns over rampant growth in the sector, impacting lenders and potentially affecting borrowers' access to credit.

Factors driving interest rates up

The increase in risk weights is a strategic reversal of the RBI's September 2019 decision, when risk weights for consumer credit, including personal loans, were reduced to 100 per cent to enhance credit flow. The recent move aims to modulate loan demand and encourage responsible lending practices, reflecting the central bank's concerns over aggressive lending.

How risk weights affect capital usage

Risk weights play a pivotal role in banking regulation, determining the capital required to cover potential losses on different types of loans. With personal loans now carrying a risk weight of 125 per cent, banks must set aside more capital for the same loan volume. For instance, a Rs 100 personal loan, previously requiring Rs 8 of capital, will now necessitate Rs 10, reflecting the increased risk weight.

This higher capital usage will result in a dip in lenders' core capital ratios. Core capital ratios, specifically Common Equity Tier 1 (CET1) ratios, are critical indicators of a bank's financial health, representing the proportion of its core equity capital to its risk-weighted assets. As lenders allocate more money to cover the increased risk weights on consumer loans, their CET1 ratios are expected to contract, signalling a potential impact on their financial stability.

Impact on lenders and borrowers

As the risk weightage for unsecured loans increases, Mahesh Shukla, CEO and founder of digital lending firm Payme warns of potential consumer challenges. Banks, becoming more cautious, may restrict credit access for individuals deemed higher risk, leading to difficulty obtaining credit cards or personal loans.

Even those eligible may face stricter terms and conditions. Shukla notes that if banks raise interest rates on existing balances due to increased risk weightage, it directly impacts consumers with outstanding debt, resulting in higher monthly payments and increased overall borrowing costs.

Experts suggest the RBI's move aims to manage growing defaults and risks associated with unsecured loans, making lending costlier and increasing expenses for borrowers in this category. The circular issued by the RBI suggests that lenders, both commercial banks and non-banking financial companies (NBFCs), will experience a dip in their core capital ratios. Analysts estimate a contraction in CET1 ratios, with potential increases in lending rates on personal loans to compensate for the additional capital requirement.

Non-banking financiers (NBFCs) are expected to bear the brunt of this move, experiencing increased funding costs. Fintech companies like PayTM, relying on lending partners, may also be affected as the financial system becomes more cautious about unsecured loans.

As per RBI data, the growth in some unsecured loans had outstripped total credit growth significantly. In September, credit card outstanding increased by 30 per cent year-on-year, other personal loans grew by 25 per cent, and consumer durable loans rose by 11 per cent. In contrast, overall bank credit growth was 20 per cent during the same period. This data underscores the urgency behind the RBI's move to address the disproportionate growth in unsecured lending.

The increase in risk weights on unsecured consumer credits signals a potential rise in interest rates on personal loans. Higher interest rates will likely impact consumer loan demand, particularly in personal loans and credit card dues. Borrowers seeking unsecured loans may face increased borrowing costs, potentially leading to a decline in demand for discretionary spending.

The move affects both lenders and borrowers. In response to higher capital requirements, lenders may tighten lending standards and raise interest rates on personal loans. This, in turn, affects borrowers, making access to credit more expensive and potentially curbing spending on non-essential items. The ripple effect extends to non-banking financial companies (NBFCs) and fintechs, influencing their funding costs and overall business models.

Adhil Shetty, CEO of BankBazaar.com, a financial services website, pointed to the swift expansion of unsecured loans, encompassing personal loans, consumer durables, and credit card dues. As reported by Outlook, Shetty pointed out that these loan segments might see a slight uptick in costs due to elevated risk provisioning.

Shetty was quoted as saying that the impact on interest rates will vary among lenders, with those heavily exposed to unsecured advances potentially reacting more sharply. He underscores the need for banks and Non-Banking Financial Companies (NBFCs) to raise funds strategically, aligning with the new risk weights while managing profit margins and mitigating risks from non-performing assets (NPAs).

While the RBI's decision to raise risk weights reflects a cautious approach to unsecured lending, aiming to strike a balance between economic growth and financial stability, the impact on lenders and borrowers underscores the interconnected nature of regulatory decisions in the financial sector.