Banks and non-banking financial companies (NBFCs) are witnessing a change in the approach to lending as the Reserve Bank of India (RBI) recently decided to enforce stricter capital norms. As a prudential measure, RBI has increased the risk weight on bank exposure towards unsecured loans, such as personal loans and credit card receivables. The move aims to enhance the Capital to Risk-Weighted Assets Ratio (CRAR) for banks lending to these sectors. These guidelines encompass unsecured loans, which depend significantly on a borrower’s credit score and do not require any collateral.
Understanding the Capital Adequacy Ratio (CAR)
CAR is the available capital of a bank, calculated as a percentage of its risk-weighted credit exposures. Known alternatively as the Capital-to-Risk Weighted assets ratio (CRAR), it is employed worldwide to safeguard depositors and ensure financial system stability and efficiency.
Explaining Risk Weight on Bank Exposure
Risk weight on bank exposure is a method used by regulators, like central banks, to evaluate the risk associated with different types of assets held by banks. This tool determines the extent of capital that banks should hold against these assets to cover possible losses. The risk weight assigned to different categories of assets reflects their perceived riskiness. Banks are required to allocate more capital against higher-risk assets and less against lower-risk assets.
RBI’s Move for Unsecured Loans and its Necessity
The RBI has raised the risk weight on banks’ exposure to certain categories, such as consumer credit and NBFCs. The increase means that banks need to set aside more capital to cover potential losses arising from specific loan categories. The move aims to control the unchecked growth of unsecured loans and align capital requirements with associated risks.
Current Landscape of Unsecured Credit for Banks
Unsecured credit makes up about 5-13% of total loans in large banks, excluding microfinance institutions. Loans extended to NBFCs form another 5-12% for banks. Among the most affected by this move would be SBI Cards and Bajaj Finance, as a significant portion of their loans are unsecured.
Anticipated Impact on Banks and NBFCs
The increased capital requirements may cause an uptick in lending rates, affecting consumers and corporate bonds. Despite the potential increase in borrowing costs, the higher capital requirements are expected to moderate unsecured loan growth while addressing systemic risks.
The Way Forward for Banks and NBFCs
Banks and NBFCs may need to reassess their risk models and lending practices for unsecured loans. They may need to focus more on creditworthiness assessments and consider alternative strategies to manage risk while continuing to lend. Moving forward, financial institutions might diversify their loan portfolios by shifting focus to more secured lending or exploring other creditworthy segments.
