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A recent circular issued by the Reserve Bank of India (RBI) on November 16 has sent ripples through India’s financial landscape. The RBI has raised the risk weights on consumer loans offered by banks, non-banking finance companies (NBFCs), and credit card providers. This adjustment effectively increases the costs for lenders, consequently leading to elevated interest rates for borrowers. Specifically, the RBI has raised the risk weight for personal loans (excluding gold, vehicle, and education loans) from 100% to 125%, necessitating banks to maintain higher reserves to tackle exigencies stemming from defaults on personal loans. In the case of credit card receivables, this risk weight has surged to 150%.

This move indicates the RBI’s intention to rein in unsecured lending, which has experienced unchecked growth, posing heightened risks in India’s financial sector. RBI data

reflects a 23% year-on-year increase in unsecured personal loans and a nearly 30% surge in outstanding credit card amounts until the last week of September. Consequently, banks and NBFCs have been directed to bolster internal surveillance to safeguard stakeholders’ interests. This article delves into the operational alterations and the impact of this decision on India’s financial realm.

Operational Changes

Banks traditionally accept deposits from the public and extend loans to borrowers. However, regulations set by the RBI prevent banks from utilizing the entire deposit amount for loans at higher interest rates without maintaining a minimum Capital to Risk Weighted Assets Ratio (CRAR) or credit adequacy ratio of 9%. This requirement mandates banks to reserve 9% of their capital to tackle unforeseen circumstances. For secured loans like home loans and gold loans, which allow banks to reclaim collateral in case of default, a 50% risk weight is typically assigned. This implies that banks reserve 4.5% of their capital (50% of the mandated 9%) for such loans. However, in the case of unsecured loans such as personal loans, banks are now mandated to increase the risk weight from 100% to 125%. Consequently, banks will need to inject more capital, directly increasing their cost of capital. This cost burden is anticipated to be transferred to borrowers, leading to higher borrowing costs.

Estimates suggest that major banks may witness a 70-80 basis points impact on their Common Equity Tier 1 (CET1) ratios, while NBFCs might experience a more substantial impact of 230-250 basis points on their Tier 1 capital due to a larger proportion of unsecured loans.

Effects on the Financial Sector

The RBI’s move is expected to elevate the cost of capital for banks, which have not received any recent capital infusion from the government. Banks have managed their operations by issuing AT1 bonds or perpetual bonds. The directive from the RBI is estimated to compel banks to reserve ` 84,000 crore, an amount that could have been otherwise used for productive purposes. This shift indicates that banks might focus more on disbursing secured loans such as gold loans, vehicle loans, and education loans. Given the ‘K’-shaped recovery of the Indian economy post-COVID-19, there is a likelihood that marginalized sections may face difficulties securing unsecured loans or may acquire them at increased rates, as banks pass on their high cost of capital to borrowers. This could deepen the recovery crisis by exacerbating the disparities in the ‘K’-shaped economy.

This change will not only impact banks and borrowers but will also affect NBFCs significantly. NBFCs, which were established with the premise of providing loans at higher rates to individuals with unstable financial positions, might now face reluctance from banks in extending unsecured loans. As a result, NBFCs with limited access to bank credit may increase interest rates for borrowers or turn to the bond market for credit. Limited access to loans or higher costs may suppress general consumption among the public, while increased bond market dependence by NBFCs could keep interest rates elevated in the economy.

This analysis underscores a pattern of unchecked and unbridled unsecured retail lending by financial institutions in India, followed by the RBI’s intervention to curb this trend. This situation could have been averted with timely vigilance from regulators. There is a pressing need for continued guidance for financial institutions to remain vigilant in the future. Banks and NBFCs should avoid pressuring susceptible borrowers for urgent loans. Instead, they should compassionately guide and educate borrowers regarding high-interest rates and the impact on credit scores in case of defaults. Borrowers should also receive counselling before applying for unsecured loans, encouraging them to assess their genuine needs and become prudent borrowers. Only a vigilant and well-informed financial system can truly serve as the backbone of an economy.