The Reserve Bank has recently increased the risk weights on personal loans and credit card receivables. Many questions would have popped up in your mind. What are risk-weights? And how do these risk-weights affect the cost of your loans? In this post, let’s find out.
Can the Banks Lend Whatever They Want?
We know that the banks are highly leveraged. How? You deposit money with the banks in a savings account or as bank FDs. The banks lend that money to the borrowers towards various kinds of loans (Home loans, personal loans, credit card, business loans etc.) Essentially, the banks lend your money to their loan customers. The difference between the interest paid to depositors and the interest collected from the borrowers is the bank’s profit. In that case, any bank would want to lend as much as it can. The more it lends, the greater the profit it stands to make.
But, can the banks lend any amount they want? What if the banks suffer a loss? This can happen if some of their borrowers fail to return the money lent by the bank. How will the bank return money to its depositors? To prevent depositors from losing money, there are certain checks and balances in place.
The Reserve Bank requires banks to keep a certain percentage of risk-weighted assets (loans) as capital. OR in other words, you can’t just make profits by lending someone else’s money. Have some of your own money at stake too. “Own money” means shareholder’s investment or retained profits.
In compliance with BASEL III norms, the RBI has set the percentage (also termed as Capital Adequacy ratio) at 9%. Here is RBI master circular on Basel III norms. Refer to Section 4.
So, if a bank must lend Rs 100, a maximum of Rs 91 can come from depositors’ funds. Minimum Rs 9 must be from the bank’s own money (shareholders’ investment or retained profits).
In a way, the Basel III norms also link a bank’s lending prowess with the amount of capital the bank has.
If the bank’s capital has eroded because of losses from its lending portfolio, it may hurt its ability to lend more. Or hurt its ability to earn profits. Therefore, the banks’ shareholders/management and the regulator keep a close eye on the capital adequacy ratio.
Having your own money at stake serves 2 purposes.
- Brings in lending discipline. It is easy to lend someone’s money. But you think twice when your own money is at stake. The bank (or the bank’s owners) can lose their investment if it does not lend responsibly.
- It acts as a cushion when the bank suffers losses. The shareholders will lose money first and then the depositors.
While I will not go into the nitty-gritties, there are multiple types of investments that qualify as eligible capital. You can refer to the RBI circular shared above to find out more about this.
What Are Risk-Weights?
Not all loans are created equal.
Secured loans (such as home loans, car loans, loans against property) have a built-in safeguard for the bank. If the borrower does not repay the loan, the bank can sell their assets (house, car etc.) to recover its money. Moreover, the borrowers may be more responsible for these types of loans.
On the other hand, unsecured loans (such as personal loans, credit card debt) have no such safeguards.
Therefore, secured loans tend to have a lower rate of interest compared to unsecured loans. And rightly so. The Reserve Bank also allows lower capital requirements for safer loans. After all, the entire idea behind capital adequacy norms is risk management. But how do they do that?
We come to the concept of risk-weights and risk weighted assets. The RBI specifies risk weights for various categories of loans. For the category of loans that are deemed safer, the risk weights are lower. On the other hand, for the category of loans deemed riskier, the risk weights are higher. The RBI also adjusts risk weights to encourage or discourage banks from making certain categories of loans. If the RBI wants to encourage a particular loan category, it can decrease the risk weight. OR if the RBI wants to discourage certain types of loans, it can increase risk weight for that loan category.
But How Do Risk Weights Encourage or Discourage Banks?
That’s why capital adequacy requirements are linked to risk-adjusted assets (and not just assets). By the way, for the banks, loans are assets.
Let’s say there are two categories of loans. Home loans and personal loans. Let’s further assume that the risk weight for home loan is say 50% and the risk weight for the personal loan is say 150%.
- To lend Rs 100 as home loan, the bank needs (Loan Amount x Risk Weight) X Capital Adequacy ratio = 100 X 50% X 9% = Rs 4.5 of capital.
- To lend Rs 100 as a personal loan, the bank needs Rs 100 X 150% X 9% = Rs 13.5 of capital
Since the personal loan locks in more capital, the bank won’t be as keen to give out personal loans. Or else the bank would increase the interest rate to compensate for higher capital requirements.
Hence, by increasing the risk weight for a loan category, the RBI can discourage banks from making loans in that category.
What Has RBI Done with Risk-Weights for Personal Loans and Credit Cards?
The RBI Governor, in his statement dated October 6, 2023, had flagged high growth in consumer credit and asked the banks and NBFCs to strengthen their internal surveillance mechanisms to notice any incipient signs of stress.
As a next step, the RBI, in its circular dated November 16, 2023, has increased risk weight for personal loans and credit card debt, making it more expensive for the banks to fund such loans.
The risk-weights for housing loans, education loans, vehicle loans and gold loans have been left untouched.
With this move, you can expect banks to go slow on personal loans or increase the interest rate for personal loans.
Note that this may not necessarily happen with all banks. Many Indian banks have strong capital adequacy ratios and they may continue to be aggressive on personal loans and credit cards because they have the capital buffer.