The Reserve Bank of India (RBI) recently made a significant move in financial sector by increasing the risk weightage for unsecured loans. This decision has far-reaching implications, particularly for borrowers. But before we delve into the impact, let’s first understand what risk weightage is.

What is Risk Weightage System?

Risk weightage is a method used by financial regulators to assess the risk associated with various types of assets held by banks. It determines the amount of capital that banks need to hold against these assets as a buffer to cover potential losses.

For instance, if a bank has given out loans worth Rs 100 crore and the risk weight for these loans is 50%, the risk-weighted assets will be Rs 50 crore. If the regulator requires the bank to maintain a Capital to Risk-Weighted Assets Ratio (CRAR) of 9%, the bank needs to hold capital worth Rs 4.5 crore as a buffer against potential losses from these loans.

If the risk weightage increases to 75%, the risk-weighted assets become Rs 75 Crore (i.e., 75% of Rs 100 crore). Now, to maintain the same CRAR of 9%, the bank needs to hold capital worth Rs 6.75 crore (i.e., 9% of  Rs 75 crore).

Why does it matter?

So, an increase in risk weightage leads to an increase in the amount of capital that banks need to hold as a buffer to cover potential losses. This is how risk weightage affects the capital requirements of banks.

When banks are required to hold more capital as a buffer against potential losses (due to an increase in risk weightage), it increases the cost of lending for the banks. This is because the capital that is set aside as a buffer cannot be used for other profitable ventures by the bank.

To compensate for this increased cost, banks may choose to increase the interest rates on these loans. This means that borrowers might have to pay more interest on their loans. 

How much did the risk weightage change?

Now, let’s discuss the changes made by RBI. 

RBI increased the risk weightage on unsecured consumer loans, including credit cards, by 25% for both banks and Non-Banking Financial Companies (NBFCs).

As a result of the RBI directive, the risk-weights on banks’ unsecured personal loans and consumer durable loans have now increased to 125% from 100%, and that on credit cards have increased to 150% from 125%

This means banks now need to hold more capital as a buffer against potential losses from these kinds of loans.

So, how does this impact borrowers?

Firstly, as I mentioned earlier, it may lead to an increase in interest rates on these loans. Since banks now need to hold more capital, the cost of lending for the banks increases. To compensate for this increased cost, banks may choose to increase the interest rates on these loans.

Secondly, it could affect the availability of credit. Banks might become more cautious in giving out unsecured loans due to the increased risk weightage. This could potentially make it harder for individuals and businesses to get unsecured loans.

Why did this happen?

RBI has been working closely with the fintech players for a long period now. As a regulator, stability of the financial system is of utmost importance for RBI. 

There are suspicions that the fintech led digital lending segment’s growth is due to a sizable share of people resorting to “evergreening” of their personal loans. (Evergreening is taking another loan to settle the first one.)

This can be dangerous, if allowed to continue like this. That’s why the RBI chose to slow down the growth of this type of lending business using increased risk weightages.

A stitch in time, saves nine. 

This may mean the fall of some lending fintechs for now. (their moat was small credits at affordable interest rates, which may no longer be the case) 

But, this will also ensure that we, as borrowers and investors stay protected from unsustainable credit booms in the future. 

Remember, credit is like fire. Its controlled use is awesome, but if we are to allow it to blow out of proportion, our fingers will surely get burnt! 

Thus, better safe than sorry 🙂

Disclaimer: The above content is for informational and educational purposes only. Not advice. Please consult your financial advisor before taking any financial decision.