[Yuvraj Sharma and Vandana Kaniya are fourth-year law students at School of Law, Narsee Monjee Institute of Management Studies, Hyderabad]
Introduction
In a recent development, the Reserve Bank of India (“RBI”) has taken decisive steps on November 16, 2023 to enhance the regulatory framework governing consumer credits. This move announced on Thursday involves a tightening of norms for banks and Non-Banking Financial Companies (“NBFCs”) with regard to unsecured personal loans. The central directives from the Reserve Bank urge these financial institutions to re-evaluate the risk associated with unsecured consumer loans and adjust their lending practices accordingly. Specifically, the regulatory authority has mandated an increase in the risk weight assigned to such loans by a significant 25 percentage points.
This blog critically examines the pros and cons of the regulatory measures outlined in the guidelines titled “Regulatory Measures towards consumer credit and banks credit to NBFC’s”. The central focus of these guidelines is to address consumer credit to NBFCs. It seeks to provide an in-depth understanding of how these measures impact consumer credit and the relationship between banks and NBFCs.
Background
The statement dated October 6, 2023 draws attention to the substantial increase in specific components of consumer credit. The Governor advises both banks and NBFCs to strengthen their internal monitoring systems, mitigate potential risks, and establish protective measures for their own advantages. Earlier, the Governor had underscored the significant expansion in consumer credit and the increasing reliance of NBFCs on bank borrowings during discussions with the managing directors and chief executive officers of major banks and prominent NBFCs in July and August of 2023. In response to these concerns, certain measures that have been decided upon are outlined in the circular issued by the RBI.
The term “Higher Risk Weight”
Risk weights represent the capital allocation required by lenders to mitigate credit risk in specific loan categories. A higher risk weighting necessitated that banks reserve a greater amount of capital for those particular loans. This capital requirement, as mandated by regulatory bodies like the RBI for banks or the National Housing Banks for Housing finance companies, is a percentage of the loan disbursed that financial institutions must set aside. Risk weights are contingent on the perceived risk by the regulatory authority, applying to various loan types, including personal, home, car and education loans as well as corporate lending. The risk weight on home loans often has a significant and direct impact on borrowers.
Regulatory Changes in Risk Weight for Consumer Credit: A Closer Look
The modifications concentrate on modifying risk weights for consumer credit exposure, distinguishing between NBFCs and commercial banks. For consumer credit exposure of commercial banks, the existing risk weight of 10% is increased to 125%. This applies to both existing and new consumer credit, encompassing personal loans but excluding specific and new consumer credit, encompassing personal loans but excluding specific categories. In a similar vein, the NBFCs’ risk weight for consumer credit exposure has been increased from 100% to 125% for retail loans, which are defined as loans against gold jewelry, housing, education, and auto loans.
The guidelines also cover credit card receivables. Previously, NBFCs had a 100% risk weight and Schedule Commercial Banks (SCBs) a 125% risk weight. Now, the risk weight for these exposures is increased by 25 percentage points to 150 percent for SCBs and 125% for NBFCs. These modifications represent a regulatory attempt to match risk weights with the perceived risks linked to these types of credit, underscoring a prudent approach.
Revised Risk Weights for SCB’s exposure to NBFCs
The guidelines pertain to bank credit extended to NBFCs by SCBs, excluding core investment companies. These exposures now have a risk weight associated with them that is determined by the ratings given by External Credit Assessment Institutions (ECAIs). A recent review has led to a decision to increase the risk weights by an additional 25 percentage points for SCBs in cases where the existing risk weight, based on external ratings of NBFCs is below 100%. This adjustment is applicable universally and is in addition to the risk weight determined by the external rating, this change will not apply to loans to Housing Finance Companies (HFCs) or loans to NBFCs that meet the requirements to be classified as priority sectors under the current guidelines.
Enhancing Credit Standards: Directives for Regulate Entities
The guidelines also focus on strengthening credit standards for regulated entities (REs). To enhance risk management, REs are required to review their existing sectoral exposure limits for consumer credit and establish board-approved limits for specific sub-segments within consumer credit. Emphasis is placed on setting limits for unsecure consumer credit exposure, with strict adherence and continuous monitoring by the Risk management committee. Additionally, top-up loans against depreciating movable assets, like vehicles, are to be treated as unsecured for credit appraisal movable assets, like vehicles are to be treated as unsecured for credit appraisal and exposure purposes. These directives, enacted under relevant banking regulations are effective immediately, except for one provision, which REs must implement no later than February 29, 2024.
Scope and Exemptions
The heightened risk weight of 125% is applicable to certain categories of “consumer credit”, including unsecured personal loans, loans without a designated purpose to individuals, and revolving lines of credit for non-business use. However, “this increased risk weight does not extend to housing loans, education loans, vehicle loans, and loans secured by gold and gold jewelry (limited to loans against gold jewelry for NBFCs).” This application of the increased risk weight is also deemed not to affect business loans and Microfinance Institution loans, as the latter may be arguing not to be for personal consumption. Notably, while NBFCs are specifically exempted from the increased risk weight for MFI loans, this exemption is not explicitly granted to banks.
Implications of the Guidelines
The adjustment in risk weighting for NBFC borrowers in comparison to non-financial entities with equivalent credit ratings is poised to instigate substantial repercussions within the banking sector. Specifically, an AAA-rated NBFC will now bear a risk weight nearly twice that of an AAA-rated corporate entity. This noteworthy difference in risk weighting is anticipated to reverberate across leading practices, with banks likely to recalibrate their pricing strategies, consequently, there is an expected increase in the cost of lending to NBFCs, encompassing not only new or incremental facilities but potentially extending to existing arrangements. This foreseen rise in borrowing costs across the board for NBFCs could significantly impact their financial dynamics.
Moreover, transactions involving direct assignments and co-lending, wherein banks engage in portfolios of personal loans originated by NBFCs, will incur augmented capital charges. This translates into heightened yield expectations for these transactions, promoting a reevaluation of the feasibility and attractiveness of collaborating lending models. The resulting increased capital charge may also influence the risk reward calculus for banks, necessitating a more cautious approach to such collaborative ventures.
The shift in risk weighting also introduces a new dimension to governance and risk management within banks. The heightened internal risk exposure limits are expected to trigger a more rigorous scrutiny at the board level. Boards of banks are likely to pose more probing questions regarding the rationale and implications of their partnership with NBFCs. This underscores the increasing importance of robust risk management practices and a clear understanding of the evolving collaborative dynamics between banks and NBFCs.
In essence, the revised risk weighting not only signifies a fundamental shift in the cost dynamics of lending to NBFCs but also has broader implications for collaborative ventures within the financial sector. The evolving regulatory landscape and the potential adjustment in lending practices highlight the imperative for adaptability and strategic foresight in navigating these transformative changes.
Conclusion
The recent regulatory changes focusing on risk weight adjustments for consumer credit have significant implications for both commercial banks and NBFCs. The amendments involve increased risk weights for various types of consumer credit exposure, including personal loans and credit card receivables. Notably, the adjustments aim to align risk weights with perceived risks, emphasizing a cautious regulatory approach. The evolving regulatory landscape necessitates adaptability and strategic foresight in navigating these transformative changes.