Stock Guide: How will RBI’s tighter retail credit norms affect lenders?

This article has been written by the InvestYadnya.in team.Over the past five and a half years, spanning from FY18 to H1 FY24, credit card loans have surged threefold, soaring from Rs 70,000 crore to Rs 2.2 lakh crore, representing a robust 23% compound annual growth rate (CAGR). Concurrently, the personal loan portfolio within the Indian banking system has expanded significantly, experiencing nearly a 2.5-times increase from Rs 5.1 lakh crore to Rs 13.4 lakh crore, reflecting a notable 19% CAGR.In tandem with this rapid expansion, lending by scheduled commercial banks to non-banking financial companies (NBFCs) has also witnessed substantial growth. Over the past 18 months alone, loans to NBFCs have witnessed a remarkable 42% upswing, climbing from Rs 10 lakh crore to Rs 14.2 lakh crore. Furthermore, in the last 5.5 years, from FY18 to H1 FY24, banking system loans to NBFCs have surged from Rs 5 lakh crore to Rs 14.2 lakh crore, indicating a robust 21% CAGR.According to the Reserve Bank of India (RBI), the total outstanding loans in the Indian banking system amount to Rs 156 lakh crore. Collectively, unsecured personal loans, credit card loans, and banks' loans to NBFCs constitute 19% of this outstanding loan portfolio, signifying that one-fifth of the entire banking system's loans are unsecured.What led to this unsecured credit growth?Numerous factors are driving the evolving dynamics and remarkable expansion of unsecured borrowings in India. While a portion of this trend can be linked to the surge in consumerism, the underlying cause remains unclear — whether it stems from the deteriorating financial conditions of households amidst escalating consumer aspirations.The pivotal catalyst for providing widespread access to convenient loans to a vast number of consumers lies in the growth of the digital economy. A significant segment of the population, which had previously refrained from borrowing in favour of securing a better present and chose to save for the future, may have been dissuaded by unappealing saving rates during a period of heightened inflation.The combined ecosystem, encompassing the ascent of e-commerce, the emergence of fintech startups, the integration of AI-based credit scoring, the adoption of digital technology, innovative developments in credit and loan products, diminishing savings rates, and the impact of inflation, have collectively contributed to the proliferation of a credit card economy and an unprecedented surge in borrowings by both consumers and smaller businesses.What rules has the RBI put in place?The RBI has recently raised the risk weights on banks’ unsecured personal loans and consumer durable loans have been increased from 100% to 125%, and risk weights on credit cards have been increased from 125% to 150%. The risk weights on NBFCs’ unsecured personal loans, consumer durables loans and credit cards have increased from 100% to 125%. Those on loans by Banks to NBFCs have also been hiked by 25% if the risk weight is below 100% as risk weight depends on the Credit Rating of the NBFCs.How will these rise in risk weights impact banks and NBFCs?A decline in capital adequacy ratio (CAR)The RBI’s new regulatory risk weights will hit Banks and NBFCs’ capital adequacy ratio. Capital Adequacy Ratio = [(Tier I Capital + Tier II Capital) / Total Risk-weighted Assets]With the increase in risk weights on lenders' unsecured loan portfolio, the total risk-weighted assets (in the denominator) would increase and it would bring down the capital adequacy ratio.For example, if the bank currently has a 20% CAR towards its unsecured loan portfolio of Rs.100, then after RBI’s new credit norms, the risk weights for the unsecured loans will increase from 100% to 125%. It means the bank’s risk-weighted assets towards its unsecured portfolio will increase from Rs.100 to Rs.125. Consequently, with the existing capital buffer of Rs.20 (assuming no fresh capital is raised), the bank’s capital adequacy ratio will fall from 20% to 16% (=20/125).Banks are expected to see a 50-60 basis point haircut on the Tier I capital adequacy ratio due to a rise in risk weights on personal loans, credit card dues and loans to NBFCs.Impact on the cost of fundsThe immediate impact of the enhanced risk weights is the excess capital that banks would now require to fund. The banking industry is expected to need Rs.84,000 Cr of excess capital due to these regulatory measures.In order to maintain the same capital adequacy ratio, the banks and NBFCs need to keep higher funds aside led by the rise in risk weights on unsecured loan books. So, the funds available for new loan disbursal would be parked aside idle (towards maintaining the same Capital Adequacy level). As a result, the banks/NBFCs would need to acquire more funds at the elevated cost of borrowing (in the current high-interest rate environment) to cater for the fresh credit requirements. Expected slowdown in unsecured retail lending activityThe RBI has been monitoring unsecured retail loans recording very high (>30%) growth over the past couple of years, whereas the rest of the banking sector credit growth hovered in the 12-14% range. These very high growth rates of unsecured loans are being closely watched by the central bank for any signs of incipient stress. The high-risk weight will no doubt slow down the lending and tighten the risk for this segment. The central bank has been indicating its discomfort with the high growth rate of the unsecured retail loan segment. Likelihood of costlier personal loans The heightened risk weights imposed by the RBI on both Banks and NBFCs are expected to result in a notable impact, particularly in the realm of retail consumer loans. Since these loans are inherently unsecured, the increased risk weights may prompt lenders to adjust their strategies, leading to potential implications for consumers.One key consequence is the likelihood of increased interest rates on retail consumer loans. Given the elevated risk weights, lenders may seek to offset the impact on their profitability by passing on the additional costs to borrowers. As a result, consumers obtaining these unsecured loans may experience higher interest rates, contributing to an overall increase in the cost of borrowing for retail purposes.Furthermore, the cost of borrowings for NBFCs is anticipated to rise as well. Banks, responding to the elevated risk weights, might opt to increase lending rates to NBFCs. This, in turn, could lead to higher capital consumption for NBFCs, influencing their operational costs and potentially impacting their ability to offer competitive interest rates to end consumers.In essence, the adjustments in risk weights are likely to have a cascading effect on the cost of retail consumer loans, impacting both lenders and borrowers in the process. This emphasizes the interconnectedness of regulatory decisions and their repercussions throughout the financial ecosystem.From a short-term perspective, tightening of credit norms by RBI on high growth unsecured retail loan segment is likely to have immediate implications for both banks and NBFCs. However, the move indicates the judiciousness of the central bank’s risk management measures to avoid future credit risks if any. Indeed, the central bank's decision to increase risk weights on loans reflects a prudent approach aimed at promoting financial stability. By advising banks and NBFCs to fortify their internal surveillance mechanisms, the RBI is emphasizing the importance of proactive risk management.(Lead image: Freepik)