The Indian financial sector has been on the rise in the past two years, with high loan growth amid soaring domestic consumption. As a developing economy, the demand for credit growth in India is on a sustained rise. This has boosted the health of the banking sector, which has seen a turnaround in the past two years, thanks to healthy balance sheets and decade low gross non-performing assets (NPA) ratios. However, one aspect of high loan growth has worried the Reserve Bank of India (RBI) - unsecured loans significantly outpacing overall loan growth.
In this edition of Chart of the Week, we analyze the RBI’s recent directive on unsecured loans, the first major regulation since 2014-15 that is aimed at reducing risks in unsecured lending.
Bad loans can have spillover effects across economies. The unprecedented rise in India’s unsecured loans – loans which lack collateral – is a major risk. While credit growth in unsecured lending stood at 23% in the past year, the overall credit growth in the banking system was just 13%.
On November 16, the RBI directed banks to increase risk weights for unsecured consumer loans like personal loans (below Rs 50,000) and credit card receivables from 100% to 125%. This means that banks must now show Rs 125 in risk-weighted assets for every Rs 100 lent as an unsecured loan. This will prompt banks to increase the capital set aside for these loans. The RBI has set 9% as the minimum capital adequacy ratio to be maintained on total risk weighted assets.
Risk weights for home loans, for example, range from 50% to 70% depending on the size of the loan. Meanwhile, it is 75% for gold loans. Segments with higher risk, like business loans, have 100% risk weightage.
Cost of funds likely to increase for top private and public sector banks
High exposure to unsecured lending leads to a marginal decrease in capital ratios
An analysis of the RBI’s increased risk weights on capital requirements finds that banks with substantial exposure to unsecured loans will see an increase in capital requirements. Banks like SBI, ICICI Bank, HDFC Bank, and Axis Bank, which have allocated over 15% of their total lending to unsecured loans, may see their capital ratios decline. These four banks may see a decrease of more than 50 bps in their CET 1 (Core Equity Tier 1 (CET 1) is an important metric as it includes only equity and reserves, which form the core capital for banks).
On the other hand, banks like Bank of Baroda, IndusInd Bank, and Canara Bank, with less than 10% exposure towards unsecured loans, could see their capital ratios fall by just 30-40 bps.
The new regulation will affect banks with higher exposure to unsecured loans in three ways. Firstly, banks have to maintain certain ratios like CET 1, which is calculated as a percentage of total risk weighted assets. Due to the increase in risk-weighted assets, banks now have to keep more capital while lending, which could result in higher lending rates.
Secondly, due to an increase in capital requirements, banks may have to raise capital from bond markets at higher rates. Finally, this could moderate growth in consumer credit, which is traditionally a high-margin segment for banks.
Regulations that make changes in risk weights, provisions, exposure limits or loan-to-value ratios aim to manage risk at a broader level rather than focusing on individual institutions. RBI’s latest regulatory move is aimed at controlling risks in vulnerable segments without constraining credit to other sectors of the economy.
