The Reserve Bank of India (RBI) has recently increased the risk weight on bank exposure to unsecured loans, such as personal loans and credit card receivables, to better manage financial stability and mitigate risks.
Unsecured loans, like credit cards, are loans that do not require collateral to be availed. To address potential vulnerabilities associated with such loans, the RBI announced on November 16 that the risk weights on unsecured retail loans and credit card exposures for banks and Non-Banking Financial Companies (NBFCs) will be raised by 25 percentage points.
What Are Risk Weights and Capital Requirements?
Risk weight is a regulatory metric used in banking and finance to calculate the amount of capital a financial institution must hold to cover possible losses. The Capital Adequacy Ratio (CAR), also known as the Capital-to-Risk Weighted Assets Ratio (CRAR), reflects a bank’s available capital as a percentage of its risk-weighted assets. It is a safeguard designed to protect depositors and ensure the stability of financial systems globally.
For example, if a bank has a loan portfolio worth ₹100 crore and the average risk weight of these loans is 50%, the risk-weighted assets amount to ₹50 crore. By increasing the risk weight to 125%, banks must hold more capital to cushion potential losses, especially from consumer credit, such as personal loans and credit card receivables.
The Impact on Banks and Credit Limits
Due to the increase in risk weights, banks are required to allocate more capital to maintain a satisfactory Capital Adequacy Ratio (CRAR). To manage this higher capital requirement, banks are left with two main options: either set aside more funds or reduce their exposure to these high-risk loans.
Most banks have opted for the latter, leading to a reduction in credit limits for consumers. By cutting down on the credit available to individuals, banks aim to better balance their capital requirements and reduce potential exposure to unsecured lending risks.