Mint Explainer: Why RBI raising risk weights for consumer loans is significant

livemint.com:

move to tighten credit control, the Reserve Bank of India (RBI) on Thursday raised risk weights for unsecured consumer credits, including personal loans and credit card dues, signalling its concerns over aggressive lending in these sectors. Mint takes a look at how the RBI’s move will impact lenders, and how risk weights act as a regulatory tool to modulate loan demand. Risk weights are pivotal in banking regulation, as they dictate the capital set aside for different loan types, reflecting their risk profiles.

Unsecured loans, perceived as riskier, have higher weights, thus requiring more capital. Home loans, for instance, attract a risk weight of 35-50%, depending on the size of the loan. In comparison, personal loans will now have a risk weight of 125%.

The revised risk weights will heighten capital consumption for the same loan volume, with a personal loan of ₹100 now necessitating ₹10 of capital instead of ₹8 - a reflection of the increased risk weight from 100% to 125%. Take the case of a ₹100 personal loan with a risk weight of 100%. In this scenario, the value of the risk-weighted asset is ₹100.

Now, banks are required to maintain a minimum of 8% core capital ratio or common equity tier 1 (CET1), which includes 2.5% in capital conservation buffer. Therefore, for the ₹100 loan mentioned above, capital consumption used to be ₹8. Since RBI has increased the risk weight by 25 percentage points to 125%, personal loans will now use ₹10 worth of capital, thereby leading to greater capital consumption for the same value of loans disbursed.