Why the central bank has increased risk weight for unsecured loans

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Bank of India (RBI) has increased the cost of funds for banks and non-bank financial companies (NBFCs), by increasing the risk weight of such loans. Currently at 100% risk weight, loans to consumers will see an increase to 125%, excluding loans for housing, education, vehicles and against gold. Banks create money, so RBI regulates their growth by a Capital Adequacy Ratio (CAR)—a function of how much the bank can lose of its own money, as a percentage of its loan exposure.

The CAR for banks is 10-12% and for NBFCs, 15%. Most such entities keep more than that, to account for growth. When they come close to the limits, they raise funds for expanding their equity.

Consider this: If an NBFC is only lending for unsecured consumer loans, and has a CAR of 20%, it would have ₹20 in capital for every ₹100 lent out. The new rules will reduce the CAR from 20% down to 16%, since ₹100 now means an exposure of 125%, or ₹125. At 16%, the NBFC is too close to the prudential limits and thus, will need to raise capital.

Management will now need to find buyers for their shares, to give some headroom for growth. Given that financiers are restricted primarily by capital in terms of where to grow, expect that they will now reduce their focus on growing consumer loans like credit cards, buy now pay later and personal loans to build more of the ‘secured’ variety. And, they will raise the interest rates for such unsecured personal loans, which means a quick or instant personal loan will be more expensive, going forward.

For NBFCs, there’s a double whammy. Not only do they see a hit to their CAR based on who they lend to, they will also pay more to borrow. NBFCs have their largest borrowings from banks, who would previously get a risk weight of