In recent years, India has seen high growth in the disbursal of consumer credit, especially through non-banking financial corporations (NBFC). While the phenomenon has triggered a virtuous cycle of consumption-led increased economic activity, it has also led to worries about an increase in delinquencies in the coming years. 

Accordingly, the Reserve Bank of India (RBI) has advised banks and NBFCs to strengthen their internal surveillance mechanisms and address the build-up of risks. Further, earlier this month, it issued a notification that effectively increased the risk weights assigned to consumer credit by banks and NBFCs. The regulatory step has trained the spotlight on bank credit exposure. 

Let’s attempt to demystify the notification and analyse its impact and applicability on different products. What could be the implications of the increased risk weight on consumer credit for NBFCs, especially the negative effects of enhanced risk weight on bank credit to A-rated NBFCs?

RBI's Risk Weight Adjustment: Unraveling the Implications

The RBI's notification introduces a higher risk weight on consumer credit for NBFCs, ostensibly to mitigate risks associated with consumer credit. The move reflects the regulator's concerns about potential vulnerabilities within the said lending segment. 

While the measure enhances our financial system’s stability, it presents challenges for lenders. A significant implication is the increased capital requirement for lenders engaged in consumer lending that forces them to maintain more idle capital. 

It can impact their profitability and liquidity, necessitating a re-evaluation of business strategies. Additionally, the increased risk weight may influence interest rates on consumer loans, potentially making credit more expensive for consumers. NBFCs, in particular, will have to navigate these challenges to stay competitive. 

How Increased Risk Weights Affect NBFC Profitability

The RBI, in 2018, vide a circular on ‘XBRL Returns – Harmonization of Banking Statistics’, defined the term ‘consumer credit’. The said definition clearly excludes loans given for business/commercial purposes under both auto loans and for loans against property. 

Accordingly, the loans given to individuals for business purposes shall fall outside the purview of consumer credit and are not subject to the increased risk weight.

The exemption recognises the distinct risk profiles of consumer and business loans, as business loans typically involve different risk factors and considerations. It further demonstrates the RBI's strategic alignment of regulations with data reporting frameworks for transparency and precision.

Business Loans vs. Consumer Credit: Decoding RBI's Regulatory Line

The notification prescribes an increase in the risk weights assigned by banks on their exposure to NBFCs by 25 percentage points in all cases where the extant risk weight as per the external rating of NBFCs is below 100 per cent.

The increase in risk weights may result in an increase in borrowing costs. It may aggravate the challenges faced by smaller and medium-sized NBFCs in mobilising funds for onward lending. 

The increased risk weight may elevate the cost of funds, potentially affecting the NBFCs’ profitability and ability to offer competitive interest rates to consumers. While the notifications exclude loans for housing and priority sector lending, they will still affect a significant portion of loans that fall outside the purview of RBI’s extant priority sector lending guidelines. 

Adapting to RBI's Measures in Consumer Credit

The recent regulatory measures by the RBI underscore ongoing efforts to enhance the financial system's resilience and protect against potential risks. While the increased risk weight on consumer credit may pose challenges, stakeholders, including NBFCs and banks, may adapt to these changes, ensuring sustained financial stability while promoting responsible lending practices in the consumer credit segment.

The distribution of banks’ available corpus for lending is disproportionately skewed towards AAA or AA-rated NBFCs. The increase in risk weights might force the banks to treat them on par with A-rated NBFCs, especially those focused on MSME lending. 

RBI’s latest regulatory move may have implications for NBFCs. It remains to be seen as to how it will impact the NBFCs’ competitiveness and the last-mile credit flow to MSMEs. Banks, on the other hand, may now have to assess the risk-return dynamics when extending credit to NBFCs carefully. 

- Sunil Lotke, Chief Legal and Compliance Officer at U GRO Capital