To appreciate the implications of the Reserve Bank of India’s (RBI) recent move on unsecured consumer loans, it will help to understand the risk weight and capital equation for banks. Here goes.
We all appreciate that a high-risk loan should be offered by banks at a higher interest rate than a low-risk loan. We also understand that home loans, where the loan amount is secured by an asset (the house), is less risky than a no-questions-asked-on-end-use personal loan that is backed only by an individual’s credibility. But how does the RBI ensure that lenders adhere to the risk principles? Here, the risk weights of assets come in.
For every category and type of asset / loan that a bank owns / gives, RBI has an assigned risk weight (based on the perceived credit risk). So, when RBI revises the risk weight for a category of asset / loan, it signals that the central bank perceives that the risk in this type of loan has gone up.
RBI’s risk weight change for unsecured consumer loans, where it upped this weight to 125% from 100% signals just that. The move, coming as it does after earlier warnings by RBI to lenders on this count, clearly indicates that the central bank believes that despite its warnings, lenders have not mended their ways. Therefore, this is a stern warning: heed or be prepared for more regulatory action.
Seen in the context of the heady growth in the unsecured consumer portfolio of banks in recent times, it can lead to this rapid expansion being stalled. But let’s revert to the subject: risk weights.
WHAT IS RISK WEIGHTED ASSET?
As mentioned above, RBI assigns risks to various kinds of assets. If you multiply the value of the asset on the balance sheet of the lender with this risk, you get the risk-weighted-asset. You sum up each of assets weighted by their risks and you get the total risk weighted assets, which is used to compute a lender’s capital adequacy ratio. The below illustration will make this clear. Please note, the risk weights indicated below are hypothetical and for indicative purposes only.
As can be seen below, cash is zero risk and hence carries a zero weight. Generally safer housing loans will carry a lower weight than a business loan or a personal loan.
| RISK WEIGHTED ASSETS MATH | |||
| Asset /Loan | Amount (Rs cr) | Risk Weight (%) | RWA (Rs cr) |
| Cash | 2000 | 0 | 0 |
| Government Sec | 5000 | 0 | 0 |
| Housing Loan | 10000 | 50 | 5000 |
| Business Loan | 5000 | 100 | 5000 |
| Personal Loan | 3000 | 125 | 3750 |
| Total | 25000 | 13750 | |
Now, if we look at the above table in the context of RBI’s recent announcement, it would be clear that a change in risk weight for an unsecured consumer loan will increase the value of risk weighted assets. Let’s take Personal Loans. At 100% risk weight, the risk weighted asset value would have been Rs 3000 crore. But with a risk weight increase to 125%, this has gone up to Rs 3750 crore.
CAPITAL IMPACT OF RISK WEIGHT
How does an increase in risk weight impact a lender? It all boils down to the capital allocation. RBI prescribes a minimum capital adequacy ratio for lenders. This has two components Tier 1 Capital (mostly equity and shareholder reserves) and Tier 2 Capital (mostly excess provisions and perpetual preference shares or bonds)—details in the Annexure for those interested. The table below spells out the minimum requirements. This for Tier 1 works out to 9.5% for banks (minimum Tier 1 of 7% + 2.5% capital buffer).
| BANKS' CAPITAL REQUIREMENTS | |
| Regulatory Capital | As %/RWA |
| Minimum Common Equity Tier 1 – Ratio | 5.5 |
| Capital Conservation Buffer (Equity) | 2.5 |
| Minimum Equity Tier 1 + CCB | 8.0 |
| Additional Tier 1 Capital | 1.5 |
| Minimum Tier 1 Capital Ratio | 7.0 |
| Tier 2 Capital | 2.0 |
| Minimum Total Capital Ratio | 9.0 |
| Minimum Total Capital + CCB Ratio | 11.5 |
Source: RBI
What stock market investors are more interested in is the Tier 1 Capital adequacy, as any dilution can impact shareholder returns. Though additional Tier 2 Capital also comes at a cost (interest on perpetual instruments). Now let’s see what a higher risk weight does to capital requirements. Remember, the capital adequacy is calculated by dividing the capital by the risk weighted assets.
Tier 1 CRAR = Tier 1 Capital / Risk Weighted Assets
Total CRAR = Tier 1 Capital + Tier 2 Capital / Risk Weighted Assets
Note: CRAR = Capital to Risk Weighted Assets Ratio
In the above example, if the bank had a Tier 1 Capital of Rs 1500 crore and the risk weight on personal loans was 100%, the Tier 1 CRAR would be 11.5%. Now, if the risk weight is increased to 125%, the CRAR drops to 10.9%. This means that more capital is being used for the same amount of business just because of a risk weight. This will lead to higher cost of capital for such loans, which in turn can translate into lenders hiking interest rates on such loans or reducing exposure to such loans to focus on segments that consume less capital.
That in a nutshell, is what RBI’s recent measure spells.
ANNEXURE – TIER 1 & TIER 2 CAPITAL (Source: RBI)
Elements of Common Equity Tier 1 Capital
Elements of Common Equity component of Tier 1 capital will comprise the following:
(i) Common shares (paid-up equity capital) issued by the bank which meet the criteria for classification as common shares for regulatory purposes
(ii) Stock surplus (share premium) resulting from the issue of common shares;
(iii) Statutory reserves;
(iv) Capital reserves representing surplus arising out of sale proceeds of assets;
(v) Revaluation reserves arising out of change in the carrying amount of a bank’s property
consequent upon its revaluation may be reckoned as CET1 capital at a discount of 55 per cent
(vii) Other disclosed free reserves, if any;
(viii) Balance in Profit & Loss Account at the end of the previous financial year;
(ix) Banks may reckon the profits in current financial year for CRAR calculation on a quarterly basis provided the incremental provisions made for non-performing assets at the end of any of the four quarters of the previous financial year have not deviated more than 25% from the average of the four quarters.
Elements of Additional Tier 1 Capital
Additional Tier 1 capital will consist of the sum of the following elements:
(i) Perpetual Non-Cumulative Preference Shares (PNCPS), which comply with the regulatory
requirements;
(ii) Stock surplus (share premium) resulting from the issue of instruments included in Additional Tier 1 capital;
(iii) Debt capital instruments eligible for inclusion in Additional Tier 1 capital, which comply with the regulatory requirements;
(iv) Any other type of instrument generally notified by the Reserve Bank from time to time for inclusion in Additional Tier 1 capital;
(v) While calculating capital adequacy at the consolidated level, Additional Tier 1 instruments issued by consolidated subsidiaries of the bank and held by third parties which meet the criteria for inclusion in Additional Tier 1 capital; and
(vi) Less: Regulatory adjustments / deductions applied in the calculation of Additional Tier 1 capital .
Elements of Tier 2 Capital
(i) General Provisions and Loss Reserves
a. Provisions or loan-loss reserves held against future, presently unidentified losses, which are freely available to meet losses which subsequently materialize, will qualify for inclusion within Tier 2 capital. Accordingly, General Provisions on Standard Assets, Floating Provisions, incremental provisions in respect of unhedged foreign currency exposures. Provisions held for Country Exposures, Investment Reserve Account, excess provisions which arise on account of sale of NPAs and ‘countercyclical provisioning buffer’ will qualify for inclusion in Tier 2 capital. However, these items together will be admitted as Tier 2 capital up to a maximum of 1.25% of the total credit risk-weighted assets under the standardized approach. Under Internal Ratings Based (IRB) approach, where the total expected loss amount is less than total eligible provisions, banks may recognise the difference as Tier 2 capital up to a maximum of 0.6% of credit-risk weighted assets calculated under the IRB approach.
b. Investment Fluctuation Reserve shall also qualify for inclusion in Tier 2 capital, without any ceiling
c. Provisions ascribed to identified deterioration of particular assets or loan liabilities, whether individual or grouped should be excluded. Accordingly, for instance, specific provisions on NPAs, both at individual account or at portfolio level, provisions in lieu of diminution in the fair value of assets in the case of restructured advances, provisions against depreciation in the value of investments will be excluded.
(ii) Debt Capital Instruments issued by the banks;
(iii) Preference Share Capital Instruments
(iv) Stock surplus (share premium) resulting from the issue of instruments included in Tier 2 capital;
(v) While calculating capital adequacy at the consolidated level, Tier 2 capital instruments issued by consolidated subsidiaries of the bank and held by third parties which meet the criteria for inclusion in Tier 2 capital (refer to paragraph 4.3.4);
(vi) Any other type of instrument generally notified by the Reserve Bank from time to time forinclusion in Tier 2 capital; and
(vii) Less: Regulatory adjustments / deductions applied in the calculation of Tier 2 capital
(Edited by : Kanishka Sarkar)
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