GS Paper III

News Excerpt:

RBI increases risk weights on unsecured loans by 25% for banks and NBFCs due to concerns about the fast-growing unsecured retail loans and rising systemic risk.

About the News:

• The move aims to stabilise and calibrate growth by requiring higher capital for unsecured loans.
• Outstanding and new consumer credit exposure of commercial banks and retail loans of NBFCs, excluding housing, education and vehicle loans, and loans secured by gold and gold jewellery, will now attract risk weights of 125 % against the current 100 %.
• Lenders are instructed to review sectoral exposure limits for consumer credit by February 29, 2024.

What do the higher risk weights mean?

• The RBI is implementing these measures to address the rapid growth of unsecured personal loans and credit cards by adjusting risk weights to counter systematic risk concerns.
• The central bank is raising the credit risk weights assigned to unsecured consumer loans, making it more costly for banks and non-bank financial institutions to provide such loans.
• Higher risk weights mean lenders must set aside more capital against these loans, potentially reducing their overall capital adequacy ratio.
• The move is expected to increase the cost of borrowing for consumers, especially for unsecured personal loans and credit cards, as lenders may raise interest rates to maintain their capital adequacy.

 What are Unsecured Loans?

• Does not require any type of collateral. 
• They are riskier than secured loans for lenders, so they require higher credit scores for approval.
• If a borrower defaults, the lender may commission a debt collection agency or take the borrower to court. E.g., credit cards, student loans, and personal loans.

Benefits of unsecured loans:

• Promote entrepreneurship: Unsecured loans can help aspiring entrepreneurs start and grow their businesses.

• Financial Inclusion: It promotes financial inclusion by providing access to credit for individuals and businesses who may not have valuable assets to use as collateral.

• Faster approval processes: The borrowers can access funds quickly in times of need, which can be vital for addressing emergencies.

• Credit products diversification: Unsecured loans contribute to a diverse range of credit products available in the market, giving borrowers a wider choice.

• No collateral: It does not require a customer to pledge assets as collateral. It means a customer is not at risk of losing property if he/she cannot repay the loan.

Challenges of unsecured loan:

• Destabilise financial system: Many borrowers defaulting on their unsecured loans can lead to significant financial losses for lending institutions, potentially destabilising the financial system if left unchecked and leading to a significant increase in NPAs.

• Economic Inequality: Uneven access to unsecured loans can contribute to economic inequality.
• High-interest rates: Due to higher interest rates, the borrowers may end up paying a significant amount in interest over the life of the loan.
• Over-indebtedness of customers:  High availability of unsecured loans can lead to consumer over-indebtedness, impacting personal finances.
• Default risk:  Since no collateral is involved, lenders face a higher risk of default on unsecured loans.

Steps taken:

• The RBI regularly monitors the financial health of banks and NBFC to ensure they maintain adequate capital and liquidity to withstand shocks related to unsecured loans.
• RBI has asked the Banks and NBFCs to strengthen their internal surveillance mechanisms and address the build-up of risks.
• It has asked banks to monitor their unsecured lending portfolios, specifically credit cards.

Way forward: 

• Unsecured loans can be a double-edged sword as they have the potential to spur growth and empower individuals, but the unchecked rise in unsecured lending can jeopardise financial stability.  Strike a harmonious balance through collaboration with international financial institutions to share best practices and regulatory frameworks for digital and online lending platforms to ensure compliance and implement strict underwriting standards to evaluate borrowers' creditworthiness.
• Also, educate consumers about the potential consequences, safeguard them from abusive lending practices, and encourage financial institutions to offer affordable, small loan products to low-income borrowers.