In today’s Finshots, we offer a simplified explainer on what the RBI’s new rules on risk-weighted assets mean.

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On paper, a bank has a simple job — accept deposits from people like you and me and then use the same monies to disburse loans to folks who need it.

But of course, it can’t just play around with other people’s money, no? There has to be some sort of skin in the game. So the bank has to cough up its own money or capital too. Because if things go south, there’s some ‘ownership’ capital involved and it’s not just depositors’ hard-earned rupees that’s at stake.

So let’s say that a bank disburses loans worth ₹100. Remember, a loan is an asset for the bank because it gets interest on it and will also be repaid at the end of a certain period. Now RBI’s rules state that a minimum of 9% should be set aside from the bank’s coffers. That means a minimum of ₹9 of its own capital should be locked up for contingencies.

That seems quite sensible, no?

But hold on, it’s actually a little more complicated than that.

See, regulators have something called “risk-weighting” of assets. This simply means that they don’t believe that all loans (assets) are equal. For instance, if the bank doles out a home loan, it can always repossess the home if there’s a default. It’s the same thing with a gold loan. There’s collateral involved. On the other hand, a personal loan doesn’t have any collateral. It’s unsecured. This makes it more riskier than other types of loans. So the regulator might say, “Ok, for ₹100 worth of home loans, we’ll assign a risk weight of 50%. That means we consider only ₹50 worth of this loan to be risky. So you only need to set aside ₹4.5 worth of your own capital (9% of ₹50). But for personal loans, the risk weight is 100%. So if you lend ₹100, you need to keep ₹9 worth of capital.”

Now if you’re a banker who’s averse to risk, you’d rather dabble in loans that require you to put up less of your own capital. But, you also know that you can charge a higher interest rate on a personal loan or a credit card. It’s these riskier types of loans that brings in the dough. So at the end of the day, you have to figure out how to balance this tightrope — squeeze out higher interest rates while putting up the lowest capital.

That’s banking in a nutshell.

And this brings us to the RBI diktat.

One fine day last week, the central bank issued one of its dreaded circulars — it had decided to tweak the risk weights. That means from now, unsecured personal loans and even the money they lend to other non-banking financial companies (NBFCs) will have a risk weight of 125% instead of 100%. And for credit cards, the risk weight will now be 150%. Ergo, the banks have to cough up additional capital because these types of loans are considered even riskier now.

Why did the RBI do this, you ask?

Well, for a while now the RBI has been tired of banks being quite trigger happy with their lending behaviour. And it has been kind of nudging banks to slow down. But the advice fell on deaf ears. Remember our story “Are Indians struggling to pay bills?” from last month? In it we said:

…while overall bank credit in FY23 grew by 15%, the growth in these unsecured loans worth ₹10,000-₹50,000 zoomed by a staggering 48%. And the defaults are already creeping up. While the overall bad loans in the retail segment is below 1.5%, in the tiny personal loan category, it has soared to 8.1% already. To make matters worse, according to a UBS report released this month, the share of lending to people who’re already past their due dates has nearly doubled from 12% in FY19 to 23% in FY23.

So, push has come to shove and the RBI simply decided to take matters into its own hands. It is changing the rules to finally force banks to change. And it’ll have a ripple effect.

What do we mean?

Firstly, banks will have to set aside additional capital on personal loans and credit cards. Even on loans they've issued previously. And this is idle money. The bank doesn’t earn anything from it. So to make up for this, they might end up charging a higher interest rates on new personal loans.

It’s not just banks, but even non-banking financial companies (NBFCs) and their fintech partners (like Paytm) will be caught up in this. Because these entities will be hit by a double whammy — both on the assets and liabilities side.

You see, NBFCs first borrow quite heavily from banks. This is a liability because they have to pay it back to the banks later. And it’s this money that they subsequently dole out as loans. But now, as we told you earlier, when banks lend to NBFCs, they have to first set aside more capital due to the higher risk weight. So the banks will charge a higher interest rate from NBFCs. Also, when NBFCs disburse personal loans (the assets), they’ll need to to set aside more capital as well to meet the new risk-weight rules.

That’s the double whammy.

And once the NBFCs factor in the impact of paying banks a higher interest rate and then setting aside their own capital before disbursing loans, they’ll end up charging the final borrower a much higher interest rate.

So yeah, that’s the bottom line. The RBI’s new rules makes borrowing more expensive for the people. And the central bank is hoping that if people have to shell out higher interest, it will slow down the demand for loans too.

And that folks is how the RBI has hiked interest rates without hiking interest rates.

Until then…

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