Risk weights UPSC NOTE

 What are risk weights and why are they being increased? 

  • Risk weights are the weights that are assigned to different types of assets to reflect their relative riskiness. 

  • Risk weights are used by banks and other financial institutions to calculate their capital adequacy ratio (CAR). 

  • The CAR is a measure of a bank's financial strength and is calculated by dividing its capital by its risk-weighted assets.

  • Risk weights are set by regulatory authorities, such as the Basel Committee on Banking Supervision (BCBS). 

  • The BCBS is an international committee of central bank supervisors that sets prudential standards for banks. 

  • The BCBS has recently revised its risk weights framework to reflect the latest changes in the financial system.

The main reasons for increasing risk weights,

  • To reduce the risk of banks becoming insolvent

  • By increasing risk weights, banks are required to hold more capital against their riskier assets. 

  • This makes them more resilient to shocks and less likely to become insolvent.

  • To promote a more level playing field for banks. 

  • The new risk weights framework is more risk-sensitive than the previous framework. 

  • This means that banks that hold riskier assets will be required to hold more capital, regardless of their size or jurisdiction.

  • To encourage banks to lend to less risky borrowers. 

  • By increasing the risk weights on certain types of loans, such as loans to unrated borrowers, the BCBS is discouraging banks from lending to these borrowers. 

  • This is because banks will have to hold more capital against these loans, which will make them less profitable.

How will it affect non-banking financial companies?

  • Increased Cost of Funds: NBFCs rely heavily on wholesale funding from banks. As banks are required to hold more capital against riskier assets, they may charge higher interest rates for loans to NBFCs. This will increase the cost of funds for NBFCs, which could put pressure on their profitability.

  • Reduced Liquidity: The increase in risk weights could also lead to reduced liquidity for NBFCs. Banks may become more cautious about lending to NBFCs, especially those with riskier assets. This could make it more difficult for NBFCs to access funding when they need it.

  • Stricter Regulatory Scrutiny: NBFCs are already subject to less stringent regulatory requirements than banks. However, as NBFCs play an increasingly important role in the financial system, regulators may impose stricter requirements on them

  • Competition from Banks: Banks may start to compete more directly with NBFCs in areas such as consumer lending and small business lending. This could put pressure on NBFCs' margins and market share.

What has the RBI proposed?

  • The idea is to address the notion of ‘credit risk.’

  •  It refers to the risk entailed by a borrower being unable to meet their obligations or defaulting on commitments

  • ‘Risk weights’ are an essential tool for banks to manage this risk

  • This metric, in percentage factors, adjusts for the risk associated with a certain asset type. 

  • In other words, it is an indicator of the essential holding the lender should ideally have to adjust the associated risk. 

  • This is what the RBI has directed to be increased.

  • The primary purpose of effective risk management by banks is to maximise their returns by maintaining credit risk exposure within acceptable parameters. 

  • The RBI had raised concerns about the growth seen in consumer credit and increased dependency of NBFCs on bank borrowings

  • It has directed that the risk weight for consumer credit exposure be increased by 25 percentage points to 125%, for all commercial banks and NBFCs. 

  • This would apply to personal loans (and retail loans for NBFCs), excluding housing loans, education loans, vehicle loans and loans secured by gold and gold jewellery

Why were the changes necessary?

  • While presenting the monetary policy statement in October this year, Governor Shaktikanta Das had flagged concerns about the “high growth” in “certain components of consumer credit.” 

  • He advised banks and NBFCs to “strengthen their internal surveillance mechanisms, address the build-up of risks, if any, and institute suitable safeguards, in their own interest.”

  • Ratings agency Moody’s also put forth that higher risk weights are intended to “dampen lenders’ consumer loan growth appetite.” 

  • RBI figures stipulate that unsecured personal loans have increased by 23% on a year-over-year basis, as on September 22. 

  • Outstanding loans from credit cards increased by about 30% during the same period.

What are the chief concerns?

  • The primary concerns relate to the impact on capital adequacy and the bank’s overall profitability. 

  • S&P’s latest report states that slower loan growth and an increased emphasis on risk management will likely support better asset quality in the Indian banking system. 

  • The worst-affected might be finance companies, as their incremental bank borrowing might surge, S&P states.

  • NBFCs face a “double-whammy” because of higher risk weights on their unsecured loans and on account of the bank lending mandates to NBFCs. 

  • Bank lending to NBFCs remained the principal source of funding for NBFCs .

  • It constituting 41.2% of the total borrowing of entities as of March end. 

  • It is expected that the increased costs would be passed onto borrowers.



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Learnerz IAS | Concept oriented UPSC Classes in Malayalam: Risk weights UPSC NOTE
Risk weights UPSC NOTE
Learnerz IAS | Concept oriented UPSC Classes in Malayalam
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