FAQs on Regulatory measures towards consumer credit and bank credit to NBFCs

– Team Finserv | finserv@vinodkothari.com

One may call it insecure about unsecured lending; the central bank has taken what in our view is a bold and timely measure, to rein in unsecured lending. Identifying a notable surge in specific segments of consumer credit, the RBI had recently met senior bankers. The latter had reportedly assured the central bank that things are under control. However, apparently, these assurances have failed to assuage the RBI’s view. Vide its notification dated November 16, 2023, the RBI has taken several mitigating measures.

We have developed a set of FAQs on the Circular, where we intend to answer some of the critical questions relating to the actionables by the REs and the impact of the circular.

Further, our detailed article on this topic can be read here – RBI raises red flag on increasing personal loans

Table of Contents:

Implication on banks and NBFCs

Applicability

Computation of Risk Weight

Top-up loans

Increase in risk weight for bank lending to NBFCs

Sectoral caps on consumer credit

Implications on Banks and NBFCs

1. The 16th Nov circular increased the risk weights for certain categories of consumer credit. Does the increase of risk weight mean increased cost of lending for the banks/NBFCs?

While it is not correct to say that the cost of lending is directly connected with the cost of credit, but one needs to appreciate that regulatory capital is an important constraint for regulated entities. A product that eats more regulatory capital is likely to be priced commensurately higher.

Increased regulatory capital requirements come in the face of perception about increased risk. Therefore, it will be difficult to believe that lenders will continue to price consumer credit at the same rates as they were doing before.

2. Regulatory capital is one of the applicable requirements. However, lot of banks compute internal assessment of capital, called “economic capital”. Will the revised risk weights affect economic capital allocations too?

Economic capital is assigned based on internal assessment of unexpected losses. A change of regulatory perception may not be the basis for a surge in unexpected losses, but in the emerging scenario of high cost of borrowing, it will not be wrong to say that unexpected losses may be seen as increasing.

3. Will the internal assessment of capital adequacy done as per ICAAP also be impacted by the revised scenario?

There is certainly a very strong reason for review of ICAAP, as the prevailing situation indicates stress. Macroeconomic stress due to globally high interest rates, depreciation of rupee etc may also be headwinds for the urban consumer and may affect default rates. These factors sholud appropriately be factored by the risk team while doing an assessment of ICAAP.

4. NBFCs covered by IndAS compute expected credit losses as per IndAS. There is a proposed ECL framework for banks as well. Will the circular impact ECL estimations too?

ECL methodology should always be dynamic – it has to be both forward-looking as well as get benefited by the feedback from the past trends of defaults. If the emerging scenario indicates increasing probability estimates, ECL should capture the same.

5. If risk weights are increased by 25%, how much should the cost of lending increase?

As mentioned above, risk weights are not a direct input into pricing of a credit asset. However, expected losses are. A compensation for economic captal, connected with unexpected losses, is also an input. Hence, there is no straight formula to relate increase of risk weights with the cost of lending.

6. From when are the different implications of the Circular applicable:

a. Increase in risk weights for consumer credit held by banks

While the same is immediately applicable, however, the increased risk weights may be applied in the applicable capital adequacy return filed with the RBI henceforth (Return on Capital Adequacy-III (RCA – III) for banks) 

b. Increase in risk weights for consumer credit held by NBFCs

While the same is immediately applicable, however, the increased risk weights may be applied in the capital adequacy return filed with the RBI henceforth (DNBS03-Important Prudential ParametersDNBS 03  for NBFCs)

c. Increase in risk weights for bank lending to NBFCs

While the same is immediately applicable, however, the increased risk weights may be applied in the capital adequacy return filed with the RBI henceforth 

d. Setting of exposure limits for exposure to consumer credit, especially unsecured consumer credit

This is immediately applicable, though an outer timeline of end-Feb., 2024 is given for achieving this. Therefore, effective steps may be taken soonest – for example, in the forthcoming board and risk management committee meetings, the setting up of limits may be considered. Based on the decision taken, the Risk Policy may accordingly be redrawn.

In our view, by Feb., 2024, the risk management committee should ensure that the limits have been adhered to.

e. Risk management function to ensure that the sectoral exposure limits are adhered to:

29th February, 2024. 

f. Top up loans backed by depreciable movable property to be reckoned as unsecured exposure 

This may require review of the product – its credit appraisal will be as if it were an unsecured loan product. Similarly, the exposure limits will capture this as unsecured loan. These may require product review soonest, by latest by the end of February, 2024.

Applicability

7. Does the increase in risk weights for consumer credit affect the risk weights in the following cases:

1. Co-lending

Yes, since the asset stays on the books of both the co-lenders, higher risk weight will have to be assigned to the respective portions. 

2. Direct assignment

The underlying loans are put on the balance sheet of the buyer. Hence, the risk weights for consumer credit will have to be increased.

3. Pass-through certificates, say represented by consumer credit?

In case of  pass-through certificates, the buyer acquires a security, which is risk weighted based on the ratings-based risk weights as per SSA Directions. There is no change in those risk weights, even if the underlying loans are consumer credits. Whether there will be a downgrade of the ratings is the call of the rating agency, in which the risk weights may be impacted.

Computation of Risk Weight

8. If we are saying the risk weights in case of an investment in PTCs will not be impacted by the increase of risk weights on consumer credit, are we therefore saying that securitisation transactions will become more efficient?

Yes, that seems a clear implication.

9. Where does the meaning of “consumer credit” and “personal loans” come from?

The terms  ‘consumer credit’ and ‘personal loans’ have been defined by the RBI in its circular on XBRL Returns – Harmonization of Banking Statistics dated January 04, 2018.

Consumer credit refers to the loans given to individuals, which consists of (a) loans for consumer durables, (b) credit card receivables, (c) auto loans (other than loans for commercial use), (d) personal loans secured by gold, gold jewellery, immovable property, fixed deposits (including FCNR(B)), shares and bonds, etc., (other than for business / commercial purposes), (e) personal loans to professionals (excluding loans for business purposes), and (f) loans given for other consumptions purposes (e.g., social ceremonies, etc.). 

However, it excludes (a) education loans, (b) loans given for creation/ enhancement of immovable assets (e.g., housing, etc.), (c) loans given for investment in financial assets (shares, debentures, etc.), and (d) consumption loans given to farmers under KCC. For risk weighting purposes under the Capital Adequacy Framework, the extant regulatory guidelines will be applicable.

Personal loans refers to loans given to individuals and consist of (a) consumer credit, (b) education loan, (c) loans given for creation/ enhancement of immovable assets (e.g., housing, etc.), and (d) loans given for investment in financial assets (shares, debentures, etc.).

Therefore, what is not “consumer credit” as per the definition above, will not be taken as consumer credit for the purpose of increased risk weights. In addition, the following, though consumer credit in the above definition, have been specifically excluded from the purview of increased risk weights:

• Housing loans. For meaning of “housing loan”, see discussion below.
• Education loans
• Vehicle loans
• Loans secured by gold/jewelry 

10. Are the following loans covered by the increased risk weight in case of “consumer credit”?

Loan given to a proprietary firm	The definition refers to credit extended to “individual”. Technically, there is no difference between an individual and a proprietary concern, but if the loan is given to a concern, it partakes the character of a business loan. Hence, it is not covered
Priority sector loans given by banks	Priority sector loans will most likely be in the excluded category. In any case, the intent of the regulator cannot be to treat a lending as priority, and risk at the same time.
MSME loans and supply chain finance	As the loans are for business purpose, hence not covered as “consumer credit”
LAP loans given without any end-use restrictions	If the LAP loan is given for personal or consumption purpose, or is not otherwise linked with business purpose, it may be taken as personal loan, and hence, subject to 125% risk weight
LAP loan given for business purposes	Not considered as consumer credit
Loan against shares, but for personal use	Would have been considered as capital market exposure, and hence, already risk weighted at 125%
Loan for purchase of a commercial vehicle	Not consumer credit
Loan for personal use vehicle	Excluded from scope, hence, 100% risk weight will apply
Top up loan in case of a housing loan	A home equity line of credit or home equity loan, does not usually qualify as housing loan. Since the end use of this is not controlled, it maybe taken as consumer credit. If yes, 125% risk weight will apply
Loan for insurance premium in case of a house	The requirement to have the house insured is stipulation of the HFC for the purpose of home loan. Hence, the loan may be incidental or ancillary to home loan. HFC regs apply the same risk weight to insurance loan too. Hence, the existing risk weight as applicable on housing loans would be applied.
Invoice finance transaction	Not a case of consumer credit
Gold loan	Specifically excludedIn case of banks both loan against old and gold jewelery and in case of NBFCs only loan against gold jewelry
Micro finance loan	Specifically excluded in case of NBFCs. In case of banks, it may be argued that the purpose is not consumption
Fintech loans, BNPL loans, etc	125% risk weight will apply
Payday loans or other similar short term financing done by new age NBFCs	125% risk weight will apply

11. Are the increased risk weights applicable only to on-balance-sheet exposure, or may be applied to off-balance sheet exposure as well? For example, committed but undisbursed loans for consumer credit will attract risk weight of 100% or 125%?

The credit conversion factors for off-balance sheet exposure are provided by the regulation. After applying the CCF, the risk weight will as applicable to the exposure. 

12. Whether all types of Housing Loans (HL) are excluded wherein there is no change in risk weights?

For being eligible for being treated “claims against residential property” under para 5.10 of Basel III circular (applicable in case of banks), the following definition should be relevant: 

“Lending to individuals meant for acquiring residential property which are fully secured by mortgages on the residential property that is or will be occupied by the borrower, or that is rented, shall be risk weighted as indicated as per Table 7 below (in the Basel circular), based on Board approved valuation policy. LTV ratio should be computed as a percentage with total outstanding in the account (viz. “principal + accrued interest + other charges pertaining to the loan” without any netting) in the numerator and the realisable value of the residential property mortgaged to the bank in the denominator.”

The above definition is sufficiently clear. 

In our view, RBI/NHB definition of what qualifies as housing finance for individuals for the purpose of “housing finance company” test seems broadly aligned with the above. The RBI HFC Master Directions states that “Housing Finance” shall mean financing, for purchase/ construction/ reconstruction/ renovation/ repairs of residential dwelling units, which includes a specified list of exposures.  . However, in case of a gap, for capital adequacy, the definition provided under the Basel Norms above should prevail.

13. For an NBFC which is, say, entirely engaged in personal lending, what is the impact of the circular on the capital adequacy?

Assume the NBFC was having an on-balance sheet exposure of Rs 100 crores, and was operating at a capital adequacy of 20%. Assuming all the on-balance sheet assets now attract a risk weight of 125% – thereby, the risk weighted assets of the NBFC will be assumed to be Rs 125 crore. Hence, the capital adequacy comes down to 16%. 

Top-up loans

14. The circular applies to top up loans secured by depreciating movable properties. Is it safe to say that top up loans given in any other case will not amount to unsecured credit?

The meaning of a top-up loan should be clearly understood:

• There is an existing lending facility, usually (but not necessarily) secured, which has been running down for some time. There is a generally satisfactory performance under that facility.
• The lender now gives another facility. Just because there is a second facility given by the lender does not mean it is a top-up loan. Only where the facility is tagged with the existing facility, it becomes a top-up loan. The tagging will usually mean one or more of the following: (a) sharing of security interest on the original facility by the second one; (b) common EMIs; © common maturity, etc.

What is the meaning of sharing of security interest by the top-up facility? The parties agree that the security interset created on the first facility should extend to cover the second one as well, that is to say, unless both the facilities are fully discharged, the lender will continue to hold the security interest. This is not just a cross default clause but an extension of the charge under the erstwhile facility to cover the second one as well.

If such extension of security interest is done, the top-up loan is a secured facility. Merely because there is a running facility which is secured, and there is second facility granted by the lender, does not mean the second facility is secured.

Now, answering the question, if the top-up loan is secured, and secured on immovable property, it does not have to be treated as unsecured loan for the purpose of the Circular. 

15. The Circular says the top up loans will be taken as unsecured consumer credit for the purpose of “credit appraisal, prudential limits and exposure purposes”. Does that mean for the purpose of risk weight, the loan will be risk weighted at 100%?

What is the purpose of the top-up loan? That depends on the facts. In case of a top-up loan given to a commercial vehicle owner, the lender will normally give the top-up for his working capital. For a home buyer, the top up loan may be given for consumption purposes.

The increase in risk weights for consumer credit, and the sectoral cap for unsecured consumer credit, are two separate things, and should not be intermixed. When it comes to increase in risk weights, the primary consideration is what is the purpose of the loan – is it for consumption purposes, or for any business or commercial purpose? If it is a consumer loan, it does not matter whether it is secured or unsecured, except where it is “housing loan”, “education loan”, “vehicle loan” or loan against gold or jewelry.

Given the definition of “housing loan”, we do not think a home equity loan will be treated as a housing loan. Hence, it will attract a higher risk weight of 125%.

16. Is there any change in documentation for top-up loans required?

We do not think any documentation changes are required. However, for ongoing business, a review of the product is strongly desirable.

Increase in risk weight for bank lending to NBFCs

17. Whether all loans given by Banks to HFCs or only those loans to HFCs that fall under Priority Sector Lending (PSL) are not affected and would continue at the existing risk weights?

All loans to HFCs has been excluded from the purview of the incresed risk weight requirement. 

18. What are the existing norms for determining the risk weights of NBFCs?

Risk weights for NBFCs (below 100%) is based on the rating, as follows:

Rating (long term/ short term claims)	AAA/ A1+	AA/ A1	A/ A2
Existing Risk Weight	20%	30%	50%

19. What will be the change in the risk weight for loans to NBFCs?

The risk weights on exposures of SCBs to NBFCs, excluding core investment companies, shall be increased by 25 percentage points (over and above the risk weight associated with the given external rating) in all cases where the extant risk weight as per external rating of NBFCs is below 100%. The revised risk weight shall be as follows:

Rating (long term/ short term claims)	AAA/ A1+	AA/ A1	A/ A2
Revised Risk Weight	45%	55%	75%

20. A bank has the option of lending directly on the balance sheet of an NBFC, or partaking business interest in one of the following ways – direct assignment, co-lending, securitisation. How do these ways of acquiring exposure compare with on-balance sheet lending to NBFCs?

The following table helps to compare. Let us assume the NBFC in question is a A-rated.

Lending directly to NBFC	25% higher than the rating-based risk weight. A-rated corporate borrower attracts 50% risk weight – hence, the NBFC risk weight is 75%
Purchase of portfolio by way of direct assignment	Depending on the nature of portfolio. If consumer credit, then 125%
Co-lending	Depending on the nature of portfolio. If consumer credit, then 125%
Investment in securitisation	Depends on the rating of the tranche, maturity, thickness, etc.,  and whether the transaction is STC. For an investment in AAA tranche, the risk weight may be as low as 15% for non STC, and 10% for STC.

Sectoral caps on consumer credit

21. Is the regulator in favour of limiting the exposure on consumer credit, irrespective of the nature or business focus of the RE/NBFC in question?

The sectoral caps are self-imposed caps depending on teh business, diversification, asset focus, etc of the RE  in question. One cannot, for example, expect a fintech lender to put a sectoral cap on unsecured consumer lending, since that is the very business of the lender.

The idea of the sectoral caps is as follows: proper risk management for a lender demands that the lender achieves a diversification. Diversification does not mean moving away from the core focus area. But even within a focal area, there may be ways to diversify. For example, a fintech entity may divide its business based on ticket size, mode of origination (e-commerce platforms or otherwise), etc. Whatever might the sources of differential risks may define segments. Having done that, the entity tries to achieve risk diversification.

There is no absolutism in the regulatory prescription. It is the call of the risk management committee to set these internal sectoral caps.

22. If risk management committee is not applicable to the RE, who monitors the sectoral caps?

The board of directors. 

23. Are the limits absolute, or based on AUM?

In our view, the limits are based on AUM.

24. If the NBFC acting as sourcing agent for transactions provides any first loss default guarantee, for the purpose of the epxousre limit, should teh amount of guarantee be captured, or should the entire portfolio exposure be captured?

A first loss default guarantee exposes the guarantor to the risk of the entire portfolio. The FLDG is only the limit of the losses that the guarantor may face. Hence, in our view, in monitoring the risk exposure, the entire portfolio value has to be considered. 

25. Can an NBFC, having reached or about to reach the sectoral exposure limits, shed the same by entering into securitisation, direct assignment or co-lending transaction?

Yes, portfolio concentrations may be corrected by either of the above methods.

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Our Article on the topic: – RBI raises red flag on increasing personal loans

Our YouTube Video on the topic: https://www.youtube.com/watch?v=vS01Wc2kaW8

Other related Resources:

1. RBI Bi-monthly Credit Policy: NBFCs moved to a ratings-based risk weight regime
2. Risk weights and provisioning norms for the Guaranteed Low Income Housing Loans, by Abhirup Ghosh, 5th December, 2013