The Reserve Bank of India ("RBI"), vide its notification titled 'Regulatory measures towards consumer credit and bank credit to NBFCs' dated November 16, 2023 ("Notification"), has increased the risk weights for consumer finance assets in the books of banks and Non-Banking Financial Companies ("NBFCs"). RBI Governor Shaktikanta Das started the statement on policy, dated October 06, 2023, with Kautilya's quote. His entire policy statement was based on risk mitigation and underwriting. Based on the governor's statement, RBI has justified the increase in risk weights by saying that this will help strengthen the internal surveillance system and safeguard the interest of the financial sector.

As per the Notification, the risk weights with respect to consumer credits on the books of banks and NBFCs have been increased from 100 per cent to 125 per cent.

Similarly, the risk weight for credit card loan assets has been increased from 125 per cent to 150 per cent for Scheduled Commercial Banks ("SCBs") and from 100 per cent to 125 per cent for NBFCs.

Lastly, the risk weight for SCB lending for NBFC, including core investment companies (NBFC-CIC), has also been increased by 25 percentage points for all such cases where the extant risk weight, as per the external rating of NBFCs, is less than 100 per cent.

Increase in cost of borrowing?

The key implication of the change is that the cost of consumer finance in India, including all Buy Now Pay Later ("BNPL") products and embedded finance, may increase.

What remains to be seen is whether the lenders will absorb this provisioning cost or pass it on to the consumers and to what extent. We will see the economic implications of this by the mid-term.

In a rational context, this process essentially involves the internal reshuffling of balances within the company's balance sheet from one item to another. Importantly, there will be no actual outflow of funds for the company.

A double-blow for NBFCs?

With regard to NBFC consumer lending, this is a double blow because not only the risk weights for NBFCs have been increased, but the risk weight for bank loans to an NBFC for on-lending has also been increased by 25 percentage points for all such cases where the extant risk weight is less than 100 per cent. For instance, if the risk weight percentage for an 'A' rated NBFC is 50 per cent, the same will be increased to 75 per cent under the new framework. However, the risk weight of a 'BBB' rated NBFC will remain unchanged because the risk weight of such an NBFC, as per the current framework is 100 per cent.

NBFCs are expected to face a significant setback, primarily due to their inability to use External Commercial Borrowings ("ECB") for on-lending. This is attributed to the minimum average maturity period requirement of ten years for loans under the ECB framework, rendering it unfeasible for consumer finance1. Secondly, the issue of listed bonds is also not a very feasible option for them. The challenge for NBFCs in securing loans from banks has been compounded by heightened scrutiny and internal guidelines. The increased risk weight is going to make it even more difficult for NBFCs to access bank loans for on-lending.

This may cause a liquidity crunch in the short run, and hence, there is a need for rationalising access of funds to NBFCs to prevent crippling of the market.

Immediate compliance concerns for Regulated Entities under the New Risk Weight Framework

From a compliance perspective, what is more alarming for Regulated Entities ("RE") is that this risk weight framework applies not only to the new assets but also to outstanding assets on their balance sheets, which have to be prepared for the Financial Year ("FY") ending on March 31, 2024, which is looming four months ahead. Hence, REs shall have to update their current balance sheet accordingly and they also have to provision for adequate capital to match these updated risk weights before the end of the current FY.

Exclusion of certain categories under the revised framework

Both SCBs and NBFCs have specific exclusions in their portfolios of consumer loans. For SCBs, consumer loans, excluding housing loans, education loans, vehicle loans and loans secured by gold and gold jewellery, are considered. Similarly, NBFCs exclude housing loans, education loans, vehicle loans, loans against gold jewellery and microfinance/SHG loans from their categorised consumer loans.

Whether or not personal loans given by NBFCs are covered under this regulatory measure remains ambiguous. However, if we read the notification, we see that the treatment of personal loans by banks is at par with retail loans by NBFCs because the consumer finance for banks as well as for NBFCs has been made at equal footing.

Comprehensive review and adherence to sectoral exposure limits by REs

Lastly, REs have to review their extant sectoral exposure limits, set board-approved limits with respect to various sub-categories of their assets, further attribute internal weight, and ensure that they do not exceed them. Moreover, all top-up loans extended by REs against movable assets having an inherent depreciating nature shall be classified as unsecured loans. This also implies that they will have to do it before finalising their balance sheet for FY ending on March 31, 2024.

Incentive through Credit Risk Mitigation tools

The Large Exposure Framework for NBFC-Upper Layer ("NBFC-UL") issued by RBI vide notification dated April 19, 2022, intends to mitigate the concentration of exposure in the hands of a few individuals/corporations/groups, thus acting as a Credit Risk Mitigation (CRM) tool. However, the same was only available for NBFC-UL2. In line with the above, the Governor of RBI vide its statement dated October 06, 2023, stated that apart from the NBFC-UL, these credit risk mitigation instruments shall also be available for NBFCs in the Middle layer and Base layer for reducing counterparty exposures.

Conclusion

The industry will have to walk the plank on this notification. They will have to find some business commercials and solutions for reworking their models. However, it is surprising that the language of the notification is such that it covers both outstanding and new loans, and there is no transition period provided for the industry to implement these guidelines. It is essential that the industry seek clarity and at least request for the implementation of these guidelines from next FY onwards.

Secondly, it is going to definitely impact the existing business models for BNPL and embedded finance. There is a possibility that the REs shall use this as a negotiation point to negotiate prices with other vendors and fintechs involved in their lending process to make up for the increase in cost, which is going to be a bad hit for a healthy and growing fintech industry in India. As a counter-argument, it can be said that this increase in cost is not a real cost, and the same is only statutory provisioning with no real money moving out of the company/RE.

What is going to be important is the innovative solutions that the industry will have to take to manage this situation. This is not the first time that the industry had to manoeuvre its way out of the regulatory strangles. For instance, when Know-Your-Customer ("KYC") guidelines were changed in relation to the acceptance of Aadhar cards, the industry faced a lot of issues. However, now they have device-relevant KYC processes to take this through. The key lies in seeking clarity, innovative commercial solutions, and leveraging past experiences to navigate this regulatory shift.

Footnotes

1. RBI Master Direction-External Commercial Borrowing, Trade Credits and Structured Obligation, Dated March 26, 2019, paragraph 2.1.

2. RBI Notification on Large Exposure Framework for NBFC-Upper Layer, dated April 19, 2022.

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