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By Sachin Malhotra
Sachin Malhotra, a banking veteran with 26 years’ experience, was an MD at Standard Chartered, analysing financial cycles and economic trends
February 27, 2025 at 1:55 PM IST
The RBI has rolled back measures taken in November 2023 to curtail runaway growth in consumer credit, which comprised an increase in risk weights on lending for consumption from 100% to 125%, and on credit to non-banking financial companies by 25 percentage points. As a result of these steps, growth in consumption credit has been moderating, although loan delinquency in the microfinance sector has been rising. The rollback announced by the RBI on Feb 25, 2025, has restored risk weights on consumer lending to 100%, including by the MFI sector, and removed the 25% additional risk weight on bank lending to NBFCs.
When these steps were taken towards the end of 2023, India was on a strong growth path (2023-24 GDP growth was 8.2%) and there was a need to address inflationary concerns. However, the GDP print of 5.4% for the second quarter of 2024-25 and estimates of a more than two percentage point fall in GDP growth for 2024-25, coupled with threats to growth from trade barriers in an altered world order wrought by the new US Presidency, has brought growth concerns back to centre stage. Clearly, the Government and the RBI view increased consumption expenditure as key to reviving stuttering GDP growth. After fiscal steps to leave more money in the hands of consumers were announced in the Budget, the RBI has followed suit by reversing its earlier restrictions.
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What exactly are risk weights? The Central Bank requires banks to maintain a minimum capital ratio relative to their total lending (called ‘capital adequacy’), which is currently 9%. However, not all lending is equally risky, for example a secured loan to a large corporate is less risky for the bank than an unsecured personal loan. This difference in risk is accounted for by multiplying the loan size by a ‘risk weight’. So the minimum capital would be 9% x Loan Amount x Risk Weight. For example, a loan of ₹100 to the large corporate may have a risk weight of 50%, resulting in only ₹4.50 to be kept as capital, whereas, for an unsecured personal loan of the same amount, the bank will have to keep ₹11.25. One implication is that if the bank needs to achieve a return on capital of 10%, it would need to charge a spread of just 45 bps on the large corporate loan, but as much as 113 bps on the unsecured personal loan. |
The RBI, in its Financial Stability Report for December 2024, noted consumer credit grew at 20.6% annually from March 2021 to December 2023, outpacing the 14.8% annual growth in overall credit during the same period, although it has moderated since the November 2023 restrictions were imposed. The RBI further notes that loan growth to prime borrowers has increased relative to others, “suggesting that lenders are exercising caution and underwriting standards are getting tighter” — this perhaps has given the RBI the comfort required to take the current steps.
While the reduction in the repo rate in the February 2025 monetary policy will reduce the cost of credit, this will take some time to work through the system, with only half of all loans being directly linked to external benchmarks like the repo. The rest would have to await a gradual fall in deposit rates, although this could be accelerated by more rate cuts over the year. A reduction in risk weights, however, is a more powerful and direct measure, as it reduces cost of lending and boosts return on capital. As per reports, around ₹400 billion of capital would be freed up through this latest relaxation. The strong rally in the share prices of MFI lenders reflects this optimism.
Likely Risks
While the Government and the RBI’s keenness to boost economic growth is understandable, any credit-driven consumption spree cannot come without its risks. Releasing the brakes on consumption lending could undoubtedly lead to more non-performing assets, particularly in an environment of slowing growth and stagnant earnings for a large section of the population. It is worth noting that lending for consumption does not lead to the creation of income-yielding assets, unlike lending for capital expenditure, and must be repaid from the borrower’s other income sources.
Microfinance lending is particularly prone to delinquency, being unsecured, as borrowers lack assets to offer as collateral. An essential tenet is a preference for lending to joint-liability groups and to women, both of whom are associated with lower default rates. However, borrowers are typically economically vulnerable but politically significant, which has led to many states including Andhra Pradesh, Telangana and Karnataka regulating the sector and placing curbs on the recovery methods. The high interest rates and overreach by MFI recovery teams have also played a part in inviting legislative countermeasures.
As the RBI noted in its December 2024 Financial Stability Report, “the micro finance sector is showing signs of stress, with rising delinquencies across all types of lenders and ticket sizes”. Loans that were significantly past due doubled as a share of total microfinance loans from 2.15% in March 2024 to 4.3% in September 2024. Another problem plaguing the sector is the tendency to borrow from multiple lenders, which probably indicates that the debt burden on relatively poor households is rising, or that they are taking new loans to partially pay existing ones. The share of borrowers availing loans from four or more lenders increased from 3.6% to 5.8% over the 2021-2024 period, according to the RBI.
A slowdown in economic growth is the last thing India needs at this juncture. Removing the fetters on consumption, which has always been the largest component of GDP, is perhaps a timely step, and the RBI is playing an important role in supporting this effort. The RBI will, of course, closely monitor the asset quality scenario.
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