In a year marked by inflation and economic challenges; interestingly, there has been a surge in the discretionary spending on consumer products by India’s growing middle class. One of the driving factors behind this consumption uptick is the improved access to unsecured loans. The rise of fintech and digital lenders has played a pivotal role in improving the ease of borrowing especially for the tech-savvy Gen Z customers. Further, advent of data analytics and increased focus on customer centricity has ushered in innovative products including no-cost EMI options. According to a study, ~75% of customers used credit to acquire consumer durables and home appliances.

In a post-covid era, banks and NBFCs have witnessed exponential growth in unsecured lending with inquiry volumes increasing across product categories. Unsecured loans such as personal loans and credit card receivables have been a driving force (nearly doubled and growing at an avg. CAGR of 21% each since COVID-2020), contributing to ~30% of the incremental growth in retail loans and ~14% in overall loans as of Sept-23. Most lenders have managed to register 20%-60% growth in their unsecured loan portfolio between FY22 and Q2 of FY24.

Paradoxically, the asset quality of the unsecured retail loans has not shown any deterioration so far. Notwithstanding the low level of delinquencies, there are some early signs of risk build up in consumer credit. RBI in its recently published FSR highlighted some datapoints which indicate:

a) The transition matrix for consumer loans and personal loans showed an increase in their risk profiling (evidenced by downgrades exceeding upgrades)

b) Declining standards of underwriting (indicated by relatively high vintage delinquency of personal loans, at 8.2%)

c) Multiple lending lines, with 43% of the customers availing consumption loans already had three live loans at the time of origination and ~30% of customers have taken more than three loans in the past six months; and

d) Overleveraging, with 7% of customers availing personal loans below Rs50k already had at least one overdue personal loan.

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While India’s household credit to GDP at ~15% (as of March-2023 vs. 5.5% in March-2020), is much lower than its peers, the rise in non-mortgage household credit to 8% as of March-2023 from 5.5% in March-2020, warrants a caution especially given the lowest debt service ratio of Indian households in the world. In fact, a report by credit bureau TransUnion CIBIL reveals that the middle-class young consumer (age group less than 35 with credit scores of 620-72) is the primary driver behind the surge in demand for unsecured loans with 51% share (vs. ~45 in March-2020) in origination terms. This poses the risk of over-leveraging and subsequent defaults in an economic downturn. Further, the ‘growth above all’ mindset and a lack of physical collections infrastructure raises concerns over a potential credit event.

The RBI, from time to time, has expressed discomfort at the expanding share of unsecured loans in the system. Banks are increasingly taking double exposure to NBFCs that are heavily skewed towards consumer lending. In the wake of this, in a recent guideline, RBI announced a sharp increase in capital requirement on unsecured retail loans for both banks and NBFCs as well as on banks’ credit exposure to NBFCs (excluding Housing Finance Companies). Broadly, the RBI now prescribes higher risk-weights, to the extent of 25pps in these two segments.

RBI’s action is a clear sign that the regulator wants to advocate disciplined growth in these segments. The current measures have the potential to reduce system loan growth from the current ~16% to 13%-14% over the next 12 months. Also, there have been concerns about higher delinquencies in low-ticket personal loans, but clearly the central bank has not made any such distinction and has taken measures to curb the growth across retail segments. Small-ticket unsecured loans (<INR50,000), where NBFCs have dominant market share, comprises only ~0.5% of the overall system loans. Management commentary, bureau data and disclosures from individual lenders do indicate a rise in stress in this portfolio but it is not at an alarming level as of now. However, if stress continues to rise in unsecured loans coupled with high growth, the credit cost in the retail segment would likely be on an upward trajectory.

The revised risk-weights will be applicable to both new and outstanding loans. While the spirit of RBI’s measure is to instil prudence, it will impact the capital ratios of lenders and compel them to increase interest rates on such products to mitigate the potential impact on margins. Evaluation of the impact on common equity tier-1 (CET1) and capital to risk weighted assets ratio (CRAR) for top banks indicate that:

1. Risk weighted assets for the top banks are expected to increase by 13%-35% based on their loan mix.

2. Consequently, CET-1/CRAR is expected to decline by 30-110 bps for banks and on an average ~350 bps for leading NBFCs.

3. We also see ~30-50 bps rise in bank lending rates to NBFCs, leading to an overall increase in cost of funds for NBFCs.

For banks, unsecured retail loans and loans to NBFCs have been significant drivers of credit growth, registering 25% and 29% year-on-year growth, respectively (driving 24% of incremental banking sector credit growth, year-to-date as of September 2023).

While the impact on CET-1 ratios would be in the range of 30-110 bps, the effect on large PSU banks (where CET-1 is relatively low) will be more pronounced. For large private banks, even after this adjustment, the capital levels would remain healthy. For most banks, the rise in risk weights does not warrant an equity raise but a possibility of AT-1/Tier-2 capital issue cannot be ruled out.

* Private banks with capital cushion can easily offset this impact by growing in other categories like secured credit, SME or corporate. However, this could exert further pressure on net interest margins (NIMs) in an environment where cost of funds is resetting higher. The only offset to this is the ability of banks to demonstrate pricing power and pass on higher rates to borrowers by increasing spreads. The banks that focus on this outcome will be shielded.

* While lending to NBFCs, banks will likely consider passing on the impact of higher risk weights by raising lending rates. However, any such increase will likely be calibrated as majority the exposure is to highly rated borrowers that have access to alternate sources of funding. Certain banks may look to trim their NBFC exposure given the capital consumption and RBI’s growing focus on concentration of banks’ exposure on NBFCs.

For NBFCs, the impact of higher risk weights is likely to be on both sides of the balance sheet.

* On the asset side, a hike in the risk weights on unsecured loans would impact capital ratios in the range of 30-450bps.

* On the liability side, given the fact that banks are the biggest source of funding for NBFCs (~60%), cost of funds for NBFCs are likely to see an increase of ~10-30bps.

* Lower-rated NBFCs are likely to face a slowdown in funding, especially from private sector banks that are mostly fair-weather friends in a liquidity crunch. Lower-ticket personal loans and lower credit limit on credit cards could further witness a slowdown in coming months.

The full-blown impact of RBI’s measure is yet to fully play out. There could be a potential slowdown in credit flow to the unsecured consumer segment, which has the potential to trigger an asset quality event. Hence, eventually, we will see both banks and NBFCs acknowledge the “regulatory intent” before RBI unleashes more stringent measures like higher standard asset provisioning on certain loan categories and a further increase in risk weights.

The rising exposure to unsecured retail loan could be a reminiscent of spike in asset quality within corporate segment that got triggered post RBI’s asset quality review (AQR) in 2015-16. Although the current exposure of banks and NBFCs within retail unsecured segment may not necessarily be drawing parallels with last NPA cycle, it shall certainly be dealt with more timely preventive measures. Prudent lending practices and continuous portfolio monitoring shall be key to sustain the healthy growth momentum in retail loans segment.

(By Abizer Diwanji, Financial Services Head, EY India; Parag Jani – Associate Director, Financial Services and Shivang Mahajan – Assistant Director, Markets – FS, EY India. Views are personal)