The Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) in its February monetary policy decision cut the policy rate by 25 basis points to 6.25 percent. The lower cost of liquidity to the banking system will eventually reduce the cost of borrowing for productive sectors. The RBI also changed its policy stance from calibrated tightening to neutral, suggesting that the RBI is inclined to cut rates further if inflation remains low. The announcement brought cheer to the markets especially the financial services sector.
This was not all. Besides the unexpected cut in interest rate and the change in its monetary policy stance, the RBI also signalled a welcome shift in its approach towards the Non-Banking Financial Institutions (NBFCs) sector. Specifically, the RBI decided to allow the benefit of the credit ratings to all NBFCs in the matter of the risk weight applicable on their borrowings from banks, against the earlier dispensation where this benefit was restricted to a narrow sub-category of NBFCs, viz. Asset Finance Companies.
Before going further, please recall that all banks are required to maintain a specified minimum capital adequacy ratio (CAR) which is a measure of a bank’s capital, expressed as a percentage of a bank’s risk weighted credit exposures. Also known as capital-to-risk weighted assets ratio (CRAR), it protects depositors and promotes the stability of financial systems globally by ensuring that banks always maintain a certain minimum level of capital, i.e. their own money, and that they do not rely too much on leverage or borrowed funds.
Coming back to RBI’s recent changes, earlier, a bank was required to maintain 100 percent of risk weighted capital for lending to most NBFCs. Now, the risk weight will be determined by the credit rating of the borrowing NBFC and will range from 20 percent risk weight to 50 percent for higher rated NBFCs. This has been done by merging three categories of NBFCs viz. Asset Finance Companies, Loan Companies, and Investment Companies into a new category called NBFC – Investment and Credit Company (NBFC-ICC). This new category will enjoy the benefit of credit rating when availing the bank funding. In fact, all NBFCs except CICs would now get the benefit of risk weights, depending on their current credit rating.
The shift in the approach allows banks to increase their credit flow to the NBFCs sector at a lower cost as the capital required to be set off against these loans is reduced. Exposures of banks to all rated NBFC-CICs would get the benefit of risk-weight as per the ratings assigned by the accredited rating agencies. For example, bank’s exposure to an NBFC like Manappuram Finance, which has AA+ credit rating would now attract only 30 percent risk weight as against the earlier 100 percent risk weight. This reduction in risk-weight would require banks to maintain lower capital against their exposure which enables banks to increase their lending to better-rated NBFCs at a lower rate of interest as their cost comes down.
A simple back of the envelope calculation indicates that NBFCs can easily expect a reduction in their cost of borrowing from banks of over 50 bps from the reduced risk weights alone. Earlier banks were required to maintain Capital to Risk Weighted Asset Ratio of 9 percent and capital conservation buffer of 1.875 percent. The total capital a bank had to keep is 10.875 percent. That means, for every Rs.100 that the bank lends in a 100 percent risk weight scenario, it was required to set apart capital of Rs.10.88.
Under the new norms, when the bank lends to AA+ rated NBFC-CIC, they would now have to provide only 30 percent of earlier capital requirement, i.e. 30 percent of Rs.10.88. Therefore, capital requirement would now be only Rs. 3.26, releasing capital of Rs.7.61 for additional lending. Assuming the cost of capital of a bank at 6 percent, the reduction in the capital requirement would allow it to increase the lending by more than 3 times (thereby earning more interest income) due to lower capital requirement. The bank would not only save on the capital cost but also earn higher interest income even at a lower lending rate.