RISK WEIGHTS Syllabus GS Paper 3 - Economy)

Context: The Reserve Bank of India (RBI) raised risk weights on specific consumer credit categories to 125% from 100% starting October 1, 2023, necessitating banks and NBFCs to allocate additional capital for these loans.

Capital Adequacy Ratio (CAR)

• About: It is the ratio of a bank’s capital in relation to its risk weighted assets and current liabilities. It is decided by central banks and bank regulators to prevent commercial banks from taking excess leverage and becoming insolvent in the process.
• Formula:

oCapital Adequacy Ratio = (Tier I + Tier II + Tier III (Capital funds)) /Risk weighted assets.

oThe risk weighted assets take into account credit risk, market risk and operational risk.

• Required CRAR: The Basel III norms stipulated a capital to risk weighted assets of 8%. However, as per RBI norms, Indian scheduled commercial banks are required to maintain a CAR of 9% while Indian public sector banks are emphasized to maintain a CAR of 12%.

RBI Proposal

• Credit Risk Defined: It pertains to the risk faced when a borrower fails to meet obligations or defaults on commitments.
• Indicator Significance: It serves as an indicator of the essential holding that lenders should ideally maintain to balance associated risks.
• RBI Directive: The RBI has directed an increase in this crucial metric.
• Objective: The primary goal of effective risk management by banks is to maximize returns by keeping credit risk exposure within acceptable parameters.