Macronomics: Of Risk Weights, Capital Ratios and the Fuelling of another Housing Bubble

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The RBI has reduced risk weights on housing loans. This is going to create another housing bubble, primarily because it pushes banks to lend to housing versus other things.

First, what did they do?

The risk weights of housing loans have been cut. Housing loans are loans given to individuals to buy (or upgrade) their houses. The risk weights of such loans have been cut. This is a factor in calculating capital adequacy ratios, so technically this means banks that lend to housing suddenly “look” healthier.

How much have they cut by? Here’s the breakdown, by loan size and the amount of loan compared to the value of the house (Loan to Value or LTV):

As you can see – risk weights of loans have been falling and the latest point has cut the higher end of loans (loan size of above Rs. 30 lakh) down substantially.

Note: this risk weight change is only for loans made from now onwards. The older (blue coloured) weights apply to loans made prior to June 7.

What Does Risk Weight Mean?

So banks are constrained by capital. Capital is, in a super-simplified way, whatever they have raised in terms of equity plus whatever they have in terms of retained profits. There are some other elements like if they bought property and it appreciated, then about 55% of that appreciation can be considered capital etc. but that stuff will make your eyes glaze over so I’ll stop here. Capital is just stuff that the bank has in terms of money it doesn’t have to pay back.

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When you have Rs. 100 capital and you lend Rs. 1000, then your Capital Adequacy Ratio – or CAR is 10%. You need about 10% to be healthy. At 6% you become petrifyingingly bad.

Why? Because if you lend out Rs. 1000, and you lose Rs. 40, in one bad loan. Now you have Rs. 960 worth of lending, and only Rs. 60 worth of capital (you’ve lost money so it’s your capital that’s gone).

Now, your CAR is 60/960 = 6.4%. This is low. And at lower than 6% you’re in trouble. So at this point you will be asked to raise more capital and bring it back up to 10%. So you might have to raise Rs. 40 from the market – and dilute yourself – and make up the capital ratio.

RBI though understands that the chances of losing money are less in certain loans. Like the government. So your “assets” (the loans you give) need to be looked at from the perspective of: Are you gonna lose money?

If the loan is to the government, which is what happens when banks buy government bonds, then the risk is near zero. If you lend to a individual personal loan, the risk is high. So what to do?

Enter the term: Capital against Risk Weighted Assets. (CRAR).

Instead of looking at your capital against all your loans, you will be asked to take each loan and look at its risk weight. RBI provides the risk weight for different type of loans from 0% to 100%. Get the total amount of loans made, multiplied by their risk weight, and you have the total risk weighted assets.

The capital against total risk weighted assets (CRAR) needs to be above 9%. Not all banks are above 9%, but we’ll get to that.

What is Capital Then?

Capital for a bank is a combination of:

• Tier 1 capital and

• Tier 2 capital.

Tier 1 capital includes the stuff that we called “equity”. That is – money received against shares, plus whatever it has made as profits over the years. This is called Common Equity Tier 1 (CET1) and is a crucial part of the capital ratio calculations. CET1 to Risk Weighted Assets is a ratio that should be above 6% otherwise RBI gets very antsy.

Tier 1 capital also contains additional stuff like perpetual bonds we have seen recently (Read this post) These are called Additional Tier 1 bonds and typically, they are bonds where principal needn’t be returned, and even interest is only paid in case there is a profit. And the banks can buy them back after some time.

Tier 2 capital is just more stuff that CAN be considered capital. Remember that property owned by a bank which appreciated in value? That additional value is effectively higher capital available to a bank as a “revaluation reserve”. Part of this is allowed as Tier 2 capital. And a bank can also issue certain types of bonds and include them under Tier 2 capital.

Tier 1 + Tier 2 form the total capital of the bank.

So Total Capital / Risk Weighted Assets = CRAR => This should be at least 9%. And Tier 1 needs to be 6%.

Look at the table below, and you’ll see why RBI isn’t quite happy about IDBI bank’s situation. It’s not the end, but it’s looking really lousy for that bank.

So What Does Cutting Risk Weight Do?

When you cut the risk weight of a housing loan, that means that a bank that lends to housing will see a lower “risk weighted asset” number. If I had Rs. 60 capital against Rs. 960 Risk Weighted Assets I have just 6% CRAR.

Assume all my Rs. 960 was lent to housing loans. If their risk weight is cut from 100% to 75%, then my risk weighted assets are now Rs. 960 * 75% = Rs. 720.

My new capital ratio is Rs. 60 / 720 = 8.33%.

I just changed the weights and my CRAR went from an abysmal 6.3% (lousy) to 8.3% (better)!

However, note that the current RBI circular only applies to loans made from now onwards. Meaning, the old loans continue to have the older, higher risk weights. So this change won’t easily rescue banks, but it will help banks cut rates for housing.

And then, Provisioning Cuts!

Every loan, even one where the customer isn’t defaulting, needs a provision of some sort. Provisions eat from your profits, and are a special reserve used against times when a loan goes into default.

That provisioning has been cut to 0.25% for new loans to housing, made from now onwards.

Will this fuel a bubble?

Lowering risk weights for new housing loans means RBI wants banks to lend more to housing.

Housing has been a huge place to lend, for banks. Of all new loans made in FY17, about 28% of all such loans went to housing. Meaning, more than 1/4th of all new credit was given to the housing sector, which is now the second largest in terms of bank exposure.

The largest (Loans to Heavy Industry) is now crippled with bad loans, on account of a big thing: lower risk weights given when lending to Infrastructure earlier. Meaning, they wanted to encourage lending to infrastructure (like steel and power) and that ended up fuelling a huge lending bubble to infra, and that’s hurting banks with bad loans now.

A 35% risk weight to small housing loans, and a 50% weight to large ones (above Rs. 75 lakh) will just pump more money into housing, by banks directly.

This could fuel yet another bubble in real estate, in the future. Simply because people will prefer to buy a house (an unproductive asset for the most part) instead of investing in businesses or in better assets, like stocks or even bonds. Much has been written about the subprime bubble in the US after they reduced the regulatory requirements on home loans. In India we are speaking of a 35% weight on loans worth less than Rs. 30 lakh, which have a pretty solid relationship with lower income borrowers.

However there is a small hope. Banks also have to maintain a 4.5% leverage ratio. Ignore the risk weights, tell us your total exposure and in the leverage ratio we’ll see the Tier 1 capital as a percentage. This limits the usage of risk weights to go berserk.

However, this will still push people into Real Estate (RE) Investing. If RE prices fall, we then have issues of NPAs that will then bog banks again. Instead of pushing the second highest exposure of banks, it might have been better for the RBI to push other kinds of securitized lending instead, where risk weights are 100% or more.

It’s Good For Consumers, But Not So Good for Housing Finance Companies

Banks can now reduce their lending rates for housing loans. Because it’s just more efficient use of capital. And banks can’t charge you a fee if you pre-close your housing loan, so you should absolutely look to shift to a bank if rates are lower. Banks might also shy away from other forms of lending just to avoi

Housing finance companies charge a pre-closure fee. They will now face competition from banks. And if banks cut rates they’ll have to cut rates too, to compete, especially at the lowest end.

Residential housing might see a further push with lower rates. This is undesirable in terms of bubble-potential but it’s a sector that’s politically motivated too – people who own houses or want to, are a huge vote bank. With the Prime Minister saying he wants housing-owned-by-everyone, it’s quite likely we see more such measures.

The flip side? Banks might not cut rates. They haven’t cut rates too much even after having huge amounts of deposits. They are afraid to cut rates now because it impacts all their current borrowers. If there’s no cut from the bank end, nothing changes – and this measure goes to waste.

We hope this post helps you understand how an obscure RBI measure impacts the loan rates a bank can offer you. And how, in this case, this cut in risk weights can have reaching consequences.

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