Unpacking RBI’s Concerns Over Rising Personal Loan Disbursements by Banks

The Reserve Bank of India (RBI) has recently tightened the norms for personal loans disbursed by banks and non-banking financial companies (NBFCs) in order to curb the risks arising from the rapid growth of unsecured lending in the country. The central bank has increased the risk weights for personal loans, which will require lenders to set aside more capital for such loans. It has also imposed stricter guidelines on the disbursement, verification and collection of personal loans, especially those offered through digital platforms.

Why RBI is Worried About Personal Loans?

Personal loans are loans that are given to individuals for various purposes, such as consumption, education, medical expenses, travel, etc. They are usually unsecured, meaning they do not require any collateral or guarantee from the borrower. They are also typically short-term and have higher interest rates than secured loans.

Personal loans have witnessed a sharp increase in demand and supply in India in the past few years, driven by factors such as rising income levels, easy availability of credit, digital penetration, changing consumer preferences and aspirations, and the impact of the Covid-19 pandemic. According to a report by ETBFSI.com, personal loans jumped 42% in FY22, with NBFCs leading in disbursements. NBFCs disbursed a total of 120 million loans from March 2021 to March 2022, reporting a 64 per cent increase, compared to the previous fiscal year.

However, this growth also poses significant challenges for the financial stability of the system, as personal loans are inherently risky and prone to defaults. Some of the risks associated with personal loans are:

• High leverage: Personal loans can lead to over-indebtedness among borrowers, as they may take multiple loans from different lenders without proper assessment of their repayment capacity. According to a report by UBS, borrowers with more than five personal loans rose from 1% in 2018 to 7.7% in March 2023.
• Low quality: Personal loans can attract borrowers with weaker credit profiles, who may not have access to other forms of credit or may have poor repayment history. According to UBS, new disbursement of personal loans to borrowers with weaker credit profiles accounted for 22% of disbursements.
• Fraud and malpractice: Personal loans can be subject to fraud and malpractice by both lenders and borrowers, especially in the digital space. There have been instances of lenders using coercive and unethical methods of collection, such as harassment, intimidation, blackmail and violence. There have also been cases of borrowers using fake or forged documents, identity theft, multiple borrowing and wilful default.
• Regulatory arbitrage: Personal loans can be used to circumvent the regulatory norms applicable to other types of loans, such as home loans, vehicle loans or business loans. For example, some lenders may offer personal loans for specific end-uses that are otherwise regulated by RBI or other regulators, such as real estate or gold purchase. Some borrowers may also use personal loans for purposes that are prohibited or restricted by law or regulation, such as gambling or money laundering.

What RBI Has Done to Address These Risks?

In order to address these risks and ensure prudent lending practices in the personal loan segment, RBI has issued a circular on November 16, 2023, which prescribes the following measures for banks and NBFCs:

• Higher risk weights: RBI has increased the risk weights for personal loans from 100% to 125%, which means that lenders will have to set aside more capital for every rupee of personal loan they give out. This will increase the cost of lending and reduce the profitability of lenders. It will also discourage excessive lending and encourage better risk management.
• Stricter disbursement norms: RBI has mandated that all personal loan disbursements shall be made into the bank account of the borrower, except for certain exceptions covered under statutory or regulatory mandate or specific end-use. This will prevent cash disbursements that can be misused or diverted by borrowers or intermediaries.
• Enhanced verification process: RBI has directed that all personal loan applications shall be verified through multiple sources of information, such as credit information companies (CICs), Aadhaar authentication, income tax returns (ITRs), bank statements, etc. This will ensure proper due diligence and verification of the identity, income and creditworthiness of borrowers.
• Improved collection practices: RBI has stipulated that all personal loan collections shall be done in a fair and transparent manner, in accordance with the Fair Practices Code (FPC) and the Code of Conduct (CoC) issued by RBI and industry associations. This will protect the rights and interests of borrowers and prevent harassment and abuse by lenders or their agents.

What Will Be the Impact of These Measures?

The measures taken by RBI are expected to have a significant impact on the personal loan market in India, both in the short term and the long term. Some of the possible implications are:

• Reduced growth: The personal loan segment may witness a slowdown in growth, as lenders will become more cautious and selective in lending, and borrowers will face higher interest rates and stricter eligibility criteria. According to analysts, the tighter norms may impact Paytm’s break-even timelines if there is a slowdown in loan disbursals. Aditya Birla Finance and IIFL may need to infuse capital after the tightening of capital norms by RBI.
• Improved quality: The personal loan segment may see an improvement in the quality of loans, as lenders will adopt better underwriting standards and risk management practices, and borrowers will have more awareness and responsibility towards their debt obligations. This may reduce the delinquency and default rates and improve the asset quality and profitability of lenders.
• Increased competition: The personal loan segment may experience increased competition, as lenders will try to differentiate themselves on various parameters, such as product features, pricing, customer service, technology, innovation, etc. This may benefit the borrowers who have good credit profiles and repayment capacity, as they may get access to more options and better deals.
• Enhanced regulation: The personal loan segment may face enhanced regulation, as RBI and other regulators will monitor the developments and trends in this space more closely and intervene as and when required. This may ensure more transparency, accountability and compliance in the sector.

Personal loans are an important source of credit for millions of Indians who need funds for various purposes. However, they also pose significant risks for the financial stability of the system, as they are unsecured, short-term and high-cost loans. RBI has taken proactive steps to tighten the norms for personal loans disbursed by banks and NBFCs in order to curb these risks and ensure prudent lending practices. These measures will have a significant impact on the personal loan market in India, both in the short term and the long term. They will reduce the growth, improve the quality, increase the competition and enhance the regulation of the segment. They will also protect the interests of both lenders and borrowers and promote responsible borrowing and lending behaviour.