Rationale for risk weights

B. Venkatesh

PUBLIC-SECTOR banks propose to extend loans to the Unit Trust of India (UTI) for it to redeem units in the US-64 scheme. Such loans are likely to attract 100 per cent risk weights for banks. What is the rationale for providing such risk weights?

Risk weights are norms banks follow for their 9 per cent capital adequacy purposes. It enables banks redeem deposits even if the loans turn bad.

Suppose Bank `A' receives deposits of Rs 500 crore and lends the money to a steel company. What will happen if the steel company defaults on its repayments? Bank `A' will be unable to repay the depositors, as it will not have the money. Such defaults will turn depositors away from banks. And that is not good for the economy. Why? If banks do not receive enough deposits, they cannot provide credit for businesses to make project investment.

It is, therefore, important to lower bank defaults, and this is where risk weights help. Banks need to provide a risk weight of 100 per cent of the 9 per cent capital adequacy norm if money is lent to companies. The risk weights in India are lower if banks lend to the government.

In the above example, Bank `A' will provide risk weight of 100 per cent of 9 per cent as it is lending to a steel company. It can, thus, lend only Rs 45 crore against deposits of Rs 500 crore.

But how can a reserve of Rs 45 crore (9 per cent of Rs 500 crore) prevent Bank `A' from defaulting on its deposits should the loan turn bad? It cannot if the entire Rs 500 crore turns bad, but that may not happen.

Moreover, banks receive deposits, redeem some and lend money on a daily basis. The regulators, therefore, do not expect banks to face redemptions of more than 9 per cent of the deposits under normal conditions. Banks wanting to assign 100 per cent risk weight for loans extended to the UTI has to be viewed in this light.