Taking a loan? Rates to now be linked to external benchmark

RBI deputy governor N.S. Vishwanathan said linking rates to external benchmarks will assure transparency. Photo: Abhijit Bhatlekar/Mint

RBI deputy governor N.S. Vishwanathan said linking rates to external benchmarks will assure transparency. Photo: Abhijit Bhatlekar/Mint

Mumbai: Banks must set their interest rates for new loans against an external benchmark beginning 1 April, RBI said Wednesday, in its latest attempt to bring transparency into loan pricing.

The new rule will apply to all new retail loans and small business loans with floating rates. Existing loans will not be affected. Currently, banks price their loans against their marginal cost of funds-based lending rate (MCLR).

“This will bring a lot more transparency in (setting) interest rates,” RBI deputy governor N.S. Vishwanathan told reporters.

Banks are free to decide on the external benchmark—it could be the RBI’s policy repo rate, 91-day treasury bill yield, 182-day treasury bill yield or any other benchmark market interest rate produced by Financial Benchmarks India Pvt. Ltd (FBIL), including the Mumbai interbank offered rate, or Mibor. The central bank will announce all the specified benchmarks towards the end of this month.

The way banks set interest rates is critical for the smooth transmission of policy rates. To make this process transparent, RBI has, over the years, directed banks to price their loans against their benchmark prime lending rate, base rate, and, finally, MCLR. This, though, is the first time that banks have been asked to price their loans against an external benchmark.

FBIL, jointly owned by fixed income money markets and derivatives association, Foreign Exchange Dealers Association of India and the Indian Banks’ Association (IBA), was formed in 2014 as a private limited company. Its aim is to develop and administer benchmarks relating to money market, government securities and foreign exchange in India.

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Banks are also free to fix the spreads over the benchmark rate at the beginning of the loan cycle. However, this spread, RBI said, should remain unchanged through the life of the loan, unless the borrower’s credit assessment undergoes a substantial change.

The RBI move comes in the face of opposition from banks to an external benchmark. In October 2017, the central bank had released the report of an internal study group to review the working of the MCLR system. The IBA opposed the move, writing to RBI that the MCLR system is working well and that it should continue.

“All banks, barring some foreign banks, are of the view that none of the three external benchmarks recommended by the Study Group can be adopted…since banks’ funding cost is not related directly to any of the proposed external benchmarks,” a press release by RBI had said on 9 February.

Still, while RBI’s move is expected to impart transparency, the various risk spreads used by different banks, over and above the specified rates, are likely to stay opaque.

Bankers Mint spoke to said that moving away from MCLR will only affect new loans to home buyers and small and medium enterprises. They added that there is no deadline to discontinue the MCLR system for existing loans.

“Most of the retail portfolios like personal loans and auto loans are fixed rate loans, and, therefore, there will be no change. However, the external benchmark will be applicable to our housing loan book which in currently under the MCLR regime, akin to a majority of our total loan book,” said P.K. Gupta, managing director, State Bank of India (SBI).

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Gupta agreed the new pricing methodology will make the rate-setting exercise transparent because banks will have to use the specified external benchmark.

However, a chief executive at a mid-sized public sector bank disagreed that this will bring in more transparency. “We already disclose our MCLR rates every month so people are aware of what the spreads of each bank is,” the banker said.

While it is fairly certain that this move will have some effect on bank margins, bankers said they would not be able to quantify it at the moment. However, a look at these benchmarks and existing MCLR rates indicate a margin squeeze if spreads and deposit rates remain constant.

Ashvin Parekh, managing partner, Ashvin Parekh Advisory Services, termed it a laudable move that will push banks towards discouraging long-term deposits as they will have to calibrate rates according to very fluid benchmarks.

For instance, SBI’s one-year MCLR between April 2016 and November 2018 stood at 7.95-9.2%. In the same period, RBI repo rate stood between 6% and 6.5%; government 91-day treasury bill yield was 5.82-7.19%, and 182-day treasury bill yield was 5.97-7.45%. Therefore, some experts believe that banks will either increase their spreads or lower interest rates on their deposits, since most banks in India depend on customer deposits to fund loans.

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