Banks borrow funds from the Reserve Bank of India (RBI) at the repo rate. It is the interest rate at which the RBI lends money to commercial banks against government securities. Lowering of repo rate by the RBI makes banks lend at a lower rate. The Monetary Policy Committee (MPC) of the RBI reviews the repo rate once in two months. This provision was considered to be problematic as individual banks were empowered to fix the rate of interest at their own. Therefore, the RBI, in October 2020, issued a circular, which made the provision for banks to link their retail loans like home loan, vehicle loan, or loan for essential electronics, etc., to external benchmark rates. When banks decide the interest rate they will charge for giving out loans, they set a benchmark below which they will not lend. Over and above this benchmark, banks also charge what they call ‘spread’, which varies across categories. This spread is usually higher for riskier loans, like unsecured loans; and lower for less risky loans, like home loans that are backed by an asset. Until now, these rates were internally decided by individual banks. For a long time, the RBI was unhappy about the rate cuts by banks as per the previous base rates and even marginal cost of fund based lending rate (MCLR). Above all, as the rates were based on internally decided benchmarks, transparency was a great concern. In order to ensure more transparency in lending rates, the RBI has now made external benchmarking as mandatory.
Benchmark rates or reference rates are regularly updated interest rates that are useful basis for all kinds of financial contracts and transactions. Internal benchmark lending rate implies that banks decide their own lending rate.
Under external benchmark lending rate, banks follow the external benchmarks to calculate their lending rate based on cash reserve ratio (CRR), operational expenses, and profit margin.
MCLR is the internal benchmark rate used by banks to fix the interest rate on floating or fixed rate loans. It is the minimum interest rate that a bank can lend at. This internal benchmark, which means the rate is determined internally by the bank depending on the tenor (period left for the repayment of a loan), was problematic. In October 2017, an internal study group of the RBI, headed by Janak Raj, recommended the adoption of external benchmarks to ensure effective policy transmission, after observing that the MCLR failed to deliver. Finally, on September 4, 2019 a circular of RBI directed lenders (banks) to link all new floating rate loans given to borrowers in the personal, retail, and micro, small and medium enterprises (MSME) categories to an external benchmark such as, the repo rate, etc.
This benchmark can be repo rate, or government of India’s three-month treasury bill yield published by the Financial Benchmarks India Pvt. Ltd. This means that every bank will have its own repo linked lending rate (RLLR).
RLLR is the lending rate linked to the RBI’s repo rate. As such, it depends on RBI’s repo rate. For example, if the RBI’s repo rate is 5.35 per cent and is cut by 35 basis points to settle 5 per cent, the RLLR of all banks (having repo rate as the external benchmark) will be reduced by 35 basis points. When repo rate rises, the above situation will be reversed. External benchmark is a benchmark lending rate for floating-rate loans. Floating interest rate moves up and down with the market or an index.
Implications
Now, in the case of home loans benchmarked against the one-year MCLR, lending rates will be changed every year. Under the external benchmark structure, the RBI has mandated that loans are reset at least once in three months. This means that lending rate will be revised much faster. Lending rates change every time the RBI tweaks its repo rate. The RLLR changes from the first of the following month in which the RBI changes its repo rate. Under a regular loan, one that is linked to MCLR, equated monthly instalment (EMI) on home loan will be fairly stable. Even when the lending rate is reset based on the latest MCLR, banks usually change the tenure. This in effect will keep borrower’s EMI steady. Indian lenders, especially private banks and financial institutions, that have been reluctant to pass on the benefit of low policy rates to borrowers, will witness a contraction in their net interest margins (NIMs) as borrowers will migrate to the new rate regime.
Concern
Since the RBI’s stand on exploring the idea of external benchmarks (to arrive at lending rates), banks are panicked as it will bring a large impact on their earnings. The RBI has laid down a minimum three-month reset period for interest rate on loans. While this is good news for borrowers as it will bring in more uniformity and transparency, it will lower banks’ flexibility on loan pricing. This also lowers banks’ ability to manage risk.
The move will surely lower the interest cost on new floating rate loans availed by borrowers to buy cars or homes. On the other hand, it may force banks to start cutting the interest rate they pay to deposit holders.
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