External Benchmarking of Interest Rates

Fixing interest rate in relation to an external benchmark was proposed by RBI while announcing the monetary policy review held on December 5, 2018. Banks were suggested to adopt this method for new floating rate loans extended by banks under retail loans and Micro and Small Enterprises.  It is a major deviation from the existing practice of linking interest rate to internally derived rate. By forcing banks to link interest rate to external benchmark, RBI expects to ensure better transmission of policy rate changes announced by the regulator during monetary policy reviews.  The effective date of implementation is April 1, 2019.

What is the existing benchmark for interest rates for floating rate loans?

From April 1, 2016 banks are linking floating rate interests applicable for retail loans and loans for business purposes to Marginal Cost of Lending Rate, popularly known as MCLR.  This methodology was proposed by RBI to replace Base Rate (BR). MCLR is an internally derived benchmark and it is calculated by considering the following parameters:

Marginal Cost of funding

Negative carry on SLR and CRR

Operating costs

Tenor premium

 

Marginal cost of funding is arrived by considering the interest rate given by banks for various kinds of deposits like term deposits, savings bank accounts, current accounts etc, return on networth, and cost of borrowing like repo rate, other borrowing rate etc.

 

Why did RBI propose external benchmarking methodology?

 

Changes in policy rates is a quantitative control available with RBI to ensure optimum money supply in the market and control inflation. RBI announces periodical changes in policy rates with an intention to get the same reflected in market. Based on the past trends, it was assessed that banks failed in ensuring interest rate transmission. Further, there was ample scope for banks to manipulate the MCLR interest rate as calculation of the same lacks transparency.

 

RBI has been making attempts over a period to ensure proper interest transmission. Prime Lending Rate (PLR), Benchmark Prime Lending Rate (BPLR), Base Rate (BR) and Marginal Cost of Lending Rate (MCLR) have been efforts in this regard. Proposal to link interest rate to external benchmark is the latest attempt by RBI to ensure smooth interest transmission.

 

What is the proposal from RBI on external benchmarking?

 

According to the directive from RBI, banks are required to link floating interest rate to one of the following external benchmarks-

a.       Repo Rate announced from RBI from time to time

b.      Government of India 91 days Treasury Bill yield.

c.       Government of India 182 days Treasury Bill yield

d.      Any other benchmark rate announced by Financial Benchmarks India Pvt Ltd (FBIL). The rates against both b&c are also maintained by FBIL.

 

RBI has proposed that this should be implemented for all new floating rate personal loans and loans to Micro and Small Enterprises. Retails loans like housing loans, auto loans etc. come under personal loan category.

 

How does interest rate linked to external benchmark affect borrowers?

 

1.       It will ensure better interest rate transmission. Interest rates on loans will reflect changes in policy rates.

2.       Interest rates of banks and the additional amount charged (spread) by various banks under same category of loans can be easily compared by borrowers as interest rates are linked to publicly known external benchmarks.

3.       Customers will have better bargaining power as external benchmark rate is known.

4.       As interest rates become more transparent, competition among banks may increase compelling efficiency in operations.

At the same time, customers should expect more frequent changes in interest rates and EMIs based on the changes in external rates. Further, in an interest increasing scenario, the proposal can become disadvantageous. As per the proposal, only new borrowers are covered.

RBI had announced to publish guidelines for banks by December 2018, but has not published so far.   Final decision by banks will be based on these guidelines. It is expected that guidelines applicable for existing customers also will be announced by RBI. RBI might want to address the challenges faced during previous interest rate regimes and that could be the reason for delay.  Meanwhile, SBI has announced changes in interest rate on SB accounts and certain category of loans by linking interest rate to Repo rate, a proposed external benchmark.     Interest Rate Linked to External Benchmark – SBI Decision & Its Impacts