Interest Rate Linked to External Benchmark – SBI Decision & Its Impacts
The proposal to link interest rates of retail loans and loans to SME sector was announced by the Reserve Bank of India (RBI) during the monetary policy in December 2018. The guidelines on this methodology are yet to be announced by RBI. Meanwhile, State Bank of India (SBI) in a smart move announced its decision to switch to external bench marking for interest payable on balance in savings accounts and interest chargeable for cash credits (CC) and overdraft (OD) accounts. With this move, SBI has become the front runner in transmission of interest rate to market.
SBI decides to link interest rate to External Benchmark
As per the announcement made by SBI, it will link its interest rates as shown below, effective from May 1, 2019.
a. Interest rates on savings accounts with balances above Rupees one lakh – 2.75 per cent below RBI’s Repo rate
b. Interest rate on cash credit (CC) and overdraft (OD) accounts – Minimum 2.25 per cent over RBI’s Repo rate
However, loans and SB deposits below Rs 1 lakh will continue to have interest rates linked to the present marginal costs for funds-based lending rates (MCLR). Since present Repo Rate is 6.25%, the SB accounts above Rupees one lakh will continue to have the present interest rate 3.50% itself. At the same time, minimum CC/OD account interest rate will become 8.5%.
Why is the decision of SBI on interest rate important?
RBI reduced Repo Rate by 200 basis points (2%) between 2015 and 2017. Yet, not much impact was felt in the market, as banks declined to pass on the full benefit to the market. Banks have been blaming the high cost of legacy deposits with them, for not effecting quick transmission. The attempt by SBI can be considered as a step in addressing this issue by making the interest rate on SB accounts also floating.
Wii SBI move bring about drastic changes in interest rate scenario?
The move can be considered as a good move in right direction. However, it is unlikely to bring sudden changes in the market for various reasons.
1. Excluding a few leading banks, the major resource for lending is term deposits. Term deposits constitute 50-70 per cent of deposits for many banks. In term deposits, banks are bound to pay interest at contracted rate till expiry of contracted tenure. For these deposits, the rates will continue to be in the old pricing system till expiry of the tenure. On asset side too, banks will not be in a position to reprice the existing interest rates till the time of renewal/ next interest reset date.
2. Even in the case of SBI, the SB portfolio is only in the range of 35% of total deposits (Of this itself, a major portion is below Rs.1,00,000 category). With this logic, for every 25 basis point reduction in interest rate, SBI may succeed to pass on only around 5-8 basis points to borrowers. Further, with any reduction in Repo rate the interest rate in SB accounts will become lesser by corresponding reduction. This will cause shifting of at least a portion SB account balance to fixed deposits, where interest rate will continue to be higher.
3. Repo rate is the rate at which RBI is ready to lend to banks. Banks will not be in a position to extend credit at this rate to borrowers. They will have to recover operational cost and profit for investors from the lending and hence will be compelled to add a margin called spread to this rate. This spread depends on the risk profile of the customer. The minimum of ‘minimum 2.25 per cent over RBI’s Repo rate’ become important here, indicating that SBI will charge higher interest for borrowers with increased risk of default.
4. The presence of spread, provides ample scope for banks to tweak the spread as in the existing MCLR regime.
5. At present, credit growth is higher compared to deposit growth and hence banks which offer higher rate only will be able to mobilise resource. Lending at a lower rate in comparison to cost of deposits is a loss making preposition for banks.
6. RBI had announced to release guidelines on linking interest rate to external benchmark by December 2018, but is yet to release. Hence banks are likely to take remain silent till the time they receive the guidelines and compelled to act.
As of now, the decision of SBI may not impact market or decision of other lenders. But, coupled with the decision of RBI, this move can rewrite the functioning of banking system in India in the long run.
External Benchmarking of Interest Rates
