External Benchmark - Loan Pricing

Why in news?

An internal Study Group constituted by the RBI has recommended basing external benchmark for setting bank interest rates.

What are the drawbacks of current practise?

• The present loan pricing regime is based on marginal cost of fund based lending rate (MCLR). Click here to know about MCLR.

• The Study Group has noted that MCLR is calculated based on banks’ internal factors such as cost of funds.
• These internal factors are insensitive to changes in the policy interest rate or repo rate.
• Though MCLR includes repo rate, the effect of change in repo by RBI is not fully translated to the public.
• It has also been found that banks deviated from the specified methodologies for calculating the rates.
• Arbitrariness in calculating the MCLR and spreads charged over them has thus undermined the integrity of the interest rate setting process.

What are the suggested measures?

• Benchmark - The study group has cited some 13 possible options as external benchmarks for determining interest rates.
• The group has shortlisted 3 among these, one of which is to be selected by the RBI. Those are-

1. T-Bill rate
2. Certificates of Deposit (CD) rate
3. RBI’s policy repo rate

• It has been recommended that all floating rate loans extended beginning April 1, 2018 could be referenced to the selected external benchmark.
• Banks may be advised to facilitate existing loans to shift to new benchmark without any conversion fee or any other charges within one year of its introduction.
• Duration - It suggested that lending rates should be reset once every quarter, from the current practice of once a year.
• Interest Rate Spread - Also, the decision on the interest rate spread over the external benchmark should be left to the commercial judgment of banks.
• However, the spread fixed at the time of sanction of loans to all borrowers should remain fixed all through the term of the loan.

Quick Facts

Interest rate spread

• Spread refers to the difference in borrowing rates and lending rates of financial institutions.
• In other words it is the interest yield on earning assets such as a loan minus interest rates paid on borrowed funds.

T-Bill Rate

• Treasury Bills are government bonds or debt securities with maturity of less than a year.
• T-Bill Rates are determined by the central bank and used as a primary instrument for regulating money supply and raising funds.

Certificate of Deposit

• A certificate of deposit (CD) is a savings certificate with a fixed maturity date and specified fixed interest rate.
• A CD restricts access to the funds until the maturity date of the investment.

Source: The Hindu