RBI's Proposal on Loan Pricing - External Benchmark

What is the issue?

The Reserve Bank of India (RBI) has proposed linking the interest rates charged by banks on loans to the external benchmarks.

What is the current practice?

• Currently, interest rates on loans are linked to internal benchmarks.
• All loans such as for car and home disbursed from April 1, 2016 are linked to marginal cost of funds-based lending rate (MCLR).
• The MCLR-based regime had replaced the earlier base rate regime.
• The shift was to provide transparency in the transmission of monetary policy decisions.
• MCLR is an internal benchmark rate that depends on various factors such as fixed deposit rates, source of funds and savings rate.
• The price of loan comprises the MCLR and the spread or the bank's profit margin.

What is the concern with MCLR-based system?

• The biggest problem with the current system is the lack of required transmission of policy rates. Click here to know more.
• The internal benchmark is not influenced solely by the policy rate cut but depends on a variety of factors.
• So, policy rate cuts often do not reach the borrowers i.e. when the RBI cuts repo rate there is no guarantee a borrower will get the benefit of it.
• Also, the MCLR system is opaque since it is an internal benchmark that depends on the way a bank does its business.

How will the new system work?

• The new system will come into effect from April 1, 2019.
• Banks will then have to link their lending rates charged on different categories of loans with an external benchmark instead of MCLR.
• The RBI has given the following options to banks:

1. RBI repo rate
2. the 91-day T-bill yield
3. the 182-day T-bill yield
4. any other benchmark market interest rate produced by the Financial Benchmarks India Pvt. Ltd

• One of these benchmarks will be used to decide the lending rate in addition to the spread.
• Banks will be free to decide their spread value but it will have to be fixed for the tenure of the loan.
• However, it can change if the credit score of the borrower changes.
• The interest rates under the new system will change every month. 

How will it benefit borrowers?

• It will help better transmission of policy rate cuts i.e. an RBI rate cut will immediately reach the borrower.
• It will make the system more transparent since every borrower will know the fixed interest rate and the spread value decided by the bank.
• It will help borrowers compare loans in a better way from different banks.
• Under the new system, a bank is required to adopt a uniform external benchmark within a loan category.
• This will ensure transparency, standardisation and ease of understanding for the borrowers.
• This would mean that same bank cannot adopt multiple benchmarks within a loan category.

Source: Economic Times

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.