Banks Tip-Toe Towards External Benchmarking Of Corporate Loans

In an attempt to retain top corporate borrowers, who currently have a wide array of financing options, large banks are offering short-term term corporate loans linked to an external benchmark. In most cases, this is the Reserve Bank of India’s repo rate, currently at 4%.

Lenders such as State Bank of India, Axis Bank Ltd. and Union Bank of India are among those who have been offering short-term corporate loans linked to an external benchmark. For now, these products are aimed at borrowers rated AA or above. These loan products allow borrowers to draw bank funding at a cost of around 5.5-6%, which is comparable to borrowing from the bond market today, bankers said.

“To ensure that the well-rated corporate borrower has more reason to come to the bank, we have been offering short term working capital loans linked to an external benchmark to them,” said Rajiv Anand, executive director of wholesale banking at Axis Bank. “Companies which have the ability to borrow from multiple sources have been using this facility to control costs.”

A senior official at Union Bank of India, speaking on condition of anonymity, said the lender has started offering ultra short-term corporate loan products linked to the repo rate to its AAA and AA-rated customers as well as some top government enterprises. The product offers credit for three months and has near-zero default rates owing to the highly-rated borrowers.

“We have seen instances of banks providing either fresh loans or investments to companies by linking the lending rate to an external benchmark,” Anil Gupta, vice president at ICRA Ltd., said. “In the case of loans, banks have to be careful that the effective lending rate does not fall below the prevailing MCLR for such loans. However, they can provide loans at a lower cost, which they are doing.”

While helping banks compete with bond markets better, these products also help banks manage liquidity better, since parking funds in the Reserve Bank of India’s reverse repo window earns them only 3.35%.

By offering rates competitive with the bond markets, banks are able to better sell the advantages of credit they offer vis-a-vis funds raised via debt issues. According to a senior official at State Bank of India, who spoke on condition of anonymity, accessing working capital loans from banks lets a borrower spread borrowings over the year, as compared to the bond market where fundraising usually happens in one or two tranches for a larger amount.

So External Benchmarking Has Worked?

Ahead of the implementation in October 2019, lenders were reluctant to accept external benchmarking of loans as they feared the volatility this would lead to for bank balance sheets. However, the Reserve Bank of India, having experimented with a number of different loan pricing formulas over the years, insisted on it.

For about 15 months now, new floating rate retail loans and small business loans have been linked to external benchmarks ranging from the repo rate to government bond yields. Bankers estimate that for the system, external benchmark linked loans would be in the range of 10-15%, however, an industry-wide figure is not publicly available.

At the country’s largest bank SBI, such loans form about 18% of the outstanding book, with marginal cost-based lending rate still accounting for about 57%, according to CS Setty, its managing director.

While the share of these loans is small, those who moved to such credit have benefited most from the sharp fall in interest rates over the past two years.

According to the RBI’s April Monetary Policy Report, the weighted average lending rate on fresh rupee loans has dropped by 107 basis points between March 2020 and March 2021 compared to a reduction of 115 basis points in the benchmark repo rate during the period. Between February 2019 and September 2019, while the repo rate was cut by 110 basis points, the one-year median marginal cost-based lending rate dropped by 30 basis points, while the weighted average lending rate for fresh rupee loans fell by just 40 basis points for the banking system.

Between October 2019 and March 2021, after the introduction of external benchmarking, the repo rate was cut by 140 basis points, while the weighted average lending rate on fresh rupee loans came down by 138 basis points, suggesting the new loan pricing system has worked better than previous mechanisms such as marginal cost lending rate and base rate among others.

Since the introduction of external benchmarking, private banks reduced their weighted average lending rate most for unsecured personal loans and housing loans, while for state-run banks the widest cut was in auto loans and MSME lending.

According to Setty of SBI, the bank has passed on 100% of the policy rate cuts to its customers on the external benchmark-linked lending rate, while in the case of customers on marginal cost-based rates, the transmission has been around 80%.

“We offer our home loan customers a chance to move to the external benchmark linked lending rate for a small fee. However, customers haven’t shown much interest in such a swap because a home loan is a long-term product and they can switch only once during the period of the loan,” Setty said. “So when the cycle turns, they may have to face quicker transmission than under MCLR.”

Anand of Axis Bank shares the sentiment.

“While the transmission is fast through the external benchmarking system in a cycle of easing, it’s going to be as fast when the cycle turns as well,” he said. “Some of the more cautious borrowers are choosing to stay with MCLR, which changes only twice a year.”

Do PSU Banks Have The Edge?

Interestingly, data from the RBI’s report shows a wide gap in margins being charged by private banks and government-owned lenders over and above the benchmark rate.

An analysis of the median spread over the policy repo rate shows that 12 public sector banks charged a lower spread for retail and MSME loans, as compared with 20 private banks which are active in the system.

In the case of home loans, the median spread over the external benchmark stood at 3.6% for public sector banks, while it was nearly double at 6.7% for private banks. Similarly, in the case of education loans, public sector banks charged a median spread of 4.5%, while private banks charged 7.4%.

The spread in externally benchmarked loans typically consists of two components. The first is based on the concerned bank’s business strategy, market competition, embedded options in the loan product, market liquidity of the loan etc. The second component is the credit risk premium which takes into account the riskiness of the borrower determined by credit scoring or internal ratings of banks.

A public sector bank would have the benefit of lower cost due to a large number of sticky customers who have remained with the bank despite deposit rate cuts. “It would always have the edge in providing lower-cost loans to retail customers over a mid-sized private bank,” Gupta of ICRA said. “But we must also remember that customers today are sensitive to service quality and additional services that private banks are better geared to provide.”