BQ Explains: How Lending Rates Linked To An External Benchmark Will Impact Borrowers And Banks
What can banks and their borrowers expect as external benchmark linked rates become the norm
The Reserve Bank of India (RBI) has made it mandatory for banks to link new floating rate loans to retail borrowers and micro, small and medium enterprises (MSMEs) to an external benchmark, starting October 1.
Banks can choose one of the following benchmarks:
- RBI’s repo rate
- Three-month treasury bill yield
- Six-month treasury bill yield
- Any other benchmark approved by Financial Benchmarks India Pvt. Ltd.
Banks can only use one of these benchmarks within each product category.
Customers will be charged a spread over and above the benchmark. While banks will have complete freedom in determining that spread, they can only change the credit risk premium charged to borrowers if the credit profile of that customer changes materially.
External-benchmark linked loans should be reset every three months, the RBI said.
Existing borrowers can switch from an MCLR -linked loan rate to an external benchmark-linked rate, provided they are eligible for pre-payment of their loans. While the RBI’s circular applies to banks so far, housing finance companies may also have to move to external benchmark linked rates soon in order to stay competitive.
What Does This Mean For Borrowers?
Borrowers in India have often complained about the lack of transparency in the manner in which banks fix interest rates and how the change in these rates is determined.
An external benchmark-linked rate will provide greater transparency.
You can now compare products across lenders by looking at which benchmark they are using and what is the spread they are charging you over and above that benchmark.
You would also know that your interest rate and EMI would move in tandem with the chosen benchmark. So if you have picked a loan linked to the RBI’s repo rate, a cut or a rise in that rate would impact your EMI payments directly.
Borrowers will also need to be more mindful of their own credit quality. Since the credit premium charged by banks will be linked to the borrower’s credit score, any change in that score could impact lending rates.
While the transparency will be welcome, borrowers may also need to weigh the impact of increased volatility.
Benchmark rates, such as the RBI’s repo rate can move down but it can also move up. Borrowers will need to plan their EMI payments in a way that they are in a position to withstand any sudden increase in rates as well. In their interactions with the RBI before the introduction of this new loan pricing system, banks had cautioned that volatility in rates could lead to increased defaults.
Will Lending Rates Fall?
In the near term, though, interest rates in the economy are on a downtrend. As such, new borrowers will be able to avail of lower rates. Existing borrowers can also switch to these lower rates, without a fee but with some administrative charges imposed by banks.
Ahead of the announced, some public sector banks had introduced repo rate-linked loan products.
State Bank of India, Punjab National Bank, Oriental Bank of Commerce, Bank of India, Union Bank of India are some of the lenders that have introduced external benchmark-linked loans selectively. Private banks, barring Federal Bank and IDBI Bank, have stayed away from such products but will need to introduce them starting October 1.
A Credit Suisse comparison of rates on MCLR-linked loans and repo-rate linked loans shows that the latter are much cheaper at this stage. A repo-rate linked loan at SBI, for instance, can be availed at 8.2 percent while an MCLR-linked loan will bear an interest rate of 8.8 percent or more.
Will Deposit Rates Be Impacted?
The loans banks give out are on the asset side of a lender’s balancesheet. On the liabilities side are deposits.
If a part of a bank’s asset base is linked to an external benchmark, will lenders link a part of their deposits to the benchmark as well?
Earlier this year, State Bank of India said that the savings deposit rate will be linked to the repo rate for accounts which hold more than Rs 1 lakh. This announcement was made at the same time as the lender introduced some repo rate linked lending products.
Since then, however, in order to protect depositors from a sharp fall in deposit rates, SBI put a floor on its savings deposit rate at 3 percent.
It is possible that banks will introduce bulk deposits linked to an external benchmark. However, the impact of this may be restricted to corporate depositors since bulk deposits are high value deposits of Rs 2 crore or above.
What It Means For Banks?
Banks could see a drop in their net interest margins as they move to external benchmark-linked loan products.
According to Credit Suisse, lenders like ICICI Bank and Axis Bank will see a larger impact on their books, with 25-35 percent of their loan book likely to be linked to an external benchmark. HDFC Bank and IndusInd Bank would be more insulated since most of their existing book is fixed rate.
“This is likely to add to NIM pressures and put earnings at risk, though given it is only on incremental business, near term earning impact would be limited,” Credit Suisse analysts said in their report.
Banks would need to hedge their losses by conducting more corporate lending on the marginal cost linked lending rate and trading in interest rate derivatives, CLSA analysts said in their report on Thursday.
According to Barclays, banks may choose to charge a high administrative fee to existing customers looking to switch to external benchmark linked loans,thus potentially offsetting the benefit of the new structure. ‘’The linking to benchmark rates may lead to spreads being raised by banks to protect their margins,” Barclays said.