New Loan Pricing Rules: What’s Good For Customers May Not Be Good For Banks

The Reserve Bank of India has directed banks to change the manner in which they fix lending rates for retail borrowers and small and medium enterprises.

Until now, banks were using their own cost of funds to determine the lending rate charged to different categories of borrowers. But starting April 1, 2019, banks will need to use an external benchmark -- such as the yield on a government bond -- to determine the lending rate to be charged. Banks can decide on the spread (difference) they want to build in over and above the external benchmark, but thereafter they can’t change that spread unless the credit score or credit rating of the borrower changes.

So far, these rules are applicable to banks. The RBI has not said whether and when non-bank lenders would move to this framework.

For borrowers, the new framework will make loan pricing more transparent even though it could bring with it greater volatility in EMIs or monthly payments. For banks, the change could mean the need to manage their own borrowings better and more swings in lending margins.

Why The Change?

Before we look at how the new system will work, a brief background on why we needed a new way to price loans. Over the years, India has moved from the prime lending rate and the benchmark prime lending rate to the base rate and the marginal cost of lending rate.

Each of these have been based on the internal cost of funds of a bank. To be sure, these internal costs are not disconnected from external interest rate benchmarks like bond yields. But a bank’s cost of funds reflects a large number of choices made by the lender including source of funds, rates offered on fixed deposits or savings deposits. Over and above this cost of funds, banks would build in margins and decide on the lending rate.

The problem, in varying degrees, with each of these loan pricing methods was that they didn’t always move in tandem with broader interest rate movements. At least not over a shorter time period. As such monetary policy transmission, as it’s called in central banking parlance, was not as effective as it should be.

Away from the concerns of the regulator, consumers often complained as well. That loan rates rise fast but don’t fall as fast. That old customers are charged rates different from new customers. So on and so forth.

The main reason for these was the lack of clarity in how a loan was priced.

To some extent, the move towards an external benchmark will address both the central bank’s concerns and customer complaints. It will, though, make life tougher for banks.

Good For Customers...

So, how will the new system work? And how will it help customers?

As a start, a bank will need to decide on an external benchmark. The RBI has given banks a few options to choose from:

• RBI’s repo rate
• The 91-day T-bill yield
• The 182-day T-bill yield
• Any other benchmark market interest rate produced by the FBIL (Financial Benchmarks India Pvt. Ltd).

Once a bank picks a benchmark, it will add a spread or margin to it (which determines what the bank earns on the loan) and arrive at the lending rate. Banks have flexibility to determine that spread value but they must keep it fixed for the tenure of the loan unless the credit score of the borrower changes.

This does two things.

One, as a borrower you are more aware of what is impacting your lending rates and EMIs.

Two, since you know that a change in credit score will impact your EMI, you will be more careful to maintain it.

Also since you are now in a better position to understand and compare rates across lenders (since you know the benchmark and the spread), you are probably more likely to make a smarter choice. The transparency will also mean that banks will be less able to throw in hidden costs (atleast into the loan rates) since competition will force them to offer rates which are in line with the broader market.

But...

There are some possible downsides here. The most obvious one being that your lending rates will become more volatile.

Final guidelines from the RBI are awaited but the regulator will most likely prescribe a periodic adjustment in rates based on the movement in the underlying benchmark. For instance, rates could reset every one month in keeping with the frequency of EMI payments. This probably means that customers will need to be prepared for more volatility. If bond yields spike or fall, EMIs will be immediately impacted.

Banks will also become more nimble with deposit pricing.

In the past, bankers have suggested that linking lending rates to external benchmarks should be combined with a move towards floating rate deposits. “Such a move may also imply a floating interest rate structure of deposits, otherwise there would be significant ALM mismatch for the banks,” said Soumya Kanti Ghosh, chief economist at State Bank of India in a note.

While this has not happened yet, an eventual move towards this could lead to volatility in deposit rates too.

What Does This Mean For Banks?

What the move will mean for banks is a more complex subject.

So far, bankers and analysts that BloombergQuint spoke to have raised a few issues.

First, banks will have to pay a lot more attention to the liability side of their business. Deposit pricing, mix of deposits, tenure of deposits will all need to be looked at more carefully. They will also have to hedge interest rate risk more effectively. Banks will have to essentially run the liabilities side as a separate business, explained a senior banking consultant.

Two, banks may see more volatility in their net interest margins. This is because while the spread is fixed for the period of the loan (unless the credit profile of the borrower changes), the bank’s underlying cost of funds may vary based on how well they manage their liabilities.

Three, any pricing differences that exist, particularly in the heavily competitive retail load segment will diminish further.

What Does This Mean For The Economy?

For the broader economy, linking lending rates to external benchmarks may mean better transmission of policy rates. Finally!

“It’s unambiguously positive for interest rate transmission,” said Sajjid Chinoy, chief India economist at JPMorgan. “The more transmission that central banks can be confident of, then the long and variable lags of monetary policy become shorter and less variable.”

I think this also induces greater market discipline, greater liquidity management and greater risk management, added Saugata Bhattacharya, chief economist at Axis Bank.

Watch the interview of Axis Bank’s Rajiv Anand on the new loan pricing rules.