RBI Asks Banks To Link Retail, SME Loans To An External Benchmark From Oct.1
A customer exits a ICICI Bank Ltd. branch in Mumbai, India (Photographer: Dhiraj Singh/Bloomberg)  

RBI Asks Banks To Link Retail, SME Loans To An External Benchmark From Oct.1

The Reserve Bank of India has asked banks to link all new floating rate retail loans and loans to micro-small enterprises to an external benchmark starting Oct. 1. Existing loans, which are eligible for pre-payment, should be allowed to transition from interest rates linked to the marginal cost lending rate to the new external-benchmark linked rates without any fee, the RBI said.

The RBI had first suggested the transition to external benchmark-linked loans in December 2018. However, the transition, which was to kick-in starting April 1, 2019, was delayed. The regulator then tried to convince banks to voluntary introduce loans linked to an external benchmark such as the RBI’s repo rate. This had partial success with only public sector lenders moving to introduce such products.

The RBI has now finally made it mandatory for all banks to move to this new loan pricing regime, in the hope that linking loans to a benchmark such the RBI’s repo rate would make monetary transmission more effective.

The Eligible External Benchmarks

The RBI has given banks a choice of external benchmarks to pick from. The eligible benchmarks include:

  • RBI policy repo rate
  • Government 3-month treasury bill yield
  • Government 6-month treasury bill yield
  • Any other benchmark published by Financial Benchmark India Private Ltd

While banks have a choice of external benchmarks, they must adopt a uniform external benchmark within a specific loan category. This means that the interest rate for two home-loan borrowers will be linked to the same external benchmark and not multiple benchmarks within the same category.

The loan rates should be reset every three months, the RBI said.

Also read: Loan Pricing Debate: Should RBI Ask Banks To Link Lending Rates To An External Benchmark?

Banks To Decide On Spread

Banks have been given full freedom to decide the spread they charge over the external benchmark.

However, the credit risk-premium that is charged on top of the external benchmark rate by banks, depending on the borrowers' credit profile, can only be changed when the borrower's credit assessment undergoes a substantial change, the RBI said.

Other components of the spread, like operating cost, can be altered once in three years, the notification says.

Transition For Existing Borrowers

While the RBI has not specified a time within all existing borrowers must be transitioned to external benchmark linked rates, it has asked banks to allow borrowers to switch without any fee.

  • All existing retail and micro-small enterprise loans that are linked to the Marginal Cost of Funds based Lending Rate, Base Rate or Benchmark Prime Lending Rate, will continue until it is fully repaid or renewed.
  • Floating rate term loans sanctioned to borrowers who are eligible to prepay a floating rate loan without pre-payment charges, shall be eligible for switch over to External Benchmark without any charges/fees, except reasonable administrative/ legal costs.
  • The final rate charged to this category of borrowers, post switch over to external benchmark, shall be same as the rate charged for a new loan of the same category, type, tenor and amount, at the time of origination of the loan.

Impact On Banks

Banks have been given less than a month before they need to link all new retail and SME floating loans to an external benchmark. Some like State Bank of India have already introduced such products but private banks have not.

“Most of what the RBI is saying has been done at SBI. Housing is the only big piece which would need to move. Currently we have two housing loan products. One is external benchmark linked and the other is MCLR based. We would have to do away with the MCLR based product fully from October 1,” said PK Gupta, managing director at State Bank of India.

Gupta added that the impact on margins due to the switch-over for existing customers would need to be calculated.

A senior private bank official, while speaking on condition of anonymity, said that banks will definitely see pressure on their margins because of the RBI’s decision. This banker added that the bigger concern for banks will be managing their liabilities, which are based on a fixed rate. Banks would also need to use hedging products to manage their interest rate risk.

In a recent report, Soumya Kanti Ghosh, chief economist at State Bank of India wrote that the best option would be for banks to link bulk deposits to an external benchmark. Deposits above Rs 2 crore are characterised as bulk and make up about 30 percent of the deposit base. “Most of the bulk deposits are from institutions. It is thus logical that large institutions could afford to take interest rate risk as this would spare the retail depositors from taking the same,” Ghosh said.

Analyst Views

According to sector analysts, net interest margins for banks could turn volatile and see a mark-down if a significant part of the existing loans transition to external benchmark-linked loans. Those with a higher proportion of fixed rate loans, such as HDFC Bank Ltd, would be impacted less than others.

“As bank funding costs are unlikely to reprice as quickly as the external benchmark, this migration will lead to volatile profitability for 25 percent of their incremental business,” said Ashish Gupta of Credit Suisse in a note on Wednesday.

Among our coverage, ICICI Bank and Axis Bank are likely to be most impacted with 25-35 percent of their loans likely to be linked to external benchmark, while HDFC Bank and IndusInd Bank with largely fixed rate consumer portfolios will be least impacted.
Ashish Gupta, Head of Equity Research, Credit Suisse

While the norms do not directly apply to housing finance companies, competitive pressures may push them into introducing external benchmark linked products, CLSA added.

(In the case of HFCs), the ability to manage spreads will be key to watch as these loans form close to 70 percent of total. They may mange spreads by increasing corporate lending or using derivatives. Among HFCs, the impact will be higher for LIC Housing Finance.
Aashish Agarwal, CLSA
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