External Benchmarking Of Interest Rates: A Welcome Challenge

Earlier this month, the Reserve Bank of India made it mandatory for banks to link their lending rates on consumer loans to an external, observable benchmark. After trying to persuade banks to do so voluntarily, the central bank finally used its regulatory powers to enforce this benchmarking. Expectedly, this move has generated a degree of disquiet among bankers.

RBI was motivated to take this step, it appears, due to its concerns about poor monetary policy transmission. The banking system is the predominant channel of monetary transmission in India as the other channels, such as the foreign exchange market and the bond markets, play a marginal role. Despite the significant reduction in policy rates, it believed that banks’ lending rates have not come down and the overall credit in the economy has not picked up.

A pick-up in credit is critical to the growth of the economy. Linking banks’ lending rates to external benchmarks—policy rates being the most obvious such benchmarks—will result in a quicker adjustment of rates in response to policy action and thus could increase bank credit.

Addressing Basis Risk And Consumer Protection

In addition to the concerns of monetary policy transmission, there are two other strong reasons for linking lending rates, especially on consumer loans, to an external, observable benchmark.

The first reason is related to the issue of basis risk. When the pricing of any loan is linked to any reference rate which is not transparent, then it is difficult for the buyer of that product to understand the price-risk embedded in it. This issue comes to the fore in the case of securitisation of floating-rate loans.

When a pool of floating-rate loans is securitised, the investor in the securities issued demands the yield on the securities be linked to the investor’s own reference rate.

This creates a basis risk for the parties in a securitisation transaction. It is for this reason that the Committee on the Development of Housing Finance Securitisation Market, constituted by the RBI, and chaired by this author, made a recommendation of linking the pricing of floating rate housing loans to an external, observable benchmark. With such a benchmark, it becomes much easier to price the basis risk in the transaction.

The strongest reason for linking loan pricing to external benchmarks is for consumer protection. A borrower who takes a floating loan must know how her interest rate on the loan changes. If it is linked to a reference that is opaque (like the lender’s marginal cost of funds based lending rate) then she is at the mercy of the lender and there is no transparency on the interest rates. It also makes it impossible to compare offers from two lenders at the time of availing the loan, if the loan pricing is not transparent.

Consumer protection is a foundational principle of financial regulation and hence linking of loan pricing to external benchmarks as a regulatory requirement rests on strong foundations.

Managing Interest Rate Risk

Pushback from bankers on this regulation is based on the claim that this makes asset-liability management (or interest rate risk management) much more complicated for banks. Banks’ funding mix is dominated by term (or fixed) deposits whose pricing does not change with policy rate changes. Thus, the cost of funding for a bank does not change materially with changes in policy rates as only the new (fixed) deposit pricing is adjusted while the pricing on the stock of deposits remains unchanged. Managing interest rate risk and margin on lending will, therefore, become a more challenging task when only the loan prices change with policy rates and cost of deposits does not.

This claim is legitimate. Interest rate risk management does indeed become more challenging with the proposed change. However, this cannot be an argument for rejecting the change. Interest risk management is not an irritating inconvenience but an intrinsic part of managing a bank.

When loan prices are linked to an external benchmark, banks will have to develop a point of view on the future trajectory of policy rates, carefully analyse the impact of policy rate changes on loan prices and cost of deposits. They will then have to ensure that the mark-up over the reference rate includes a component to compensate for the interest rate risk. It is important to note that the regulations do not impose any restrictions on the mark-up banks can add to the external benchmark in the loan pricing. There will always be a possibility that the actual margin that a bank generates from a loan with pricing linked to an external benchmark will be different from what was anticipated at the time of originating the loan, but that is a part of the job of running a bank.

The systemic benefits of this regulatory change far outweigh the claimed challenges. In addition to making monetary transmission better, it is going to improve transparency in loan pricing and hence enhance consumer protection. We should all welcome this change.

Harsh Vardhan is Executive-In-Residence at the Centre of Financial Studies, SP Jain Institute of Management & Research, and chaired the RBI-constituted Committee on the Development of Housing Finance Securitisation Market.

The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.