Loan Pricing Debate: Should RBI Ask Banks To Link Lending Rates To An External Benchmark?
To avoid confusion, RBI would be best advised put some ground rules in place if it wants banks to move to external benchmarking.
The idea of moving the Indian banking sector towards lending rates linked to an external benchmark is neither new nor abrupt. Discussions around this possibility have been underway for years, and since 2017 there have been formal recommendations to make this shift in public domain.
Yet, the likelihood of a mandated move in this direction has prompted an active debate as to whether such a move is needed and if it is unnecessarily burdensome for banks.
The debate has been sparked off by recent comments from Finance Minister Nirmala Sitharaman and Reserve Bank of India Governor Shaktikanta Das.
The comments were, perhaps, prompted by an all-too-familiar frustration with the glacial pace of monetary policy transmission, particularly when interest rates in the economy are falling.
A Long-Traveled Road To External Benchmarking
India has experimented with a whole gamut of loan pricing mechanisms – from the benchmark prime lending rate, to the base rate, and the marginal cost of funds lending rate. Each of these iterations have thrown up a less-than-desirable outcome in terms of transmission of monetary policy.
To review the functioning of the MCLR system — the lending rate formula currently in use — the RBI set up an internal group in 2017 headed by Janak Raj, principal advisor in the Monetary Policy Department.
Janak Raj Committee
The committee conducted extensive research into the prevailing loan rate systems.
The RBI had introduced the MCLR in 2016 as a replacement for the base rate. The latter was a formula based on the average cost of funds, while the former used the marginal cost of funds.
The MCLR was introduced without any clear sunset clause. Two years into the introduction of the MCLR, the committee found that banks were dragging their feet on the transition and as a result a wide gap had emerged between lending rates on new loans and existing loans.
In the absence of any sunset clause on the base rate, banks have been quite slow in migrating their existing customers to the MCLR regime. Most of the base rate customers are retail/SME borrowers. Hence, the banking sector’s weak pass-through to the base rate is turning out to be deleterious to the retail/SME borrowers in an easy monetary cycle.Janak Raj Committee (2017)
The committee had also found that the setting of the MCLR remained ad-hoc and non-transparent, thereby preventing quick monetary policy transmission. To correct this, the committee recommended:
- That banks be asked to link floating rate products to an external benchmark.
- Banks could be given more than one option to chose from when deciding the external benchmark. For instance, they could pick the repo rate or the 91-day T-bill or another approved benchmark.
- They would have full freedom to decide on the spread they want to charge over that benchmark. However, that spread would remain constant unless there is a change in the customer’s credit profile.
- Banks may be encouraged to accept deposits, especially bulk deposits, at floating rates linked directly to the external benchmark.
- Banks would need to migrate all customers to the external benchmark linked rate system within a year, without charging any fee.
Tarun Ramadorai Committee
The Janak Raj committee took a monetary policy view to the issue of external benchmarking. A separate on household finances, headed by Tarun Ramadorai, recommended such a move even from a customer viewpoint.
Apart from the lack of transparency in deciding on the MCLR, the Ramadorai committee flagged off that the tenor-based approach inherent to the MCLR system is troublesome. Under the current system, banks determine the MCLR for different periods of time such as 6-months, 1-year, 3-years etc. Different loan products are linked to different MCLR benchmarks, making comparison difficult.
“Moving to a ‘standardised rate + spread’ quoting convention would provide prospective borrowers with an immediate and useful benchmark for cross-product comparison,” the committee had said.
It had also recommended that banks should pass on any rate changes to borrowers every month to ensure quick transmission of rates.
Half Measures Versus Burden For Banks
Presumably, the RBI studied recommendations of these committees and finally decided to a move towards an external benchmark.
The RBI’s December policy announcement was very close to the recommendations of the Janak Raj committee. It said that banks can choose from one of four benchmarks (including the repo rate); they have full freedom to decide on the spread; they can alter the spread only if the customer’s credit profile changes; they must transition all customers to this new rate over the period of a year.
The new rules were to kick-in starting April 1, 2019 but Das put them on hold.
In the months since, the matter was discussed at various meetings. Finally, State Bank of India took the lead and announced that it would start by linking the savings deposit interest rate and working capital loans to the repo rate.
A few months passed and no other bank followed. In the last one month though, there has been a flurry of announcements from PSU banks offering home loans linked to the repo rate. No private bank or NBFC has announced such products.
In the absence of clear RBI directions, banks will move to external benchmarks in an ad-hoc manner. PSU banks will offer such products but may not actually prioritise them while selling loans to customers. Private banks are unlikely to offer such products at all, without a regulatory nudge. Non-bank lenders and housing finance companies, too, are not likely to rock the boat unless pressured by the regulator of market forces.
The result, going by the experience of the transition period between the base rate and the MCLR, will be a split market where rates will differ significantly for new and existing borrowers. Banks charging non-transparent fees to switch customers from MCLR-based loans to external benchmark-linked loans is also not an inconceivable scenario.
To avoid such confusion, the RBI would be best advised put some ground rules in place if it wants banks to move to external benchmarking.
What of bank margins?
There is no doubt that an external benchmark-linked interest rate regime would be tougher on banks. While they have complete freedom to set their spreads, they would need to manage interest rate risk more actively and treasury management would need to improve. Banks would also need to start linking some part of their liability franchise to an external benchmark.
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.
Will it be easy? No. But does the status quo of a rate regime which has meant poor transmission and low transparency need to be broken? Yes.
Ira Dugal is Editor - Banking, Finance & Economy at BloombergQuint.