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From April 2019, interest rates on retail loans, including those given to micro and small enterprises, will have to be linked to external benchmarks and not the marginal cost of funds-based lending rate (MCLR).
For borrowers, the new framework is aimed at making loan pricing more transparent. But it may also mean more volatility in their EMIs (equated monthly installments).
For banks, the change from MCLR to external rates could put some pressure on their margins and may impact efficient management of their assets and liabilities.
To bring about more transparency in interest rate calculation, the Reserve Bank of India (RBI) has directed banks to change the manner in which they fix lending rates.
So far, banks were using their own cost of funds, which are internal to the banks, to determine the lending rate charged to different categories of borrowers.
Banks will have to now link to any one of these external benchmarks:
- RBI’s repo rate
- The yield on the government's 91-day treasury bill
- The yield on the government's 182-day treasury bill
- Any other benchmark market interest rate produced by FBIL (Financial Benchmarks India)
Treasury or T-bills are debt instruments issued for one year or less. Their yields fluctuate when they are traded, based on demand and supply.
Final guidelines on the new rates will be released by December end.
Let us now see how this impacts banks and their customers
At a time when banks are already struggling with their asset portfolios, this move may hamper their ability to handle liabilities further.
“This brings in more transparency for customers and banks need to see what is the best external benchmark they can link the loan rates to...We will now have to build margins in the spreads applied to the interest rates,” said PK Gupta, Managing Director - Retail & Digital Banking, State Bank of India (SBI).
To arrive at a final interest rate to offer, banks will add a spread or a margin to whichever benchmark rate they choose for that particular category of borrowers. Once fixed, banks cannot change the spreads for the entire tenure, unless the credit score of the borrower changes.
However, Gupta said this will mostly impact new loans and therefore, will not immediately banks' performance.
"Ultimately, linking to cost of funds will go away and we have to see how much impact it would have on the personal or housing loans," he said.
Transparency and transmission
Earlier, borrowers were offered interest rates linked to benchmark prime lending rates (BPLR) and banks' base rates, and since April 2016, they were offered rates linked to MCLR, which is based on the internal cost of funds of the respective banks.
The external benchmark rates will be more aligned to market rates and therefore, could result in more transmission of RBI's policy rate actions.
Karthik Srinivasan, Group Head- Financial Sector Ratings ICRA said this is expected to improve the transparency in loan pricing by banks as the existing benchmarks, especially the base rate, have not led to a full transmission of the benefits of a decline in cost of funds for banks.
"Furthermore, the profitability of banks may see a higher volatility, unless they are able to raise floating rate deposits linked to external benchmarks," he said.
Frequent EMI changes, less awareness
Although the external benchmark rates are more transparent, they can be volatile, which means customers' EMIs may change more frequently.
“It will also depend on how strong a bank’s treasury book is to decide on the rates. Also, while the rates may look attractive to begin with, but banks may add T-bill rates plus 1.5/2 percent spread (margin) which may not serve purpose," said Sukanya Kumar, Founder of RetailLending.com, a home loan advisory firm.
"So, I don’t think rates will change immediately for the customers. But maybe overtime if customers understand the T-bill rates and the linking of rates and banks take responsibility of awareness, it may help going forward," she said.
Also, most individuals rarely spend time to understand how their home loans work.
"Not all customers shifted from BPLR to MCLR system quickly which was better than the previous arrangements due to want of understanding of the home loan products," Kumar said.
As banks await the final guidelines, consumers may well want to learn more about how they can avail the benefits of more transparent interest rates.