Linking lending rates to Repo etc.

What is the new Reserve Bank of India rule?

The Reserve Bank of India (RBI) made it compulsory for banks to link their new floating rate home, auto and Micro, Small & Medium Enterprises (MSME), that is small scale industries, loans to an external benchmark from October 1 so that the borrowers can enjoy lower rate of interest.

The new regime will only apply to banks and not to Non-Banking Financial Companies (NBFCs). 

Lenders have been allowed to choose between 

• RBI’s repo rate, 
• Government of India’s three-month treasury bill yield published by the Financial Benchmarks India Private Ltd (FBIL), 
• Government of India’s six-month treasury bill yield published by the FBIL or 
• Any other benchmark market interest rate published by the FBIL.

What are floating and fixed rate?

Floating rate changes with the change in the overall economy and the monetary and credit policy revisions. Fixed rate does not.

What is external benchmarking of loans?

When we borrow money from a bank for purchasing a house, car or for business purposes, interest is levied based on certain criteria approved by the Reserve Bank of India (RBI). At present, banks use Marginal Cost-based Lending Rate (MCLR) to arrive at their lending rate. MCLR is based on factoring the repo rate changes as they take place along with all other factors. 

Prior to this, it was the Base Rate (BR) which was preceded by Prime Lending Rate (PLR). 

These were all internal benchmarks. 

What are BR and PLR?

BR was adopted to make sure that banks donot lend below it. The idea was to stop banks from lending extra-cheap to best borrowers which was being `cross subsidised’ by the small scale industry who were paying much higher rates. They were subsidising the rich borrowers. They were not getting the lower rates.  

MCLR replaced BR. Why?

Because, BR was not reflecting every repo rate change.

BR replaced PLR. Why?

PLR was the rate at which the best customers were lent. Some were even lent sub-PLR. It led to banks charging much higher from small scale industry to recover what they had foregone while lending to the rich. Therefore, the Base Rate was introduced so that such reverse cross subsidisation is prevented. In a normal cross subsidisation, rich subsidise the poor.  

Can you give an example?

Since February 2019, RBI cut its policy rate (repo rate) by 110 basis points (100 bps=1 percentage point), including the higher-than-expected reduction of 35 bps in its August policy review. However, banks until August, only passed on 29 bps in rate cuts to borrowers, which the RBI thought was unfair.  

What are the advantages of the policy shift?

As the trend is lower rates due to growth slowdown and benign inflation, the following benefits are expected

• Cheaper rates due to quicker monetary policy transmission
• Investment and consumption will pick up
• will increase transparency
• Equity by way of small scale industry not being denied the rate cuts. 

What is repo rate?

Repo rate is the rate at which banks borrow from the RBI to meet their day-to-day asset-liability mismatch and this is granted against government securities in which the banks have invested. 

Do banks borrow substantially in percentage terms from the RBI at the repo rate?

No. The amount of such borrowing is negligible. As of July 2019, it was a mere 0.35 per cent of banks’ loans. 

Is it fair and viable to link lending rates to external benchmarks solely?

Critics object to the RBI rule on the following grounds:

• When banks are not even getting one per cent of their funds requirement from the RBI at repo rate, repo rate can not be a benchmark
• If banks reduce the interest rate on loans without a corresponding reduction in deposit rates, it will hurt them. If deposit rates are reduced, then the household savings rate, which is already dwindling, will come down further and banks will find it difficult to mobilise funds. They have to contend with the post office rates which are much higher. Monetary policy transmission depends on a host of factors and repo rates are one such factor. Cost of funds for one per cent of required funds can not be transmitted for hundred per cent of loans
• As part of financial liberalisation, the RBI had long back allowed banks to decide the interest rate on deposits and loans, barring those to the priority sector. Now pressuring banks to link directly with the repo rate amounts to going back to the days of administered rates.
• Other benchmarks offered by FBIL also suffer from such infirmities as the criteria that banks consider for setting their rates are quite distinctive and not identical to any other external benchmark. 

What are financial benchmarks?

Financial benchmarks are indices, values or reference rates used for the purpose of pricing, settlement and valuation of financial contracts. Globally huge volumes of financial transactions are referenced to or valued using various such benchmarks. Financial benchmarks play a very critical role in promoting efficient and transparent financial markets and ensuring financial stability.

What is Financial Benchmark India Pvt. Ltd (FBIL)? Is it a government entity?

No. Its promoters are Fixed Income Money Market and Derivatives Association of India (FIMMDA), Foreign Exchange Dealers’ Association of India (FEDAI) and Indian Banks Association (IBA).

It was formed in 2014 as a private limited company under the Companies Act 2013. Its aim is to develop and administer benchmarks relating to money market, government securities and foreign exchange in India.