A common grouse among many loan borrowers is that banks are very keen to hike the interest rates when the rates are moving up in the economy. However, banks are not very prompt to pass on the benefit when the rates are going down. Do you fall in the same category of borrowers? If you do not trust your bank to pass the fall in interest rates to your loan and constantly feel that you are being short-changed, then I have some good news for you.
Starting April 1, 2019, all the NEW floating rate loans have to be linked to an external benchmark, which is not linked to the cost of the funds for the banks. Yes, MCLR (marginal cost of funds-based lending rate) regime is being shown the door. The Reserve Bank is not happy with the bank’s reluctance to pass on the lower rates to the borrowers. RBI has come to this conclusion based on the findings of an internal study group to review the working of the Marginal Cost of Funds based lending rate (MCLR) System. This report makes for an interesting read. Some of the important bad practices highlighted were: banks revising spreads upwards for new loans to make up for cut in MCLR, banks not passing the lower rates to the older borrowers. At the same time, the report has also highlighted a few practical and business limitations of the banks on the liability side. I will not discuss the report in detail but move quickly to the RBI statement.
Extract from the RBI Statement
Here’s an extract from the RBI Statement on Developmental and Regulatory Policies dated December 5, 2018:
It is proposed that all new floating rate personal or retail loans (housing, auto, etc.) and floating rate loans to Micro and Small Enterprises extended by banks from April 1, 2019 shall be benchmarked to one of the following:
– Reserve Bank of India policy repo rate, or
– Government of India 91 days Treasury Bill yield produced by the Financial Benchmarks India Private Ltd (FBIL), or
– Government of India 182 days Treasury Bill yield produced by the FBIL, or
– Any other benchmark market interest rate produced by the FBIL.
The spread over the benchmark rate — to be decided wholly at banks’ discretion at the inception of the loan — should remain unchanged through the life of the loan, unless the borrower’s credit assessment undergoes a substantial change and as agreed upon in the loan contract. Banks are free to offer such external benchmark linked loans to other types of borrowers as well. In order to ensure transparency, standardisation, and ease of understanding of loan products by borrowers, a bank must adopt a uniform external benchmark within a loan category; in other words, the adoption of multiple benchmarks by the same bank is not allowed within a loan category. The final guidelines will be issued by the end of December 2018.
You can read the complete RBI statement here.
Benchmark + Spread
Floating rate loans are offered at a Benchmark + Spread. PLR, Base rate and Marginal cost of fund-based lending rate are all benchmarks. Spread can depend on multiple factors, with credit worthiness of the borrower being the most important aspect. Spread typically remains constant for the duration of the loan. Therefore, your loan interest rate varies with the change in the benchmark rate. Till now, this benchmark was internal. i.e., linked to cost of funds of the bank. However, the benchmark still remained susceptible to manipulation or gaming the system. As per the RBI statement, these internal benchmarks will be done away with. Now, the banks will have to link the loans to an external benchmark, which is beyond their control.
Points to Note
- RBI has given freedom to banks to choose the external benchmark as they wish. RBI has given 3 suggestions (Repo, 91 day Treasury Bill and 182 day Treasury Bill). However, the banks can use any benchmark maintained by FBIL.
- The banks can’t have multiple benchmarks in the same category. For instance, all the floating rate home loans will be linked to the same benchmark.
- For now, there is no direction about what happens to the existing home loans. Will those loans be automatically shifted to the new external benchmark regime? Or will there be any cost involved for switching? How will spreads change during the switch?
- There is no clarity about the reset period. Reset period is the period after which your loan interest rate will be reset. For instance, if the reset period is 1 year, your loan interest rate will change only at 1 year interval. Any changes to the benchmark in the interim will not change your loan interest rate immediately.
- Spread will be decided at the inception of the loan. The bank shall have complete discretion in deciding the spread of the loan. However, the spread will remain constant during the loan tenure (unless borrower’s credit profile changes substantially). This is in line with what we had for MCLR. However, as I understand from study group report, banks have been quite arbitrary in choosing spreads.
The internal study group report mentioned earlier touches upon all the aspects discussed above. RBI will come out with detailed guidelines in this matter by the end of this calendar year (2018). Expect more fireworks and clarity from the Reserve Bank.
What Is in It for You?
We had discussed a home loan product from Citibank, where the benchmark was 91 day Treasury Bill. So, we already have loan products that are linked to external benchmarks. Clearly, the RBI move will bring this mainstream. I had discussed the pros and cons in that post too.
The greatest benefit is the transparency. When the rates are going down, you will easily get the benefit of lower rates. The transmission of monetary policy will be much quicker. However, there is a flip side too. The transmission will be quicker even when the rates are going up. Moreover, since these rates are market driven, expect more volatility and frequent changes in your EMI. So, it can be a double edged sword.
Here is the 91 day Treasury bills yield chart since the beginning of 2017. As you can see, it is quite volatile.
Not as straightforward. What if banks prefer to bypass the system to an extent and lend more through NBFCs or HFCs, which do not face similar restrictions, a case of regulatory arbitrage? How this will impact deposit rates? We must understand that bank deposit rates face competition from savings schemes and other financial investments such as mutual funds and can stay rigid.
In my opinion, a more transparent system is always a better choice.