RBI group suggests linking lending rates to 3 external benchmarks by April 2018

Accordingly, there is a need for switching over to one of the external benchmarks recommended by the Study Group, after wider public debate and taking into account the feedback from all stakeholders.

“Overall, monetary transmission has been impeded by four main factors: (i) maturity mismatch and interest rate risk in the fixed rate deposits but floating rate loan profile of banks; (ii) rigidity in saving deposit interest rates; (iii) competition from other financial saving instruments; and (iv) deterioration in the health of the banking sector,” the Study Group said.

The lower transmission from the policy rate to the base rate loan portfolio was mainly because banks followed different methods to calculate the base rate, it added.

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 harmful to the retail/SME borrowers in an easy monetary cycle.

“To address this concern, besides immediate recalculation of base rates, banks may be advised to allow existing borrowers to migrate to the MCLR if they so choose to do without any conversion fee or any other charges for switchover on mutually agreed terms. However, after the adoption of an external benchmark from April 1, 2018..., banks may be advised to migrate all existing benchmark prime lending rate (BPLR)/base rate/MCLR borrowers to the new benchmark without any conversion fee or any other charges for switchover on mutually agreed terms within one year from the introduction of the external benchmark, i.e., by end March 2019."

In other measures to make liability side more flexible, it also suggested that deposits, especially bulk deposits of Rs 1 crore and above, need to be at floating rates linked to the external benchmark.

Why T-Bills, CD and repo rates?

“The T-bill rates are risk free and also transparent. They also have a reliable term money market curve. CD rates relate to the credit market directly in the sense that banks could meet their marginal requirement of funds from this market. CDs also have a reliable term money market curve. Unlike the T-Bill market where the money market term curve is available up to 12 months, in the CD market, the term curve is generally up to six months (and up to 9 months occasionally)," the Study Group said.

The RBI’s policy repo rate has the primary advantage that it is robust, reliable, transparent and easy to understand. It reflects the appropriate rate for the economy at any point in time based on the MPC’s assessment of macroeconomic conditions and the outlook. With the repo rate as the benchmark, the transmission of the repo rate changes to lending rates of banks will be quick, direct and strong.

The repo rate as a benchmark, however, can constrain future changes in the monetary policy framework. Banks also have limited access to funds at the repo rate. Being an overnight rate, the repo rate also lacks a term structure.

The main challenge in using either T-bill rates or CD rates as the benchmark is that the current level of market depth in the T-Bill and CD markets can make such benchmarks potentially susceptible to manipulation.

For smooth transition, it is important that banks need to be given enough time and that they are also adequately capitalised before the new lending rate system is introduced.

Hence, with a view that the three benchmarks are better suited than other interest rates to serve the role of an external benchmark, the Study Group recommends that all floating rate loans extended beginning April 1, 2018 could be referenced to one of the three external benchmarks.

Disadvantages of external benchmark

The Study Group is of the view that there could be certain unintended consequences of an external benchmark, which need to be guarded against.

These include:

(a) banks may fix spreads arbitrarily too high for retail borrowers initially to account for future uncertainty;

(b) the new regime may increase the scope for cross-subsidisation as corporates may negotiate for finer rates close to the external benchmark, as the T-bill rate, CD rate and the repo rate are lower than the current MCLR;

(c) credit flows/demand for credit may change in a manner that could defeat the objective of stronger transmission in the credit market;

(d) banks may lower the tenor of loans

(e) banks may shorten deposit maturity profile, which may improve transmission but may pose financial stability concerns;

(f) in a tightening cycle, automatic raising of rates by banks may not go well with retail borrowers;

(g) implementation of Indian Accounting Standards (Ind-AS) and Net Stable Funding Ratio (NSFR) in 2018 could amplify transition uncertainty under a new loan pricing regime, which may pose a huge challenge for banks, particularly when they are engaged in clean-up of their balance sheets.

The Study Group is of the view that the spread over the external benchmark should be left to banks to be decided based on their commercial judgment.

In a competitive market, average spreads for similar tenors and risk profiles should converge across banks. However, once the spread is fixed at the time of sanction of a loan, banks should not be allowed to change the spread during the tenor of the loan unless there is a clear credit event necessitating a change in the spread, it said.

The 13 possible candidates for external benchmark were -- weighted average call rate (WACR), collateralised borrowing and lending obligation (CBLO) rate, market repo rate, 14-day term repo rate, G-sec yields, T-Bill rate, CD rate, Mumbai interbank outright rate (MIBOR), Mumbai inter-bank forward offer rate (MIFOR), overnight index swap (OIS) rate, Financial Benchmark India Ltd (FBIL) CD rates, FBIL T-Bill rates and the Reserve Bank’s policy repo rate).