The Reserve Bank of India has now made it mandatory for all banks to link the interest rates they offer to customers for floating personal, retail and MSME loans to an external benchmark, starting October 1.

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When banks decide the rate they will charge for giving out loans, they set a benchmark below which they will not lend, and that incorporates the cost that the bank has to incur to give out the loan. Over and above this benchmark, banks also charge what they call ‘spread’, which varies across categories. This spread is usually higher for riskier loans, like unsecured loans, and lower for less risky loans, like home loans that are backed by an asset. The key part being, that these rates were internally decided by individual banks keeping their cost model in mind.

RBI has been unhappy about the pace of transmission of its rate cuts by banks under the earlier regime of base rates and even Marginal Cost of Funds based Lending Rates, or MCLR. Given that these rates were set based on internally decided benchmarks, transparency was also an issue.

While RBI was signalling a falling rate regime with repo rate cuts, banks only partially transmitted these cuts to customers. To be fair, the borrowings from RBI form a very small part of the banks’ total corpus of borrowing options, which primarily consists of deposits, and market borrowings. Therefore, a repo rate cut does not immediately bring down a bank’s cost significantly.

So, in order to ensure faster transmission and more transparency in lending rates, the RBI has now made external benchmarking mandatory.

How will external benchmarking work?

For linking rates to external benchmarks, the RBI has provided banks with four options to choose from. Banks may link these loans to one of the following: RBI’s repo rate, the 3-month Treasury Bill (91 day T-Bill) yield, the 6 month Treasury Bill yield, or any other benchmark market interest rate that is published by Financial Benchmarks India Pvt Ltd (FBIL).

Adoption of multiple benchmarks by the same bank will not be allowed within a loan category. For instance, a bank cannot link some retail loans to repo rates, and other retail loans to a T-Bill. This has been done to ensure transparency, standardisation, and ease of understanding of loan products by borrowers.

However, RBI has given freedom to banks to decide on the spread over the external benchmark, as has been the practice with the earlier base rate, and then MCLR regime in the past. Banks now have to mandatorily reset rates on such external benchmark linked loans at least once in three months.

What does it mean for borrowers?

Right now, this is great news for those looking to take new personal, retail or MSME loans. The RBI is currently in an ‘accomodative’ stance, which means rates will only be cut further, and rate hikes are off the table. In this falling interest rate regime, borrowers will benefit from lower rates. For example, SBI’s 1-year MCLR for floating loans is at 8.25 percent, for the cheapest category of home loans of up to Rs 30 lakhs. On this MCLR, SBI charges a spread of 15 bps, which effectively makes the interest rate on home loans for this specific category 8.40 percent. However, its repo linked lending rate (RLLR) is currently 2.25 percent. With repo rates at 5.40 percent, this effectively brings down the new home loan rates with external benchmarking to as low as 7.65 percent plus spreads, which will depend on the risk profile of borrowers.

Therefore, in the current regime of falling interest rates, this should bring cheer to borrowers. Since the external benchmark linked loans are only mandatory for new borrowers, existing borrowers won’t immediately benefit from this new regime, until their rates are reset.

However, there is also a flip-side to this cheer. While rates will continue to fall for borrowers in the current environment, given the mandatory 3-month reset, interest rates may also rise equally fast when the cycle turns.

Net net, if you are taking a floating rate loan linked to an external benchmark after October this year, you most certainly stand to reap the benefit of the lower interest rate regime if it is a short tenure loan. But typically, home loans, for instance, with longer repayment tenures of 15-30 years, will mean that borrowers face the risk of higher interest rates as the interest cycle reverses, as well as high volatility as rates are often reset.

As for existing borrowers with floating rates, RBI has clarified that provided they are eligible to prepay a floating rate loan without pre-payment charges, these borrowers will be eligible to switch over to the external benchmark regime without any charges or fees, at mutually agreeable terms.

First Published:Sept 4, 2019 10:15 PM IST