External Benchmark for Floating Rate Loans

The amended Reserve Bank of India Act, 2016 has mandated the RBI to conduct monetary policy for achieving price stability as its primary objective while being mindful of growth. This mandated objective is difficult to achieve unless supported by a robust transmission mechanism (Acharya, 2017).

If lending rates of banks do not rise in response to rise in the policy repo rate by the MPC, consumption and investment by households and firms will continue to rise and credit demand of firms and households will continue to grow. As a result, the corresponding aggregate demand conditions in the economy would not allow inflation to drop. Conversely, in an easing cycle of monetary policy, if lower policy repo rate is not followed by reduction in bank lending rates, consumption and investment demand will not pick up to help bring the growth back to the steady state.

For more than 20 years after the RBI deregulated banks’ lending rates, the absence of smooth transmission has remained a matter of concern. The first regime of Prime Lending Rate (PLR) was introduced in 1994. However, both the PLR and the spread were seen to vary widely across banks and bank-groups. Moreover, PLR continued to be rigid and inflexible in relation to the overall direction of interest rates in the economy.

With the aim of introducing transparency and ensuring appropriate pricing of loans,  the PLR was converted into a reference benchmark rate and banks were advised in 2003 to introduce the Benchmark Prime Lending Rate (BPLR) system. While lending below the BPLR was expected to be at the margin, in practice about 77 per cent of banks’ loan portfolio in March 2007 was at sub-BPLR². In essence, both PLR and BPLR did not produce adequate monetary transmission to the real economy. This defeated the very purpose for which these benchmarks were introduced.

In July 2010, the Reserve Bank replaced the BPLR system with the base rate system. The actual lending rate was the base rate (for which an indicative formula was also prescribed) along with the spread. However, the flexibility accorded to banks in the determination of cost of funds – average, marginal or blended cost – which was a key component of base rate calculation – resulted in opacity in the base rate computed by banks. In particular, the average cost of funds did not move much with monetary policy changes due to the term nature of deposits. Moreover, banks often changed over time the spread over the base rate for some borrowers, even without any change in credit quality of borrowers, while leaving the base rate unchanged.

Given these deficiencies, the RBI introduced a new lending rate system for banks in the form of the marginal cost of funds based lending rate (MCLR) in April 2016. Unlike the BPLR and the base rate, the formula for computing the MCLR was prescribed. While some discretion remained with banks, the MCLR has continued to suffer from the same flaw in that transmission to the existing borrowers has remained muted as banks adjust, in many cases in an arbitrary manner, the MCLR and/or spread over MCLR, which has kept overall lending rates high in spite of the monetary policy being accommodative since January 2015

The system of using internal benchmarks such as the base rate and the marginal cost of funds based lending rate (MCLR) for pricing of loans in the banking system in India has not resulted in satisfactory monetary transmission so far. Hence, the Internal Study Group constituted by the Reserve Bank to review the working of the MCLR system in its report recommended switchover to one of the three external benchmarks, viz., the treasury bill rate, the CD rate and the Reserve Bank’s policy repo rate.

Period	Change in policy rate	Change  in average term deposit rate	Change in weighted average lending rate o/s rupee loan	Change in WALR fresh rupee loan
Jan 2015 to Dec 2017	-2.00	-2.11	-1.58	-2.04
Jan 2018 to March 19	0.25	0.31	0.07	0.28

After March 19 Repo rate was reduced twice from 6.25. on 4 April 2019 by 25bps and 6 june 2019 by 25bps and current repo rate is 5.75

Recommendations of the Internal Study Group

Each of the above mentioned four benchmarks (PLR,BPLR,Base rate and MCLR) can be considered as “internal” in that banks set it themselves or choose at their discretion many of the factors that get into the prescribed formulae. The task of the Study Group was to evaluate the MCLR system and suggest changes in the lending interest rate system for improving monetary transmission. The key recommendations of the Study Group are summed up below:

• There is a need to move to one of the three external benchmarks, viz., the treasury bill rate, the certificate of deposit (CD) rate and the RBI’s policy repo rate, which is outside the control of an individual bank, from April 1, 2018. The decision on the spread over the external benchmark should be left entirely to the commercial judgment of banks, with the spread remaining fixed all through the term of the loan, unless there is a contractually pre-defined credit event.
• The periodicity of resetting the interest rates by banks on all floating rate loans, retail as well as corporate, be reduced from once in a year to once in a quarter to expedite the pass-through from the monetary policy signals to actual lending rates.
• Quite a sizeable part of the bank loan portfolio continues to be at the base rate and some even at BPLR, which has also hampered monetary transmission. To address this concern, the Study Group recommended that banks be advised to migrate all existing loans linked to the BPLR/base rate to the MCLR if the borrowers so choose to do without any conversion fee or any other charges for switchover and on mutually agreed terms between borrowers and lenders within one year from the introduction of the external benchmark, i.e., by end-March 2019.
• Finally, in order to enhance flexibility on the liability side, the Study Group recommended that banks be encouraged to accept deposits, especially bulk deposits, at floating rates linked directly to one of the recommended external benchmarks.

Feedback from Banks

First, the IBA and banks, barring some foreign banks, are of the view that none of the three external benchmarks recommended by the Study Group can be adopted in the near to medium-run since banks’ funding cost is not related directly to any of the proposed external benchmarks. Loans of most Indian banks are funded primarily by retail deposits and not from the wholesale market as is the practice abroad. Banks have pointed out that they are currently not in a position to hedge interest rate risk given the absence of a developed Interest Rate Swap (IRS) market. recommendation to switch over to an external benchmark by April 2018 is too early a time frame, given the many irritants to effective implementation.  As per a report by Soumya Kanti Ghosh, SBI’S group chief economic adviser, the T-bills are more volatile than policy repo rate. In a higher interest rate scenario, volatility also remains on higher side.

Second, banks have indicated that in a deregulated interest rate environment, spread over the benchmark – be it internal or external – must be the exclusive domain of commercial banks. Also, for commercial reasons, spread cannot be fixed forever. With the switchover to an external benchmark, the spread decisions may get more complex, because of the uncertainty about managing interest rate risk, which may partly influence spreads. For example, the spread itself could become a function of the interest rate cycle.

Third, banks have opined that the reset period cannot be fixed on a quarterly basis always. Currently, one year MCLR linked loans having one year reset period, banks address the interest rate risk in the banking book. Moreover, Indian Accounting Standards (Ind AS) and International Financial Reporting Standards (IFRS) also suggest compatibility between tenor of the loan and reset period. Even if an external benchmark is adopted, the reset period should be linked to the tenor of the underlying external benchmark. While longer reset periods increase transmission lags, shorter resets increase interest rate risk for banks. Retail customers would resist a shorter (quarterly) reset, particularly in a rising interest rate cycle, because of the increase in equated monthly instalments (EMIs) or longer repayment period with uniform EMIs.

Banks’ preference, therefore, is to continue with the MCLR regime, and should be given more time to enable a fuller assessment of its performance on transmission. One and a half years,  is too short a period to assess the effectiveness of a MCLR regime, given the normal lags in transmission. Once the base rate linked loans move completely to MCLR, one should expect even better transmission. To facilitate this, banks have suggested that the RBI could indicate a sunset date for the base rate/BPLR regime – say March 31, 2019 only on the basis of mutually agreed terms and conditions. However, banks feel that rendering free switchover would lead to loss of interest earnings for banks. In particular, the RBI could examine the components and methodology adopted by banks under the supervisory review process.

Finally, to deal with such country-specific challenges, banks have suggested that the more ideal benchmark could be constructed based on deposit rates of the banking system as a whole. Banks have indicated that they experimented but the response on floating rate deposits, was not encouraging. Retail depositors are particularly averse to such products. Even institutional/wholesale depositors prefer fixed rates when they perceive interest rates to have peaked and an easing cycle of monetary policy is about to begin.

Feedback from public and other Stakeholders

In contrast to the feedback received from IBA and banks, the feedback received from public, however, in general, suggests that the RBI should move to an external benchmark. Major suggestions received from the general public are set out below:

1. The T-Bill rate, CD rate and the RBI’s policy repo rate are better suited than other interest rates to serve the role of an external benchmark and the customers would be benefited from better pass-through to lending rates.
2. Banks should try to mobilise deposits based on external benchmarks; and the RBI should create a market environment that enables banks to raise funds based on external benchmarks.
3. Financial markets will deepen as banks increase the use of market products to hedge and manage their interest rate exposures.
4. Proposal of moving over to a single benchmark (by compulsory migration of past loans) will remove the confusion prevailing today due to multiplicity of benchmarks.
5. The RBI should issue a circular/master direction asking banks and financial institutions to allow existing borrowers to migrate to MCLR or any new system without any conversion fee or other charge for the switchover. Special helplines may be required to facilitate this conversion.
6. Banks have made half-hearted attempts to educate customers on the switchover from base rate or BPLR to MCLR and on the many complex nuances under the new MCLR structure.
7. Developed markets typically have two benchmark rates – one for retail loans and another for corporate loans. For instance, in the US, the prime rate – normally 3 percentage points higher than the Federal Funds Rate – is the benchmark rate for consumer and retail loans, and London Inter-bank Offered Rate (LIBOR) is the reference point for corporate loans. Similarly, in the UK, the Bank of England’s base rate is a key benchmark rate for consumer and retail loans, while LIBOR is the benchmark for commercial loans.Comments received through print media – press reports/press articles in particular – covered a broad canvas as mentioned below:
   1. The Indian banking model is different from western models in terms of dependence on wholesale funding.
   2. Signals from monetary policy are only indicative and not like traffic signals.
   3. The global best practice is that banks’ liabilities are the ultimate deciding factor for pricing their assets, not any single external benchmark.
   4. Competition, rather than diktat from the RBI, should set lending rates of banks.
   5. RBI must stop micro-managing how banks should set their lending rates.
   6. Pegging interest rates to external benchmarks is the way forward and that it must apply to both liabilities and assets for the transmission to work effectively.
   7. With the adoption of an external benchmark, there will be more transparency, uniformity and comparability in loan pricing for customers and transmission will improve.

Some Reflections on the Feedback Received

Banks have suggested persisting with MCLR, an internal benchmark based on marginal deposit funding cost. While an internal benchmark such as MCLR (or any other equivalent based on deposit funding cost) seems attractive from the standpoint of banks, it suffers from a fundamental flaw in that it makes banks insensitive to policy rate changes. Put simply, banks face no urgency to adjust their deposit rates in response to policy rate changes. And as long as banks do not change deposit interest rates, that would continue to stifle transmission to their lending rates. saving deposit interest rates by banks are not changed for six years from October 2011 to July 2017 even as monetary policy cycles changed in either direction?. It is all the more intriguing as banks were vehemently opposed to deregulation of saving deposit interest rates on the ground that it would lead to a rate war amongst banks.

Action taken by the bank

In 2005, ING Vyasa Bank had linked home loan rate with Mumbai Interbank Offer Rate.

In March 2018, Citibank linked its home loan rate with three-month Government of India T-bill benchmark. The data is based on Financial Benchmarks India Pvt Ltd.

In December 2018 policy, the RBI proposed that all retail loans, including floating rate loans to Micro and Small Enterprises, extended from April 2019, shall be benchmarked to either the RBI repo rate, or any other external benchmark produced by the Financial Benchmarks India Ltd (FBIL).

In April 2019 Reserve Bank of India (RBI) has postponed its decision to peg all floating rate loans such as home, car and SME loans to external benchmarks. The central bank while unveiling the

• Management of interest rate risk by banks from fixed interest rate linked liabilities against floating interest rate linked assets and the related difficulties, and
• The lead time required for IT system upgradation,

It has been decided to hold further consultations with stakeholders and work out an effective mechanism for transmission of rates, ” RBI said in its statement.

The SBI has adopted the Repo Rate as an external benchmark for pricing savings deposit and all cash credit (CC) and overdraft (OD) above ₹1 lakh, effective from May 1, 2019. While CC/OD lending rates would be at least Repo Rate plus 225 basis points (bps), saving deposits above ₹1 lakh would fetch Repo Rate minus 275 bps. It is not clear whether these spreads are fixed for a considerable period or can be reset every time there is a change in the Repo Rate.

The implications

After the Repo Rate cut in the June 2019 policy, savings deposit rate above ₹1 lakh is 3.0 per cent. Consequently, savings deposits above ₹1 lakh will be shifted to term deposits. This would increase the cost of funds for SBI and therefore, pass-through of rate cut benefit to borrowers will be difficult without reducing the margin. If the SBI appropriately adjusts spreads to maintain the margin, there would be no transmission. CC/OD base lending rates would be 8%.

Long-term solutions

Banks in western countries generally rely on short-term funds and offer variable interest rate on deposits, well below LIBOR.

Hence, in western countries, banks conveniently set their lending rates above LIBOR, which cover cost of funds and a spread depending on the risk profile of borrowers. A similar situation is yet to emerge in India.

It is too early to claim that FBIL has been successful in giving LIBOR-like benchmarks to the Indian financial system. Given the RBI’s commitment to maintain price stability under the flexible inflation targeting, the CPI inflation can be used as a suitable external benchmark for the purpose of pricing of both deposit and lending rates.

As Repo Rate is interest rate administered by the Monetary Policy Committee and does not emerge from the market, it is not a suitable external benchmark for the purpose of pricing of both deposit and lending rates. It is better to nurture financial markets to increase their depth and price discovery of financial products, which would eventually improve the process of monetary policy transmission.

References

https://www.thehindubusinessline.com/

https://economictimes.indiatimes.com/news/

https://m.rbi.org.in/Scripts/PublicationReportDetails.aspx

Authored By :

B P Sharma
Chief Manager (Faculty)
Union Bank of India
Staff Training Centre, Bhopal