Bank rates: benchmarking alone isn’t enough

Meeting the twin objectives of monetary policies — accelerating growth and controlling inflation — largely depends on the magnitude and promptness of transmission of policy rates. To bring promptness in transmission of interest rates, on December 5, 2018, the Reserve Bank of India (RBI) proposed floating rates on personal or retail loans (housing, auto, etc) and micro and small enterprises to benchmark to an external rate (repo rate or any other benchmark market interest rate published by the Financial Benchmark India Private Ltd) and to re-set the rates on quarterly basis, instead of yearly, effective April 2019.

The freedom to decide the ‘spread’ over the benchmarks continues. Instead of announcing the final guidelines, on April 4, the RBI preferred to have further consultations with stakeholders. Meaning: benchmarking with external rates (instead of the bank’s MCLR, or marginal cost of funds-based lending rate) is put on hold.

Meanwhile, the State Bank of India (SBI) has announced benchmarking savings bank (SB) interest for balances of over Rs 1 lakh to repo rates (repo rate–2.75%) and overdraft/cash credit (OD/CC) over Rs 1 lakh to repo rate+2.25%, effective May 1. Paradoxically, the repo rate has come down to 6% and the SB interest should be 3.25%, against 3.5%, for balances below Rs 1 lakh.

The RBI has experimented with different methods to bring transparency in pricing/re-aligning lending rates as per the requirements (1994: Prime Lending Rates, or PLR; 2003: Benchmark Prime Lending Rate, or BPLR; 2010: Base Rate, and since April 2016: Marginal Cost of funds-based lending rate, or MCLR). Interest rates can be either be floating (linked to MCLR) or fixed (remains fixed either for the tenure or is re-set at pre-determined intervals).

Floating rates

Floating rates are levied based on MCLR+spread. The spread cannot be increased to existing borrowers, except on account of deterioration of borrower’s credit risk profile. Variations are observed in computation of MCLR by individual banks. There was no consistency in the ‘spread’ levied as it differed from bank to bank, sector to sector and even month to month within the same bank.

The Internal Study Group to review the working of the MCLR system (chaired by Dr Janak Raj) in September 2017 revealed that banks deviated in an ad hoc manner in calculating MCLR. Banks did not re-adjust the deposit rates to policy rates, fearing deposit loss on account of competitive pressures from other financial savings instrument like small savings and mutual funds (the government has not reduced interest rates on small savings for April-June quarter). The extent of responsiveness of interest earnings and interest expenses to the policy rates is broadly the same.

In a falling interest rate scenario, if the interest rates are benchmarked to repo, lending rates will fall; whereas the rates on the existing deposits will continue. When interest rates go up, the depositors can opt for premature renewal and earn higher interest. Therefore, banks may find it difficult to manage the Net Interest Margin (NIM).

Benchmarking floating rates to repo rates and re-setting the lending rates on quarterly basis will result in timely transmission. The spread charged by private sector banks on fresh loans are higher than that of PSBs. Large variations in the spreads across banks exist on account of business strategy and borrower-level credit risk. Banks could manoeuvre lending rates by adjusting the spreads. Arbitrary adjustments in spreads to offset reduction in MCLR, treating spreads as a balancing figure (between the lending rates and MCLR), etc., is not uncommon.

Term deposits accepted by banks are largely on fixed rate basis and re-set of the interest rates on existing deposits happens only on maturity dates. A shift from MCLR to repo rate will compel banks to jack up their spread to maintain their NIM, especially now as banking sector health has deteriorated.

Fixed rates

About one fifth of scheduled commercial banks’ (SCB) credit continues at fixed rates (public sector banks, or PSBs — 15.27%, private banks — 26.47%, and foreign banks — 34.5%) and this ‘segment’ will have little impact on the new benchmarking.

RBI restrictions — not allowing levy of foreclosure charges/prepayment penalties on home loans (June 12) and other term loans to individual borrowers (May 2014) — are only on floating rate loans. Several private sector banks provide term loans (except home loans) to individuals only on fixed rates and continue to levy heavy foreclosure/prepayment charges. Stipulating a specific date for paying the EMIs and not apportioning the repayments received prior to these dates’ results in interest loss to the borrowers. Ordinary borrowers are guided by the interest rates/EMI, without understanding the implication of fixed rate loans. For a customer, total cost is important — whether it is in the form of interest or charges.

The regulator should keep in mind the interest of consumers by balancing the consumer protection and freedom to banks. The RBI can either consider issuing guidelines on levy of prepayment/foreclosure penalties on fixed rate loans or direct banks to provide both fixed and floating rate option on loans to individuals.

The continuation of freedom to banks in deciding spread over the benchmark and providing several loans only on fixed rates may make the impact of the move of RBI to substitute the repo rate as benchmark only marginal. A re-set of floating rates on quarterly basis is certainly a welcome move. The final guidelines are awaited.

(The writer teaches banking at ICICI Manipal Academy, Bengaluru)