On September 4, 2019, the Reserve Bank of India [RBI] has made it mandatory for all banks to link new floating-rate loans – to retail customers and micro, small and medium enterprises [MSMEs] – to an external benchmark. The external benchmark could be the repo rate [rate of interest that the apex bank charges on money lent to banks – also known as ‘policy rate’], yields on 3-6 month treasury bills as published by the Financial Benchmarks India Private Ltd [FBIL] or any other benchmark rate published by FBIL.
The decision will be applicable to all fresh loans under ‘floating rate’ given from October 1, 2019. Borrowers with a floating rate loan who are eligible to pre-pay without pre-payment charges can also switch to the external benchmark.
The immediate trigger for the decision is the mounting concern [ repeatedly expressed by the RBI in its monetary policy review] that the banks are not transmitting the reduction in the policy rate [against the cumulative cut of 0.75% affected in the first three consecutive reviews (February, April, June) during 2019, the banks transmitted only 0.29%]. Besides, there is considerable time lag between the date of cut in the policy rate and reduction in lending rate [whatever limited] as and when it happens.
With the RBI having affected yet another rate cut of 0.35% in the August, 2019 policy review in the backdrop of slowdown in economic growth [during the first quarter of current year, GDP growth plunged to a five year low of 5% and indication of continuing sluggishness in the second quarter as well], the government is particularly keen on ensuring ‘full’ and ‘immediate’ transmission. Hence, the decision for bench-marking lending rate to the policy rate.
Currently, banks determine the lending rate based on marginal cost of funds-based lending rate [MCLR] which as the nomenclature suggests, is the cost at which they mobilize incremental funds. Add to this the cost of intermediation [wages & salaries, overheads, services charges etc] and certain margin to cover the risk associated with lending. The resultant figure is the rate of interest charged from the borrower. The rate fixed on this basis is reviewed once every year.
The MCLR introduced in 2016 though a significant improvement over the ‘base rate’ system in vogue since 2010 [that was based on weighted average cost of all of the liabilities including long-term deposits] remains cost-plus. While, arriving at the rate, banks also provide for the loss they suffer on account of non-performing assets [NPAs] as also under-recovery arising due to advances to priority sectors such as farmers at subsidized rate and operating branches in remote and inaccessible locations. This results in unusually high rate and poor transmission.
The use of external benchmark [replacing the internal benchmark being used hitherto] is unlikely to change the situation on ground zero. This is because the repo rate serves as the minimum even as banks will have the freedom to charge a spread [a euphemism for adding certain percentage to cover the extra cost and risk associated with lending]. The borrowers may face double whammy. Whereas, the banks will promptly pass on any hike in the repo rate by way of corresponding increase the lending rate; even when the former is reduced, they won’t reduce the latter citing higher spread.
Furthermore, borrowers will face increased volatility in the cost of loans as unlike the present dispensation wherein, the banks review the interest rate once in a year, from October 1, 2019 henceforth this will happen once every two months synchronous with the monetary policy review [they might be spared only when RBI decides to keep repo rate unchanged in any review but that offers little consolation as the under-current of volatility will remain]. This will render unstable the budgets of all those taking loans for building homes, buying car etc.
The full transmission of cut in the policy rate resulting in relief to borrowers could happen only if the spread is kept at the bare minimum. This in turn, would be possible only when the banks are able to drastically bring down the NPAs and are spared the burden of social responsibilities such as subsidies or they are required to pay lower interest rate on deposits. ALAS! none of these appears to be within the realm of feasibility at least in the near term.
In an interactive session with media, recently finance minister, Nirmala Sitharaman informed about huge recovery of over Rs 300,000 crore from defaulters made possible largely by concerted action under the Insolvency and Bankruptcy Code [IBC] which helped banks reduce their gross non-performing assets [GNPAs] from 11.6% of total loans as on March 31, 2018 to 10.3% on March 31, 2019. But, fresh NPAs of about Rs 300,000 crore are in the making.
This is primarily because of non-bank finance companies [NBFCs] such as Infrastructure Leasing and Financial Services [ILFS] and Dewan Housing Finance Corporation Limited [DHFCL] etc going bust besides fresh NPAs in infrastructure and power sectors. Even if these are taken care by way of recovery or fresh dosage of recapitalization, there is no guarantee that more NPAs won’t emerge. Likewise, given the current affliction of all parties across the political spectrum to populism, it is unlikely that the cult of subsidies and other forms of largesse given through PSBs will go away too soon.
As regards interest rate on deposits, these are downward inflexible. The paramount reason for this is the rate on small savings instruments which are controlled by the government and are generally higher than the interest rate on deposits offered by banks. If, in a bid to give relief to borrowers, banks further reduce interest rate on deposit, they run the risk of losing funds thereby hitting at the foundation of their business. So, they would refrain from opting for it.
Another potent factor contributing to high interest rate and poor transmission is high fiscal deficit/borrowings by union government. Because of this, last year, the central bank was forced to conduct open market operations [OMO] to the tune of about Rs 300,000 crore to ease liquidity in the system.
To sum up, merely having an external benchmark to fix lending rate won’t help in giving relief to borrowers [this is like applying band-aid to a patient who requires major surgery]. The government and the RBI need to work on tackling structural issues viz. high NPAs, high fiscal deficit, inefficiencies in banks and rigidity in small savings schemes etc. Once this is done, on their own volition banks will offer lower interest rates obviating the need for any intervention by the banking regulator.