RBI's new loan pricing rules

The central bank believes that this will bring a lot more transparency in the setting of interest rates. But this will impact your loans.
By Morningstar |  06-12-18 | 

The Reserve Bank of India, or RBI, has proposed that floating interest rates on personal, home, auto and micro and small enterprises (MSEs) loans will be linked to external benchmarks.

The RBI will probably prescribe the periodicity of adjustment in rates. Which translates into more volatility as far as EMIs on loans go.

While this is to promote transparency, it could also lead to banks discouraging long-term deposits as they have to calibrate rates according to very fluid benchmarks. Soumya Kanti Ghosh, chief economist at State Bank of India, stated in a note that such a move may also imply a floating interest rate structure of deposits, otherwise there would be significant ALM mismatch for the banks.

A brief look at history.

Prime Lending Rate, or PLR

  • Introduced in 1994.
  • 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.

Benchmark Prime Lending Rate, or BPLR

  • Introduced in 2003.
  • With the aim of introducing transparency and ensuring appropriate pricing of loans – wherein the PLRs truly reflected the actual borrowing costs – the PLR was converted into a reference benchmark rate and banks were advised in 2003 to introduce the BPLR system.
  • 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.

Base Rate

  • Introduced in 2010
  • This replaced the BPLR system.
  • It included all those elements of the lending rate that are common across all categories of borrowers. Banks were allowed to determine their actual lending rates on loans and advances with reference to the Base Rate and by including such other customer specific charges as considered appropriate. All categories of loans are required to be priced only with reference to the Base Rate.
  • Since the Base Rate is the minimum rate for all loans, banks are not permitted to resort to any lending below the Base Rate.
  • Banks are required to review the Base Rate at least once in a quarter.

Marginal Cost of Funds-based Lending Rate, or MCLR

  • Introduced in 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.

External Benchmark Linked Rate

  • To commence from April 1, 2019
  • Until now, banks were using their own cost of funds to determine the lending rate charged to different categories of borrowers. But starting April 1, 2019, banks will need to use an external benchmark to determine the lending rate to be charged. The external benchmarks will be notified soon but will be along of the lines of:
    1. RBI’s repo rate
    2. 91-day T-bill yield
    3. 182-day T-bill yield
    4. Mumbai Interbank Offered Rate, or Mibor
    5. Any other benchmark market interest rate produced by the FBIL (Financial Benchmarks India Pvt. Ltd). FBIL is a private limited company owned by FIMMDA, FEDAI and IBA, and was formed in December 2014.
  • Banks can decide on the spread (difference) they want to build in over and above the external benchmark. Once a bank picks a benchmark, it will add a spread or margin to it and arrive at the lending rate. Banks have flexibility to determine that spread value. But after that, they must keep it fixed for the tenure of the loan unless the credit score of the borrower changes.
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