First it was BPLR, then base rate, then MCLR and now the Reserve Bank of India is again contemplating to introduce a new system to price loan rates. In fact, the repo rate has been recommended as the new benchmark to price loan rates, including home loans. The question, however, remains the same: When will the loan rates be linked to the market rates and when will the loan pricing be fairer to the borrowers?
It may be noted that the RBI in the Monetary Policy report released on October 4 has itself admitted that the overall experience with the transmission of monetary policy since the switch over to the MCLR regime from the base rate in April 2016 has not been fully satisfactory. Its observation is based on the report of the Study Group, constituted by the Reserve Bank to study various aspects of the MCLR system from the perspective of improving monetary transmission, which has recommended a switchover to an external benchmark in a time-bound manner as internal benchmarks such as the base rate/MCLR have not delivered effective transmission of monetary policy.
“Arbitrariness in calculating the base rate/MCLR and spreads charged over them have undermined the integrity of the interest rate setting process. The base rate/MCLR regime is also not in sync with global practices on pricing of bank loans,” the Study Group has said in its report submitted to the RBI.
However, before coming to the new benchmark, let us understand how the current systems of base rate and MCLR work.
If you remember, the current system of MCLR (Marginal Cost of Lending Rate) was introduced by the RBI on the 1st April 2016, vide which banks are required to determine and declare their lending rates keeping in view their marginal cost of funds, operating expenses and tenor premium, among others.
The base rate lending system takes into account four factors for interest rate calculation, i.e. rate offered on the deposits, banks’ operational costs, spread or margin over the cost, and credit reserve ratio (CRR) maintenance cost. Under the MCLR system too, four factors are considered for deciding the interest rate. CRR cost and banks’ operational cost are maintained like base rate. However, replacing the margin and cost of funding, MCLR considers tenor-based premium and marginal cost of funds. Under tenor-based lending in MCLR, banks base loan rates on the duration of the loan. Different rates are offered for short and long-term loans. In the base rate system, for all loans, there is a single benchmark rate which does not change due to tenor of the loan.
“The system of MCLR was introduced to make monetary transmission more effective, i.e. to ensure that the benefits of a rate cut by the RBI reach the common man. Under the earlier base rate regime, in the event of the RBI reducing the pepo rate (rate at which the RBI lends to banks), banks were generally slow in making a corresponding reduction in their base rate. The MCLR reform had been introduced to offset this situation,” says Rachit Chawla, Founder & CEO – Finway Capital.
However, now the RBI says that the overall experience with the transmission of monetary policy since the switch over to the MCLR regime from the base rate has not been fully satisfactory, and wants to switch over to a new system to price loan rates.
The Study Group has suggested that with the repo rate as the benchmark, the transmission of the repo rate changes to lending rates of banks will be quick, direct and strong. “The repo rate as a benchmark, however, can constrain future changes in the monetary policy framework. Banks also have limited access to funds at the repo rate. Being an overnight rate, the repo rate also lacks a term structure,” it says.
However, given that there has not been much forward movement on the external benchmark even after seventeen years from the time when it was first allowed in the country, the development of an external benchmark would need guidance from the Reserve Bank. Accordingly, there is a need for switching over to one of the external benchmarks recommended by the Study Group, after wider public debate and taking into account the feedback from all stakeholders. “Given the scope of arbitrariness under the MCLR system, however, the switchover to an external benchmark needs to be pursued in an expedient and time-bound manner,” the Study Group says.
The Study Group’s suggestion is really commendable. Maybe the new benchmark will be better than the earlier ones. Industry experts have also welcomed the move. For instance, Amit Oberoi, National Director-Knowledge Systems, Colliers International India, says, “The suggestion by RBI to fix bank borrowing rate to a fixed margin over and above the repo rate is a welcome step. This margin will reflect the credit worthiness of the borrower and will be constant unless banks have credible reason to believe there is a change in the borrower’s risk profile. This measure will ensure that banks do not delay transmitting the central bank’s rate cut benefit to the consumers over the loan tenure. This is good news for home buyers. We hope that this suggestion is implemented in the same spirit as it has been conceived.”
However, given the way lending rates are determined in India, besides taking into consideration banks’ reluctance to pass on the benefits of rate cuts to borrowers and the RBI’s inability to take any action against the erring banks, the question remains the same – ‘Will loan pricing ever be fairer to borrowers’?