Lending rates: RBI proposal poses many questions

By: | Published: October 6, 2017 4:31 AM

The Reserve Bank of India’s (RBI) proposal to link lending rates to an external benchmark might solve the persisting issue of monetary transmission but questions arise as to how these short-term rates could help in the effective pricing of long-tenure loans and how banks could convince their customers to shift to floating-rate term deposits.

rbi, reserve bank of india, rbi repo rate issueAn internal study group of the RBI has shortlisted three potential external benchmarks to which bank lending rates could be linked — the treasury-bill rate, certificates of deposit rate and the RBI’s policy repo rate. (Reuters)

The Reserve Bank of India’s (RBI) proposal to link lending rates to an external benchmark might solve the persisting issue of monetary transmission but questions arise as to how these short-term rates could help in the effective pricing of long-tenure loans and how banks could convince their customers to shift to floating-rate term deposits.

An internal study group of the RBI has shortlisted three potential external benchmarks to which bank lending rates could be linked — the treasury-bill rate, certificates of deposit rate and the RBI’s policy repo rate. These rates were shortlisted after analysing 13 different benchmarks that included government securities yield, weighted average call rate etc. The study group recommended that all floating rate loans extended beginning April 1, 2018 could be referenced to one of the three external benchmarks selected by the Reserve Bank after receiving and evaluating the feedback from stakeholders.

However, the movement in short-term rates may not reflect the change in long-tenure rates, as a result of which pricing long-term loans based on these benchmarks might not be an exact reflection of market dynamics.

As R Sivakumar, head – fixed income at Axis Mutual Fund points out, it would be imprudent to price a longer-tenure loan to a benchmark that reflects short-term rates.

“There are times when the yield movement occurs at the longer end of the maturity but short-term rates remain stable. In such cases, we may not see rate transmission to the loan market despite the fact that the market may be pricing in a fall in long-tenure yields,” Sivakumar said.

Such a situation occurs, say for example, when inflation numbers fall and expectations of a rate cut gains momentum. Such periods can last for a few weeks to a month and often leads to fall in long-tenure yields whereas short-term rates remain intact. In such a situation, rates on longer-tenure loans may not move down in tandem with the market dynamics. This gains more prominence even as the study group has recommended the periodicity of interest rate reset to be reduced to three months from a year.

The study group asserts that the repo rate should not be a handicap for term lending, as banks are equipped to factor in tenor premium appropriately, as they have already been doing.

However, it has also acknowledged there are disadvantages to the three benchmarks. The main challenge in using either T-bill rates or CD rates as the benchmark is that the current level of market depth in the T-bill and CD markets can make such benchmarks potentially susceptible to manipulation, the report stated. It added that T-Bill rates may at times reflect fiscal risks which will automatically get transmitted to the credit market when used as a benchmark.

CD rates also have their own limitations — high sensitivity to liquidity conditions, credit cycles, and seasonality. Liquidity in the CD market is inadequate because there are no large and frequent issuances by a sufficient number of highly rated banks. Latest RBI data shows that outstanding CDs in the system stand at `1.14 lakh crore while `12,130 crore worth of CDs were issued in a fortnight. At the same time, `11,000 crore worth of T-bills are issued every week.

As far as the repo rate is concerned, linking bank lending rates can constrain future changes in the monetary policy framework, the report indicates. Banks also have limited access to funds at the repo rate and being an overnight rate, the repo rate also lacks a term structure, it added.

Ananth Narayan, a money market expert, indicates that T-bills and repo rates are better benchmarks than CD rates.

“The advantages of having T-bills and repo rate as an external benchmark is that the RBI can actively manage these segments whereas in a CD market, as on date, the central bank cannot engage directly,” Narayan points out.

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