How external benchmarking of interest rates can benefit borrowing

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Published: March 25, 2019 3:17:40 AM

The expectation was that MCLR system would help in passing on the policy rate fluctuation to the lending rate, and in turn to the borrower’s EMIs, but that did not happen.

Whenever there was a change in the policy rate, the impact was not wholly reflected in the bank’s MCLR rate. (Illustration: Shyam Kumar Prasad)

The Reserve Bank of India (RBI) has been exploring a reliable benchmark to link interest rates for a while now. In the past, it has experimented with benchmarks such as Prime Lending Rate (PLR), Base Rate, and Marginal Cost of funds based Lending Rate (MCLR). Last year, it announced to put in place a new interest rate benchmarking system called the ‘external benchmark’. The new benchmark would be applicable from April 1, 2019.

Problem with MCLR rate system
Since April 1, 2016, all the loans have been linked to the corresponding MCLR rates which are the internal benchmark of banks. In this system, banks added their spread over the underlying MCLR rate.

The expectation was that MCLR system would help in passing on the policy rate fluctuation to the lending rate, and in turn to the borrower’s EMIs, but that did not happen. Whenever there was a change in the policy rate, the impact was not wholly reflected in the bank’s MCLR rate. When there was a fall in the policy rate, the benefit was not immediately transferred to the borrowers. In contrast, whenever there was a hike in the policy rates, the banks appeared more responsive in updating their MCLR rates. As such, borrowers were not able to benefit from the RBI’s rate changes. That was the overarching consideration behind RBI’s move to bring in the external benchmarking system.

External benchmark system
Under the new system, the interest rates on all the loans would be linked to an external benchmark. The central bank has given options to banks for selecting the external benchmark—they include the RBI’s Repo rate, 91 Day Treasury Bill, 182 Day Treasury Bill or other appropriate benchmark interest rates produced by the Financial Benchmarks India. Also, the banks can determine the spread over the external benchmark they select. However, such a spread would remain fixed for the entire tenure of the loan.

Impact on borrowers
The impact on borrowers would depend on the interest rate trend during the tenure of their loan. Linking the
lending rate to an external benchmark would result in quick transmission of a change in the key policy rate to the borrower. Thus, if the interest rate trend is downward, the borrower will get the benefit immediately and save money towards interest outgo. Whereas, if the interest rate trend is upward, the borrower would be shelling out extra EMI with immediate effect.

That being said, the interest rate fluctuation averages out on a long-term loan; so, the external benchmarking system may not affect the borrower significantly. Under the existing MCLR system, the banks linked different underlying benchmark rates within the same product, confusing the borrower. In external benchmarking, banks would be required to connect a loan product with a single benchmark. So, it would help in clearing ambiguities from the borrower’s mind.
Borrowers should closely and consistently monitor their bank’s chosen external benchmark and corresponding loan interest rates after the new system kicks in to be better prepared while tackling a sudden hike in EMIs.

-The writer is CEO, Bankbazaar.com

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