RBI will need to cut less if banks begin with a lower lending rate

Published: September 10, 2019 1:34:00 AM

How will the Reserve Bank of India’s introduction of external benchmarks, effective October 1, impact its Monetary Policy Committee’s rate policy?

As the external benchmark falls on RBI rate cuts, banks would duly reduce lending ratesAs the external benchmark falls on RBI rate cuts, banks would duly reduce lending rates

How will the Reserve Bank of India’s introduction of external benchmarks, effective October 1, impact its Monetary Policy Committee’s rate policy? We expect it to follow Governor Shaktikanta Das into cutting policy rates by another ‘out-of-the-box’ 35bps on October 4 and 15bps in December, pause as inflation goes up on base effects, and cut 40bps to 4.5% repo rate by September if US recession risks rise. Our base case has banks pricing fresh retail/SME loans on a spread defined as the difference between the current retail/SME lending rate and the external benchmark. As the external benchmark falls on RBI rate cuts, banks would duly reduce lending rates. Second, what if banks settle at a lower spread/lending rate to begin with? This would obviously reduce the need for deeper RBI rate cuts. Finally, what if banks are split between RBI repo rate and yield benchmarks? They would end up following the benchmark that is rising/falling faster in a rising/falling rate environment.

So, what’s changing? Banks currently price their MCLR by the following formula: MCLR = Marginal cost of funds (deposit rates, borrowing, cost of equity = risk free + mark up) + CRR cost + tenor/credit risk premiums + opex… (1).

RBI actions enter equation 1 indirectly: (a) deposit rates depend on RBI durable liquidity infusion; (b) borrowing costs on liquidity (repo/reverse repo mode) and RBI repo rates, and (c) cost of equity on RBI rate cut/OMO.

RBI has now mandated that banks should price lending rates on fresh retail/SME loans (about 50% of book) as a spread over external benchmarks like the RBI repo rate, 3m/6m T-Bill or any other benchmark market interest rate published by the Financial Benchmark India Private Ltd (FBIL), by October 1. As floating rate loans are linked to external benchmarks (at 3-month reset), transmission will naturally be direct (for RBI repo rate), or, at least far more rapid (for, say, T-Bills). Banks are free to choose their spread over the benchmark interest rate, subject to the condition that the credit risk premium can change only when the borrower’s credit assessment undergoes a substantial change, as agreed upon in the loan contract.

Lending rates headed lower at the margin

Scenario 1. Banks retain current lending rates. Our base case has banks pricing fresh retail/SME loans on a spread defined as the difference between the current retail/SME lending rate and the external benchmark. As the external benchmark falls on RBI rate cuts, banks will duly lower their lending rates. They will likely also cut their deposit rates to protect margins to some extent.

Scenario 2. Banks set lower spread/lending rate. Banks could begin with a lower lending rate if they fix a lower spread. This will obviously reduce the need for RBI to cut rates much further. As real lending rates are still very high, it is unlikely that the RBI rate cutting cycle will immediately ground to a halt (see chart).

Scenario 3. Banks split between RBI repo rate and yields. Banks will likely have to follow the faster falling/rising rate benchmark; for example, if yields fall in expectation of RBI rate cuts, banks will have to cut lending rates to retain customers. What if yields go up on fiscal stimulus fears, even though RBI is cutting rates? Banks priced on yield benchmarks will have to follow banks priced on the RBI repo rate to retain their customers again.

(Excerpted from the report ‘India Economic Watch. RBI rate cuts: How will external benchmarks affect?’ by BofAML dated September 9, 2019)

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