Should regulators be thinking on these lines and are Indian customers ready to pay for such services?
By Anjalee S Tarapore
RBI has proposed that all new floating-rate bank loans to retail customers and micro and small enterprises be linked to an external benchmark with effect from April 1, 2019. Floating rate loans would be benchmarked to either RBI’s repo rate, 91/182-days Treasury yield or any other acceptable market interest rate. The objective is to ensure effective transmission of policy rates and increase transparency in terms of pricing of such loans.
RBI has grappled with the debate on monetary policy transmission for over two decades. The central bank maintains that adjustments in policy rates must percolate across the entire spectrum of interest rates to ensure overall financial stability.
In 1994, the prime lending rate (PLR) was introduced to represent the lending rate for the most credit-worthy customer. In 2003, the PLR was converted to the benchmark prime lending rate (BPLR). As most lending continued at sub-BPLR rates, RBI mandated the base rate system in 2010. The base rate was the rate below which banks could not lend. As the spread over the base rate was deemed to be arbitrary, RBI finally prescribed a formula-based marginal cost of funds based lending rate (MCLR) in 2016.
RBI, to its credit, set up an internal committee under the chairmanship of Janak Raj to evaluate the MCLR system. The report deserves kudos for its extensive work of evaluating 13 options as potential external benchmarks. Tellingly, the committee noted, “There is no instrument that meets the requirements of an ideal benchmark. Each instrument has certain advantages as also limitations”.
It is not entirely clear as to why RBI opted to disregard the MCLR regime in such a short span of time. One fervently hopes that RBI’s decision to move to external benchmarks was not because its back was against the wall as a result of the fallout of the public interest litigation filed in the Supreme Court on unfair practices regarding floating rate loans.
No one disputes the need for a more transparent benchmark. The grouse has been that monetary transmission is faster when rates are moving upwards and vice versa. With an accommodative monetary stance between April 2016 to June 2018, some customers felt aggrieved that the interest rates on their loans did not reprice downwards at the same pace as policy rates.
It is incorrect to conclude that all lenders have been unfair with customers and lacked transparency in their internal benchmark rates. Financial market watch-dogs are needed in the system. Yet, when these entities call out financial lenders as ‘banksters’ or ‘Shylocks’, merely for not facilitating a full pass-through of policy rates, it reveals a lack of understanding of financial market realities.
The Janak Raj committee rightly identifies reasons why monetary transmission in India gets constrained. Banks inherently face asset liability mismatches and interest rate risks as deposits are fixed rates, while loans are predominantly floating rates. Indian banks rely heavily on retail deposits to fund loans and interest rates on saving accounts tend to be sticky. Depositors have rejected floating rate deposits and the interest rate swap market in India remains underdeveloped. Lastly, high non-performing loans has impacted profitability of banks and impeded policy transmission.
It is unlikely that mere transition to external benchmarks will be the panacea for monetary transmission. At this juncture, there appears to be more questions than answers.
Will external benchmarks be applicable only for prospective loans or will there be a sunset clause to ensure all existing loans transit within a defined time frame to external benchmarks? Will conversion charges be allowed?
Banks are most likely to increase their spreads over the benchmark rate as a buffer, rather than risk impacting profitability. Will this make loans more expensive for borrowers?
Will RBI prescribe the periodicity of interest rate resets? If so, will borrowers need to brace themselves for increased volatility in rates?
If the spread over the benchmark rate is to remain unchanged over the entire life of the loan, what happens to a borrower whose credit assessment gradually improves over time? Can this be construed as “substantial change in the credit assessment”? For instance, there are many first-time borrowers from the informal segment who initially pay a higher interest rate, but overtime, if their repayment record is good, they are able to reprice their loans. Would the original lender have to lose such a customer to competition? Why shouldn’t a lender be allowed to alter the spread in order to retain a customer?
Increased transparency in developed markets is not only attributable to the use of external benchmarks. Customers rely on qualified mortgage brokers and financial advisors to make the best choice for them. Should regulators be thinking on these lines and are Indian customers ready to pay for such services?
Ensuring a smooth transition to the external benchmark regime calls for clear guidelines, yet RBI knows the perils of being too prescriptive. Herein lies RBI’s greatest challenge.
Writer works for a leading housing finance company The views are personal