Why linking loan rates to external benchmarks a bad idea

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Published: February 20, 2019 2:08:01 AM

RBI has suggested banks link their floating rate retail loans and loans to micro and small enterprises to an external benchmark. This would hit lenders’ margins since retail deposits account for the bulk of their resources.

Why linking loan rates to external benchmarks a bad ideaWhy linking loan rates to external benchmarks a bad idea

RBI has suggested banks link their floating rate retail loans and loans to micro and small enterprises to an external benchmark. This would hit lenders’ margins since retail deposits account for the bulk of their resources. To be sure, there is a case for more transparency in the lending practices and processes; customers’ complaints, that banks are not always passing on a saving in the cost of funds, are probably true. The Janak Raj committee found banks are inflating the base rate by deviating in an “ad hoc manner” from the methodologies prescribed for calculating the base rate and the MCLR (Marginal Cost of Funds Lending Rate).

Moreover, they are tweaking the rate to make sure it doesn’t fall in proportion to the drop in the cost of funds. Apart from “ïnappropriately” calculating the rates, new components have been brought in to get the rate to a desired level. These are clearly not desirable. However, the solution probably lies in regular monitoring and penalising lenders if they deviate from the norms enough to make it hurt. Stiff penalties should ensure banks fall in line.

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Loan rates need to be linked to the cost of funds. Unless banks make enough of a margin to cover their costs, they will resort to lazy banking. They need to keep interest rates on deposits at attractive levels, else they will not attract enough resources to be able to lend. This is important at a time when the rate of growth of deposits is relatively slow vis-à-vis the growth in loans. The committee has noted that, although bank deposits have some distinct advantages in the form of stable returns (vis-à-vis mutual fund schemes) and liquidity (vis-à-vis small saving schemes), they are at a disadvantage in terms of tax-adjusted returns in comparison with these schemes. The rate of growth of deposits has stayed below 10% for nearly two years now whereas loans are growing at a faster pace.

External benchmarks suffer from one flaw or another. The main challenge in using either T-bill rates or CD rates as the benchmark, as the committee has observed, is that these markets are not deep enough and are therefore vulnerable to manipulation. Moreover, T-bill rates may, on occasion, reflect fiscal risks which will automatically get transmitted to the credit market when used as a benchmark. CD rates are highly sensitive to liquidity conditions, credit cycles, and seasonality.

Again, the repo rate, while reflecting the appropriate rate for the economy, suffers from the lack of a term structure; also, banks have limited access to funds at the repo rate.

The other proposal that banks are miffed about is that the spread—cushion over the base rate or MCLR reflecting the credit profile of the borrower—be left unchanged unless there is a change in the rating. So the spread can be raised only if the credit profile of the borrower deteriorates. Banks are guilty of playing around with the spreads—the committee notes these are changed arbitrarily for borrowers of a similar quality. Some banks are believed to be charging spreads that are excessive and are doing so consistently. This is unacceptable and RBI should insist the spread remains unchanged during the life of the loan.

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