It is hoping the transmission, of a change in interest rates for borrowers, will be faster.
It is certainly the case that most banks are not transparent enough while fixing loan rates, especially for the medium and small enterprises (MSME) sector. Moreover, a whole clutch of lenders—including NBFCs—takes their own time to pass on the benefits of falling interest rates to borrowers although they are very quick to raise loan rates when their cost of funds goes up. Although banks have migrated from the base rate mechanism to the MCLR—marginal cost of funds based lending—which is a more transparent pricing method, borrowers are unhappy. That’s probably why RBI wants banks to discard the MCLR method of pricing loans and to link retail and MSME loans to an external benchmark which could be either the repo rate or the treasury bill. It is hoping the transmission, of a change in interest rates for borrowers, will be faster.
Given the lending rate is linked to the cost of funds and the bulk of banks’ liabilities are customer deposits, this is a big change. If banks are forced to benchmark loans to the repo or the T-Bill—which may not reflect the true cost of funds—they are bound to keep the spreads high, which RBI has said is entirely at their discretion. Banks will use the leeway to charge borrowers a high spread, pencilling in all costs and possible risks. They will be particularly cautious since RBI will not allow them to change the spread during the tenure of the loan unless there is a substantial change in the borrower’s credit assessment. The over-cautiousness on the part of lenders, and their attempt to ensure that their net interest margins aren’t impacted, could make loans costlier. To be sure, the stronger banks will be in a position to offer better rates, especially in a keenly competitive segment such as home loans, where the spreads tend to be relatively low. But the best of lenders will be cautious. Also, it is not clear whether the credit rating will be done internally or by a rating agency, but any changes made in the credit assessment should be bona fide, else the system would get vitiated.
If they believe their margins are under pressure, lenders are likely to cut the interest rates on deposits, though that would depend entirely on their competitive position in marketplaces. At some point, they may even suggest that interest rates on deposit rates be offered on a floating rather than on a fixed basis, and also that these be benchmarked to money market rates. However, that is unlikely since customers in India are used to earning a fixed rate on deposits and those lenders with a smaller deposit base would not risk losing customers.