What will happen to your loan after banks link it to external benchmark?

The problem that most borrowers with floating interest rates on home or auto loans face is that there is no way to find out how often and by how much their lenders will increase or decrease rates. Over the past several years, banks have been quick at raising rates after Reserve Bank of India hikes the policy rate, while they have been slow at reducing when the central bank cuts the policy rate. Even if they reduce rates, the quantum is hardly in tune with the corresponding reduction in the repo rate.

To address the concern, the RBI introduced the base rate in June 2010 that required banks to declare the lowest rate below which they would not offer any loan. However, the issue with transmission of interest rates persisted. In April 2016, the RBI changed the policy rate to marginal cost of funds based lending rate (MCLR) to make the process of fixing interest rates more transparent. The move did not bear fruits either. Until July 2017, the spread between the repo rate and SBI's MCLR stood at 1.75 per cent. It has increased to 2.75 per cent now.

Why banks delay the interest rate transmission?

Interest rate transmission by banks is not as simple as it appears. Repo rate is not the only factor that determines the cost of the fund for banks. They have many sources of funds and different interest rates. "Some of factors impacting the cost of funds are share of fixed and floating rate liabilities, low cost deposits, g-sec rates, banking system liquidity and so on. Hence, fall in the repo rates does not directly lead to similar fall in the marginal cost of lending rate (MCLR) of banks," says Miren Lodha, Director, CRISIL Research.

There are mismatches of many major liabilities that banks have, cost of which does not necessarily follows the repo rate change. "Deposits form 75-80 per cent of total liabilities of the banking system and are generally priced at fixed rates. The slower transmission of rate cuts was due to the high deposit rates prevailing in the system," says Lodha.

It is impossible for banks to pass on the rate change to existing depositors as their rates remain fixed. "It takes longer time for deposits to get repriced as term deposits (which forms over 65 per cent of total deposits) on an average take up to two years to get repriced at fresh rates. Therefore, banks hesitate to reduce interest rates on advances as deposits take longer to get repriced," add Lodha.

Besides, banks are dealing with high level of non-performing assets for which they have to set aside higher provisions, which put additional pressure on margins. This is why they either increase the benchmark rate for lending or the spread over it.

How will external benchmarking impact borrowers?

With the external benchmark, RBI is trying to make the system more transparent for borrowers. "In order to ensure transparency, standardisation and ease of understanding of loan products by borrowers, banks have now an option to benchmark the loans either with the RBI policy repo rate, government of India three months or six months treasury bill yields or any other benchmark market interest rate published by the Financial Benchmarks India Pvt Ltd," says Shantanu Sengupta, Managing Director and Head- Consumer Banking Group, DBS Bank India.

If you become a borrower of loan with external benchmarking, you will not depend on the bank to tell you when your interest rate will change. You can track the benchmark yourself. Many of the benchmarks allowed by the RBI change quite frequently even on the daily basis while some make a move in a month or two.

"Those who will opt for external benchmark-linked loans will benefit from faster reduction in rates in the event of reduction in repo rate or other broader market rates vis-a-vis MCLR-linked loans. On the flip side, the same swiftness in the transmission of reduced repo rate or other broader market rates can work against borrowers, as their interest rates would increase faster than MCLR- based loans during rising interest rate regime," says Ratan Chaudhary - Head of Home Loans, Paisabazaar.com

Earlier banks used to take their own time to decide when to pass on the interest rate change to the borrowers. However, it will now change. "As far as loan reset period is concerned, external benchmark-linked loans have to be reset at least once in three months, thereby ensuring transmission of changes in policy or broader market rates," says Chaudhary.

What should an existing borrower do?

Banks will start introducing external benchmark-linked floating rate loans to new borrowers from October. Will existing borrowers be left out? "Existing customers can choose this benchmark over MCLR-based interest rate. Transmission of policy rate changes will become faster and more transparent with this move," says Sengupta. However, there could be nominal charges that you may have to pay for making the switch.

"Existing borrowers with loans linked to MCLR/Base Rate/BPLR would have the option to either continue with the same regime till repayments or renewals or switch to external benchmark-linked loans without incurring any charges/fees, except for administrative/ legal costs incurred in the process. The final lending rate of the borrower after the switch will be the same as the rate charged for a fresh loan of the same category, type, tenor and amount at the time of the loan origination," says Chaudhary of Paisabazaar.com.

Once new loans kick in, you need to contact your bank to know how to make a switch or the cost of it.

What should NBFC customers do?

External benchmark is mandatory only for banks, so what will happen to the borrowers who have taken loans from NBFCs and HFCs? "Housing loans segment will be most impacted as floating rate loans don't have prepayment charges. Since RBI has only asked banks to link their loans to external benchmark, NBFCs are free to price their loans as per existing terms," says Lodha.

However, if borrowers feel that their rates are higher and unattractive, the NBFCs will lose business, which they cannot afford. "NBFCs have become big players in the housing loan segment and contribute around 35-40 per cent to the housing loan market. High competition from banks and lower interest rate environment will force NBFCs to reduce interest rates to new borrowers. On the other hand, existing borrowers from NBFCs may continue witnessing slower transmission of rate cuts," says Lodha. As there is no penalty for transfer, existing borrowers will also have the option to transfer their loans to a bank. So, if you are an existing borrower who doesn't have eligibility issue in a bank, you can very well transfer your loan to a willing bank.

Will it be the end of rate transmission woes?

Since only lending side is being linked with the external benchmark, not the liabilities, asset-liability mismatch could be an issue for banks. "Effective monetary transmission needs to happen on both sides of balance sheet. Therefore, banks would like to link their liabilities with external benchmark or price the risk of higher interest rates by increasing the risk premium (spread) on floating rate loan borrowers. Since there is no provision to link the term deposits with any external benchmark, impact of linking the advances with external benchmark is likely to take longer to become effective," says Lodha of CRISIL Research.

Do banks have solutions to make the external benchmarking effective by finding a way in which their cost of funds also changes in tune with the external benchmark? "Banks and customers need to move to a regime of floating rate deposits as well. Cost of retail deposits is fixed for a specific tenor that changes upon maturity, which impacts the transmission," says Sengupta.

RBI notification says that under the new external benchmarking system, the interest rate can change for a borrower if his/her risk profile changes substantially. Will it result in banks using this window to change the interest rate for borrowers whenever they wish? "Banks can change the lending rate only when the borrower's credit profile undergoes a substantial change," says Chaudhary.

So, will it allow banks to frequently tweak interest rates as per change in the credit profile? "Banks can charge a spread based on credit risk premium and operating cost over the external benchmark, but will have to keep it constant for three years except for the credit risk premium," says Sengupta of DBS. Three years are good period to have a stable spread. So, if the bank changes the rate, you will always have the option to transfer your loan to a new bank if you see substantial difference between the two rates.

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