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ANALYSIS: Borrowers to gain from external loan benchmark, not banks

Thursday, Dec 6

    By Alekh Archana and Anshika Kayastha
    MUMBAI – From April, banks will have to price floating rate loans to retail customers and small units to an external benchmark as the Reserve Bank of India wants to ensure effective transmission of monetary policy.
    On the face of it, borrowers stand to benefit.
    Loan rates based on the proposed external benchmark, would be lower than those arrived at by using the current system of marginal cost of funds-based lending rate, which replaced Base Rate in April 2016.
    For instance, the country’s largest lender State Bank of India’s one-year MCLR has moved from 7.80% to 8.95% between April 2016 and November 2018.
    In the same period, the RBI’s repo rate increased from 6.00% to 6.50%, and yield on 91-day and 182-day treasury bills moved up from 5.82% to 7.19% and 5.97% to 7.45%, respectively.
    Banks are free to choose any of these above as benchmarks or any other market interest rate provided by Financial Benchmarks India Pvt for a loan category.
    They are also free to derive the spread over that benchmark, on the condition that it remains unchanged unless there are substantial changes in the credit assessment of the borrower.

DEPOSIT COST WOES
    So far, the core philosophy has been that lending rates capture the cost incurred by banks. With an external benchmark, this will alter significantly and this has been the biggest concern for bankers.
    Linking lending rates to external instruments even as deposit rates continue to be fixed could lead to asset-liability mismatch issues for banks and volatility in net interest margins.
    In India, most banks fund their loan growth through retail deposits. Hence, cost of deposits is the largest component while calculating lending rates. However, this along with other costs incurred by bank will not be reflected in the market-determined external benchmark.
    Though this could be addressed by allowing banks to offer floating rate deposits, past experience shows aversion of retail depositors to such products as they prefer fixed returns.
    The premise of an external benchmark is also that banks are well equipped to manage interest rate risks. However, the interest rate swaps market in the country is still at a developing stage.
    The reason for introduction of MCLR was that it would speed up transmission of policy rates, as it allowed for the calculation of lending rates based on incremental cost of funds and other operational costs.
    Prior to this, there existed a significant lag in transmission as banks had to wait to re-price their deposits before cutting loan rates so to as to protect margins.
    This meant that any change in MCLR had to be followed by a change in deposit rates.
    But banks don’t seem to be generally proactive in adjusting their deposit rates, in line with the changes in policy rates.
    Savings deposit rates are a case in point.
    Despite deregulation in 2011, savings rates remained around 4% for most banks until August 2017 when the deluge of deposits following demonetisation forced them to reduce the rates for the first time.
    Banks still have the freedom to include costs in the spread instead of the benchmark, by factoring in costs of deposits along with credit risks and term premium. However, because of this, spreads are now likely to be higher in absolute terms, than under the MCLR regime.

SPREADS
    Though banks have the discretion to charge the spread, it remains unclear if there are any safeguards to ensure that the charges are not arbitrary.
    The RBI study group that recommended external benchmarking had also noted that banks may fix spreads at too high a level for retail borrowers initially to account for future uncertainty.
    In its report, tt had observed similar trends for spreads on MCLR. Here, large reduction in MCLR was partly offset by some banks through simultaneous increase in spread in the form of business strategy premium, ostensibly to reduce the pass-through to lending rates.
    Given that personal loans are mostly fixed in nature, the biggest hit is seen being taken on the home loan portfolios of banks.
    As most large lenders currently charge similar rates on home loans, variations under the new regime due to differentiated spreads could hamper public perception, especially among retail borrowers, who would look for the least fluctuation in their equated monthly instalments.
    Factoring in costs into spreads might also lead to some banks adopting internal credit scoring mechanisms, such as that recently adopted by Bank of Baroda, to ascertain how much spread to charge different categories of customers based on their repayment track record.
    The sunset clause is another concern, as there is no clarity over whether existing customers will also need to shift to the new regime. At the time of roll-out of the MCLR regime, the absence of such a clause had led to several loans still being linked to the Base Rate, as customers had to pay a fee to shift their loans to the new benchmark.
    Though most state-owned banks are likely to follow market leaders such as SBI in determining which instrument to benchmark their loan against, large banks with lower cost of borrowings will clearly be at an advantage in terms of spreads, thus being able to garner high demand for such loans.
    This effectively may translate into large banks further eating into the share of smaller banks, even those who are not under the central bank’s corrective plan.
    There is also an argument that as the mandate is applicable only to banks it could lead to pricing arbitrage against loans offered by other large non-bank entities. However, with most such entities relying on banks and the market for their borrowings, banks have an advantage in terms of lower cost of funds due to their deposit base.
    Though borrowers have reason to cheer, banks are hopeful that RBI’s final norms, scheduled to be released by the end of this month, will address their concerns.  End

Edited by Ashish Shirke

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This copy was first published on the Cogencis WorkStation

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