RBI Group Recommends Linking Loan Pricing To Market Driven Rates

A study group constituted by the Reserve Bank of India has recommended that floating rate loans be linked to an external benchmark, in an attempt to improve the transmission of changes in policy rates to the end borrower.

Over the years, the banking regulator has moved from the prime lending rate formula to the base rate formula and, most recently, the marginal cost lending rate formula. However, each of these formulas were based on benchmarks specific to each bank, most notably, the cost of deposits. In the RBI's view, none of these formulas have allowed for complete transmission of policy rate changes.

This time the RBI is mulling an option which asks banks to link their lending rates to a market-based rate, which is common to all lenders. The premise behind this suggestion is that the market tends to transmit policy rate changes more quickly and fully.

The study group has suggested three options which could used as the base for loan pricing:

• A risk free curve involving Treasury Bills
• The Certificate of Deposit rate, which banks use to raise bulk deposits
• Or the RBI's benchmark repo rate

While listing out the pros and cons of each rate, the study group said that a final call on which rate to use as the benchmark would be taken in consultation with lenders.

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“The lower transmission from the policy rate to the base rate loan portfolio was mainly due to the reason that banks followed different methods to calculate the base rate,” said the working paper will explaining the need to move away from the base rate formula. “Banks have been quite slow in migrating their existing customers to the MCLR regime,” the RBI added.

The MCLR formula had been introduced in April 2016 and replaced the base rate which had come into effect in 2010. Most banks have, however been slow in migrating customers from the base rate to the MCLR.

Importantly, while the RBI study group recommends that a market based benchmark be used to price loans, banks will still have the flexibility to determine the spread over that benchmark charged to different customer segments.

The spread over external benchmark will be left to commercial considerations, said the study group. This will ensure that banks can maintain their margins, even if the movement in rates is dictated by a change in the market rates.

Further, the group recommends that interest rate resets on all floating rate loans should happen quarterly rather than annually as is the practice currently.

The suggestions made by the study group will be formalised after consultation with stakeholders. The RBI hopes that the consultation process will be concluded this fiscal and suggests that loan pricing be linked to chosen external benchmark starting April 2018.

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