The Reserve Bank of India’s (RBI’s) mandate asking banks to link their lending rates on floating rate loans to retail, personal and micro, small and medium enterprises (MSME) borrowers to an external benchmark from 1 October is credit negative for domestic banks, Moody’s Investors Service said on Tuesday.

“This is a credit negative for India's banks as it will limit their flexibility in managing interest rate risk," Moody’s said in a report.

The RBI mandate, announced on September 4, is aimed at improving transmission of interest rates. It said the transmission of policy rate changes to the lending rate of banks under the current marginal cost of lending rates (MCLR) framework has not been satisfactory.

RBI has cut the repo rate by 110 basis points from 6.5% to 5.4% since January. With RBI cutting the repo rate, the expectation was that bank lending rates will also come down. However, that hasn’t happened, with most banks holding on to their lending rates.

Lenders have been allowed to choose between RBI’s repo rate, government of India’s three-month treasury bill yield published by the Financial Benchmarks India Private Ltd (FBIL), government’s six-month treasury bill yield published by the FBIL or any other benchmark market interest rate published by the FBIL.

According to Moody’s, under the new regime, while the floating rate loan book will get re-priced, only the non-CASA (current account savings accounts) deposits will see a re-pricing on deposits.

“This will cause volatility to bank’s net interest margins (NIMs), with NIMs rising when interest rates increase and declining when interest rates fall. This volatility in NIMs will translate into volatility in the overall profitability of banks," the report said.

It also said it was not clear if banks will be able to mitigate this risk by linking the interest rates on CASA deposits to an external benchmark.

While a substantial portion of bank deposits are from CASA, interest rates on them are generally low yet stable. As a result, a bank may not want them any lower as it will risk losing customers.

“For instance, the State Bank of India (Baa2 stable, ba1)1 has linked its savings deposit rate to the repo rate, but subject to the savings deposit rate not falling below 3%," it said.

Besides, the lack of a single benchmark that can “consistently and accurately capture the movement of interest rates in the economy will also cause volatility to banks’ NIMs—key parameter of profitability." “Therefore, benchmark selection will be difficult and will cause inherent volatility to banks’ NIMs," it said.

Since banks’ funding requirement are dynamic, the new rules will impede the ability of banks to reflect such changes in funding costs of their lending rates as these rates will be linked to an external benchmark, Moody’s said.

“The new rules will be applicable only to new personal, retail and MSME loans. Therefore, the near-term impact will be mitigated as new loans will be a relatively small portion of banks' loan books to begin with. However, over time, most of the retail and MSME loans will transition to the new mechanism," it said.

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