In under 30 days, India’s banks will have to charge retail borrowers and small businessmen interest rates linked to an external benchmark.

This is part of the Reserve Bank of India’s push towards greater transmission of its policy rate cuts.

As the adjoining chart shows, the existing marginal cost of funds based lending rate (MCLR) failed to pass on the complete benefit of falling interest rates to borrowers.

Surely, better transmission would mean happy borrowers and, therefore, more business to banks.

Given that interest rates are headed down, lower cost of borrowing is expected to inspire small borrowers to avail bank loans.

Sensing this, a handful of banks, including the country’s largest lender State Bank of India, have already introduced loan products linked to an external benchmark.

But the reaction of bank stocks to the central bank’s move has been negative, with the Nifty Bank index falling nearly 1% on a day the broader market has been in the green.

Since external benchmarking divorces loan rates from deposit rates, lenders will have a tough time maintaining their net interest margins.

Analysts expect margin compression in the short term, as the fastest growing part of a loan book gets linked to an external benchmark.

Loss of income due to a huge pile of dud loans has already crimped margins of banks over the past one year.

What’s more, margins may not only compress, but may also become volatile.

According to analysts at Credit Suisse Securities (India) Pvt. Ltd, banks will see volatility in at least 25% of their business as deposits won’t get repriced as fast as loan rates.

That said, the fact that there is greater scope of deposit rates falling than lending rates, the impact on margins could be limited, analysts at Kotak Securities Ltd said in a note. “Transmission is likely to be even slower as it is applicable prospectively. MCLR, where the transmission was probably the fastest, took two years to fully reflect to its maximum potential in the books of banks," it added.

Margin compression would be greater for lenders having a large share of floating rate retail and SME (small and medium-sized enterprise) loans. Banks, such as HDFC Bank Ltd and IndusInd Bank Ltd, which have a greater share of fixed rate loans, will be able to thwart the pressure on margins, according to analysts.

As the regulator pushes for greater transmission, the lenders will have to embrace more volatility in their earnings, at least in the short term.

Now, banks will have no choice but to link deposit rates to external benchmarks, or actively hedge their assets in the interest rate swap market.

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