RBI wanted banks to pass on the benefit of lower interest rates to customers when it reduces policy rates.
For this reason, RBI recently introduced a mechanism that is the most transparent until now–external benchmark-based lending rates.
Borrowers had long complained that lenders were quick to increase interest rates on home loans when the Reserve Bank of India (RBI) increased policy rates. However, when the central bank would lower policy rates, lenders would decrease rates at a much slower pace for existing customers. RBI wanted to fix this.
The central bank wanted banks to pass on the benefit of lower interest rates to customers when it reduces policy rates. For this reason, RBI recently introduced a mechanism that is the most transparent until now–external benchmark-based lending rates.
The new rates change the market practice. Earlier, banks would offer new loans at aggressive rates. But for existing customers, there would be a significant difference between their ongoing rates than what they were offering to new customers.
For example, if a lender would offer a new home loan at 8%. Existing customers could be at 9%, or 9.5% or even 10%.
How lenders decide on interest rates
Lenders usually have an internal rate, which is the benchmark rate. Interest rates on all loans are linked to it. For example, a lender's benchmark rate is 6%. It would offer an auto loan 2% higher than the benchmark rate, which will be 8%. Similarly, it may provide personal loans at 8% higher than the benchmark rate or at 14%.
Initially, RBI focused on making the benchmark rate transparent. It introduced different ways to calculate the benchmark rates. Earlier, banks had prime lending rate (PLR), then came the base rate and later MCLR or marginal cost of funds-based lending rate.
When none of these solved the problem, the central bank introduced a new method—external benchmark-based lending rates. Instead of looking at ways to make banks' internal benchmark rates more transparent, RBI said banks will need to link their floating rate loans to an external benchmark.
It suggested that the external benchmark could be repo rate, or three-month Treasury Bill or six-month Treasury Bill. Most lenders adopted the repo rate.
From linking the floating rate to the benchmark rates, lenders now link them to an external benchmark. When RBI reduced or increases the repo rate, borrowers now know that the interest rate on their existing loans will rise or fall.
If you have your home loan or other floating-rate loans on an earlier benchmark, it's better to shift to the new regime. There are chances that the rates on your loan will reduce if you change to a repo rate-based loan. Also, there will be transparency. Whenever RBI would cut or hike policy rates, the interest rate on your ongoing loan could rise or fall in the same proportion.
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