External benchmark rates explained

Use of external benchmark rates

How does a financial institution decide on the interest on a loan? One of the key parameters is based on the benchmark rate. Banks can’t lend below that rate. The loan will also come with a spread above the benchmark rate. Usually, the spread is higher for unsecured loans such as personal loans whereas for secured loans such as home loans it will be lower. The benchmark rate usually works in sync with external rates and cost of funds of the banks. However, the regulator has not been satisfied with the way transmission works as financial institutions tend to not pass on the benefit to the consumer. Hence, talks are on to use external benchmark rate.

3 types of external benchmark rates

The RBI proposed to the use of external benchmark rates such as treasury bill rate, certificate of deposit rate and repo rate with an objective to make transmission faster. For external benchmark, it is not possible for banks to only link the asset side of the balance sheet creating asset liability mismatch. So if your deposit and loan are linked to external benchmark rate, any movement in rates will impact you. But you will have a spread which financial institution will insert to cushion the change. And considering deposit and lending get impacted due to change in external benchmark rates, you will see the deposit rates as well changes.

Banks have used external benchmark earlier too

In 2005, ING Vyasa Bank Ltd had linked its home loan rate with Mumbai Interbank Offer Rate. In March 2018, Citibank linked its home loan rate with three-month Government of India T-bill benchmark. The data is based on Financial Benchmarks India Pvt Ltd. This month, India’s largest lender, SBI, linked its savings account deposit and short term loans with repo rate. There is spread over the benchmark rate for deposit and lending rate. As per a report by Soumya Kanti Ghosh, SBI’S group chief economic adviser, the T-bills are more volatile than policy repo rate. In a higher interest rate scenario, volatility also remains on higher side.