Mumbai: The Reserve Bank of India on Wednesday directed banks to link interest rates on loans to retail and small business borrowers to an external benchmark beginning 1 October to aid effective downward transmission of the central bank’s policy rate cuts.

However, banks can link loans to other segments of borrowers as well, RBI said. For borrowers, this will mean faster transmission during both rise and fall of interest rates.

Lowering the cost of funds for consumers and businesses is crucial for supporting economic growth since GDP expansion has slowed to the slowest pace in six years at 5% in the June quarter. Consumers and small businesses may expect their interest rate costs to fall in cases where banks haven’t already fully passed on RBI’s policy rate cuts.

Banks have been under pressure to improve monetary policy transmission. Governor Shaktikanta Das said on 19 August that the transmission of policy rates at just 29 basis points (bps) this year compared to a combined repo rate cut of 75bps (excluding the 35bps cut in August) did not meet RBI’s expectations.

To be sure, some banks have already begun linking their lending rates to an external benchmark. Among them are state-run State Bank of India, Union Bank of India, Central Bank of India, Punjab National Bank, Indian Bank and private sector lender Federal Bank. Since April 2016, banks have been pricing all new loans using the marginal cost of funds-based lending rate (MCLR).

The central bank said in a statement on Wednesday that the transmission of policy rate changes to the lending rate of banks under the current MCLR framework has not been satisfactory.

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

However, a bank will have to adopt a uniform external benchmark within a category, meaning that the adoption of multiple benchmarks is not allowed within a category.

While lenders can decide on the spread they charge over the benchmark to calculate the final interest rate, RBI said the spread can be changed only if the credit assessment of the borrower undergoes a substantial change. The interest rate under external benchmark will have to be reset at least once in three months, RBI said.

According to RBI’s circular, borrowers under the MCLR or base rate regime who are eligible to prepay their loans without pre-payment charges shall be eligible for a switchover to external benchmark without any charges, except reasonable administrative or legal costs. Others who do not have the prepayment facility can move to external benchmark on terms acceptable to the bank and the borrower.

(Graphic: Paras Jain/Mint)
(Graphic: Paras Jain/Mint)

In December, RBI said that banks must set their interest rates for new loans against an external benchmark beginning 1 April. The rule was supposed to apply to all new retail loans and small business loans with floating rates from that date.

The proposal, however, was opposed by bankers who wrote to the regulator citing their concerns. In April, Das postponed the linking to external benchmarks and said RBI would discuss the proposal with the parties concerned before taking a decision on implementing it.

The way banks set interest rates is critical for the smooth transmission of policy rates. To make this process transparent, RBI has over the years directed banks to price their loans against their benchmark prime lending rate, base rate, and then MCLR. Last year, though, was the first time that banks were asked to price their loans against an external benchmark.

While the regulator has been pushing for adoption of an external benchmark, banks argue that linking of lending rates without linking of the deposit rates will hurt them.

Soumya Kanti Ghosh, group chief economic adviser, SBI, said in a 20 August report that for external benchmarking, it is not possible for banks to only link the asset side of the balance sheet to an external benchmark without creating significant asset-liability mismatches. Ghosh said close to 35% of bank liabilities are in the form of savings bank deposits and carry fixed interest rates. “Further, the banks are also not able to link external benchmark to the entire liabilities (especially time deposits), as the floating term deposits are not accepted by the Indian depositors and have already been unsuccessfully experimented by some peer banks in India," he added.

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