Investment benchmarks serve as meaningful reference points that help investors draw comparisons of their funds’ or stocks’ performance. Similarly, in lending, a benchmark rate serves as a transparent reference rate used by financial intermediaries such as banks to determine the price at which they offer loans to customers.
A benchmark rate, typically, reflects the cost of borrowing funds for the lending institution. The interest rate at which banks are willing to lend will be at a spread to the benchmark rate, say benchmark rate plus 2%. Banks in India have so far been using internal benchmarks, which have meant that the benefit of policy rate cuts don’t reach the borrowers completely.
In December 2018, RBI directed banks to use external benchmarks. A number of banks such as SBI and Bank of Baroda have launched home loan products linked to RBI’s repo rate. The banks will charge a spread above the repo rate but the net interest rate will move in sync with the repo rate. This is expected to improve the transmission of RBI rate cuts.