The Reserve Bank of India (RBI) has instituted a requirement for all banks to relate any new floating rate loans, such as retail/personal loans or those intended for Micro, Small and Medium Enterprises (MSMEs), to an external benchmark, effective from 1st October 2019. The rationale behind this step is to allow for a faster dissemination of monetary policy rates.
Available Benchmarks and Current Loan Structures
Banks are now able to choose from four available external benchmarks: the repo rate, three-month treasury bill yield, six-month treasury bill yield, or another benchmark interest rate published by Financial Benchmarks India Private Ltd. Previously, interest rates on loans were aligned with a bank’s Marginal Cost of Lending Rate (MCLR). Now, existing loans and credit limits tied to the MCLR, base rate, or Benchmark Prime Lending Rate will continue until they are repaid or renewed. Customers wishing to switch to the repo-linked rate can do so based on mutually agreed terms. However, a single bank is not permitted to adopt multiple benchmarks within a loan category. The external benchmark-based interest rate will be reset at least once every quarter.
Fixed vs Floating Interest Rate
A fixed interest rate implies that loan repayments will be made in predetermined equal instalments for the loan’s entirety. In this scenario, market fluctuations do not affect the interest rate. On the other hand, a floating interest rate changes according to market conditions. This type of interest rate can lead to inconsistent monthly instalments, which could be a disadvantage for some people.
About Financial Benchmarks India Private Ltd
This company was established on 9th December 2014 under the Companies Act 2013 and was recognized by the RBI as an independent Benchmark administrator on 2nd July 2015. Its key responsibilities include acting as the administrator for Indian interest rate and foreign exchange benchmarks, as well as formulating and implementing policies and procedures to handle these benchmarks. The company’s headquarters are in Mumbai.
| Company Name | Incorporated On | Recognized by RBI on |
|---|---|---|
| Financial Benchmarks India Private Ltd | 9th December 2014 | 2nd July 2015 |
Reasons for the New Guidelines
The current MCLR framework has not been successful in effectively transmitting policy rate changes to banks’ lending rates. Despite the RBI decreasing the repo rate by 75 basis points in its August Policy in 2019, the weighted average MCLR of banks only fell by 29 basis points. Banks contend that the MCLR formula is based on the cost of funds, meaning it only declines gradually following a repo rate cut.
These new guidelines were initially proposed in 2018 by former governor Urjit Patel and were intended to be implemented from April 1. However, due to opposition from banks, the implementation was delayed.
Key Terms Explained
Marginal Cost of Lending Rate (MCLR), which came into effect in April 2016, serves as a benchmark lending rate for floating-rate loans. This represents the minimum interest rate at which commercial banks can offer loans. The rate is determined by four factors – the marginal cost of funds, negative carry on account of cash reserve ratio, operating costs and tenor premium. If deposit rates rise, there is potential for MCLR and lending rates to increase as well.
Base Rate was a method used by banks until April 2016. Loans drawn between June 2010 and April 2016 were based on this method. The base rate, which was the minimum interest rate for bank loaning, was calculated using three parameters: the cost of the fund, unallocated cost of resources, and return on net worth.
Benchmark Prime Lending Rate (BPLR) was used by banks till June 2010. It comprised the actual cost of funds. However, resulting in an opaque system, BPLR was subverted as a significant proportion of wholesale credit was offered at sub-BPLR rates. Banks were essentially subsidising corporate loans by charging high rates from retail and SME customers.
