Why do we need external benchmarks while pricing loans?

  • An internal Study Group constituted by the Reserve Bank of India (RBI) has recommended that banks should set interest rates based on an external benchmark and not as per internal benchmarks as is the practice now. Here is what you need to know on the subject:

What is the need for external benchmarks?

  • The Study Group has found that the present loan pricing regime, that is, the marginal cost of fund based lending rate (MCLR) or the base rate under the previous regime were both calculated based on banks’ internal factors such as cost of funds.
  • They are insensitive to changes in the policy interest rate or repo rate.
  • Analyses by the group suggested that banks deviated in an ad hoc manner from the specified methodologies for calculating the base rate and the MCLR to either inflate the base rate or prevent the base rate from falling in line with the cost of funds.

What external benchmarks are available?

  • The study group has cited 13 possible candidates as external benchmarks: the weighted average call rate (WACR), collateralised borrowing and lending obligation (CBLO) rate, market repo rate, 14-day term repo rate, G-sec yields, T-Bill rate, certificates of deposit (CD) rate, Mumbai interbank outright rate (MIBOR), Mumbai inter-bank forward offer rate (MIFOR), overnight index swap (OIS) rate, Financial Benchmark India Ltd. (FBIL) CD rates, FBIL T-Bill rates and the Reserve Bank’s policy repo rate. The report also said that no instrument in India met all the requirements of an ideal benchmark.
  • However, the group shortlisted 3 candidates from these 13 — one of which could be selected by RBI as external benchmarks after receiving feedback from all stakeholders. The Study Group is of the view that the T-Bill rate, the CD rate and the RBI’s policy repo rate are better suited than other interest rates to serve the role of an external benchmark.

From when will the external benchmark come into effect?

  • The Study Group has recommended that all floating rate loans extended beginning April 1, 2018 could be referenced to one of the three external benchmarks selected by RBI. The report said banks may be advised to migrate all existing loans to the new benchmark without any conversion fee or any other charges for switchover on mutually agreed terms within one year from the introduction of the external benchmark, i.e., by end-March 2019.

What will the spread be?

  • The Study Group was of the view that the decision on the spread over the external benchmark should be left to the commercial judgment of banks. However, the spread fixed at the time of sanction of loans to all borrowers, including corporates, should remain fixed all through the term of the loan, unless there is a clear credit event necessitating a change in the spread.

What is the reset clause?

  • The group suggested quarterly interest rate resets as opposed to a one-year reset as practised now for improvement in monetary transmission.

Will deposits also be linked to the external benchmark?

  • The report said banks may be encouraged to accept deposits, especially bulk deposits at floating rates linked directly to one of the three external benchmarks.
  • The new State Bank of India chairman Rajnish Kumar has already expressed the need to move deposits rates to an external benchmark, in case loan prices are based on such benchmarks.


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