External benchmarks for retail loans will lead to higher earnings volatility

Banks’ tardiness in cutting their benchmark lending rates even under the much-touted MCLR structure has led the RBI to propose external benchmark rates in place of bank-specific benchmarks.

In a bid to fix the perpetual issue of transmission, or the lack of it, the RBI has now mandated banks to peg their lending rates on new floating rate personal or retail loans and loans to micro and small enterprises from April 1, 2019, to external benchmarks.

Banks will have to choose either the RBI’s repo rate at which banks borrow short-term funds from the RBI – 91-day T-Bill, 182-day T-Bill – or any other benchmark market interest rate produced by the Financial Benchmarks India (FBIL).

While the final guidelines are awaited, broadly, the move should benefit borrowers. A common market-linked benchmark can resolve some of the issues prevalent in the earlier structures, and ensure better transmission of policy rates.

Higher rate risk

However, for banks, this would imply higher interest rate risk and more volatility in earnings at least in the near-term. The crux of the problem, under both base rate and MCLR, lies in the fact that each bank decides its benchmark rates based on its costs and profitability.

Under base rate, since most banks followed the average cost of funds method to set their base rates, bulk of their deposits were unaffected by rate changes, thus limiting changes in lending rates.

The RBI sought to remove this hurdle through MCLR by mandating banks to calculate their cost of funds based on the latest rates offered on deposits or borrowings.

This was to ensure that changes in deposit rates immediately reflected on banks’ cost of funds. But adhoc practices followed by banks while fixing lending rates under MCLR led to a wide set of transmission issues for new and old borrowers (under base rate). Several issues such as slow migration to MCLR regime by banks, and arbitrary charging of spread (over and above the benchmark rate), as was highlighted by the RBI in an earlier report, has impeded transmission even under MCLR.

By moving to an external benchmark, the RBI is looking to iron out some of these issues. All banks will have to benchmark their loan against a common benchmark, which will make it easier for borrowers to track it.

Also, as these rates will be market-linked, policy rate changes will get reflected faster, leading to better transmission. The key structural issue with earlier systems was that since banks source only a minuscule portion of their funds (1 per cent) from the repo window and rely significantly on longer term deposits, only about 50-60 per cent of banks’ funding gets re-priced.

Hence, a cut in repo rate does not immediately reduce their costs. Setting an external benchmark could help tackle some of these issues.

Besides, the RBI has now reiterated that spread over the external benchmark rate should remain unchanged through the life of the loan, unless the borrower’s credit assessment undergoes a substantial change. If implemented properly, it should aid borrowers.

But banks are likely to face some challenges in the near-term. The move, which implies faster reset of loan rates, would mean that banks will have to create a portfolio of deposits and loans with a balanced mix across tenors such that the overall asset-liability gaps are managed well not only to reduce liquidity mismatches but also to mitigate earnings volatility.

One way could be to take short-term deposits. So, in a falling interest rate scenario, banks’ deposits can get re-priced quickly and it can manage its loans getting re-priced quickly.

But in such a scenario, banks could run a liquidity gap. The other way would be to develop floating rate deposits, which is still nascent. Hence, banks will have to weather some volatility in earnings in the near-term.

One way to gauge the impact on earnings on account of holding assets and liabilities across different maturities or re-pricing dates is to look at the interest rate risk in the banking book (IRRBB) as disclosed under the Basel requirement by Indian banks.

For instance, as per SBI’s FY18 annual report, for every 100 basis points fall in interest rates, SBI’s earnings (net interest income) will fall by ₹2,635 crore.

In general, interest rate risk to net interest income for Indian private and public sector banks have varied from 2 per cent to 9 per cent.

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