Pitfalls of external reference for loan rates

Madan Sabnavis | Updated on December 10, 2018 Published on December 10, 2018

Interest regime Fixing the floor rates must be left to the banks   -  /iStockphoto

RBI’s move to link loans to external benchmarks could introduce new uncertainties for banks, going beyond ‘floating rate’

The RBI’s policy has an interesting proposal which talks about fixing the interest rate on floating rate loans to a market oriented benchmark. There are four options provided which include the repo rate, 91 days T-Bill, 182 days T-Bill or any other FBIL benchmark. The concept of benchmarking is not new as all floating rates are fixed to an anchor rate across global markets which is normally LIBOR or in our case erstwhile PLR, base rate or marginal cost of funds-based lending rate (MCLR).

There are some questions which come to mind when we move the benchmarking process to market-oriented rates which are susceptible to greater shifts.

The difference between say a base rate and market rate is that they tend to move with different velocities. Base rates or MCLR are formula driven and change normally when the repo rate changes. The repo rate rarely moves by more than 50 bps at a point of time while 25 bps has been the norm in the last few years.

Anecdotally it was seen that a 50 bps movement in repo rate changed the base rate by less than 10 bps. This was why the MCLR concept was adopted as it was more elastic to repo rate changes.

At times banks may change the basic cost of funds, i.e. deposit rates to attract more deposits in which case the benchmark also gets altered. It could also be motivated by asset-liability mismatch (ALM) issues where deposit rates of specific tenures are altered.

However, the deposit rate does not change much in a year and the repo cost is very small in the overall cost of funds as there is a ceiling of 1 per cent of net demand and time liabilities (NDTL ) which can be accessed through this window. Therefore, even a 50 bps cut in repo will not affect the base rate significantly which has been the cornerstone of the ‘transmission’ argument that has often been put forward by the RBI when it changes policy rates.

But let us look at the T-Bill rates. They can change more frequently and tend to be fairly volatile. For example if we look at the difference between the minimum and maximum rate on a 91 days T-Bill over the last one year, the range was between 6-7.2 per cent while the base rate hardly moved and the MCLR changed by not more than 50 bps.

In such a case, any loan taken on a floating rate basis would show similar variation even if the resetting is done once a year (though it would be based on some kind of an average). In case of 182 days T-Bill the difference between the minimum and maximum rate has been 125 bps which increases to almost 150 bps for 364 days T-Bills and 135 bps for five years G-Sec (if considered as an alternative benchmark).

Swings likely

The point really is that once the benchmark is a market based interest rate which is volatile there will be swings in the cost and benefit depending on which side of the loan the party is on. A rising interest rate scenario is not good news for the borrower relative to the earlier MCLR/base rate benchmark, while a declining rate scenario is not exciting for the bank as the deposit rates would be fixed anyway for most of the funds. Deposits get re-priced only on renewal unlike loans which almost always change immediately unless on fixed rate contract.

Ideally floating rates should be driven by a LIBOR kind of a rate which changes but not really significantly most of the time. MIBOR is an option but it does look like the RBI has preferred an official rate which is based on the market rather than a polled one which is done by independent agencies.

As can be seen borrowers will have to seriously consider these effects when deciding on fixed or floating rates where options exist as is the case with home loans. In case banks do not offer fixed rate loans on some of the retail loans, then there would be an issue of rising cost. If rates keep rising over say a 20-year mortgage then the cash flows can be pressurised for the individual at various stages of the loan-repayment cycle as the EMIs get longer.

But SMEs would have to buffer in the negative impact when rates are rising as these rates would tend to get more volatile. Fixing to the repo rate would probably also not really work well as the entire change gets loaded on the floating rate unlike today where the repo cost is one tiny bit of the formula of base rate or MCLR. For these companies, the present system of benchmarking with base rate or MCLR could be preferable especially when rates are rising.

Regulator’s role

At a broader level a question often posed is whether the regulator should be getting into the fixation of commercial rates of banks.

Normally central banks announce the policy rate and as markets are efficient; these changes get transmitted through the system to both deposits and lending rates. But this has not quite worked out in our case where bank reaction tends to be sticky primarily because the reliance on repo has been fixed to 1 per cent of NDTL, which finally does not impact costs that significantly.

Now, the central bank can ask for transparency wherein banks should be compelled to announce their basic lending rate, which was the PLR at one time. This can be standard or floor below which no bank can go. But fixing the floor should ideally be left to banks which may like to charge rates which can be lower than their average cost of funds for some strategic reason.

This is reasonable as it happens in all industries as companies are comfortable with different levels of profit margins. By making it mandatory to not only announce the minimum rate which is driven by a formula, banks have already lost a degree of freedom. Now linking some loans (which will probably be extended to others too in course of time) to external benchmarks banks would face a new dimension of uncertainty which goes beyond the concept of ‘floating rate’ to a volatile benchmark.

The writer is Chief Economist, CARE Ratings. The views expressed are personal

Published on December 10, 2018
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