What is the issue?
The Reserve Bank of India (RBI) has proposed linking the interest rates charged by banks on loans to the external benchmarks.
What is the current practice?
- Currently, interest rates on loans are linked to internal benchmarks.
- All loans such as for car and home disbursed from April 1, 2016 are linked to marginal cost of funds-based lending rate (MCLR).
- The MCLR-based regime had replaced the earlier base rate regime.
- The shift was to provide transparency in the transmission of monetary policy decisions.
- MCLR is an internal benchmark rate that depends on various factors such as fixed deposit rates, source of funds and savings rate.
- The price of loan comprises the MCLR and the spread or the bank's profit margin.
What is the concern with MCLR-based system?
- The biggest problem with the current system is the lack of required transmission of policy rates. Click here to know more.
- The internal benchmark is not influenced solely by the policy rate cut but depends on a variety of factors.
- So, policy rate cuts often do not reach the borrowers i.e. when the RBI cuts repo rate there is no guarantee a borrower will get the benefit of it.
- Also, the MCLR system is opaque since it is an internal benchmark that depends on the way a bank does its business.
How will the new system work?
- The new system will come into effect from April 1, 2019.
- Banks will then have to link their lending rates charged on different categories of loans with an external benchmark instead of MCLR.
- The RBI has given the following options to banks:
- RBI repo rate
- the 91-day T-bill yield
- the 182-day T-bill yield
- any other benchmark market interest rate produced by the Financial Benchmarks India Pvt. Ltd
- One of these benchmarks will be used to decide the lending rate in addition to the spread.
- Banks will be free to decide their spread value but it will have to be fixed for the tenure of the loan.
- However, it can change if the credit score of the borrower changes.
- The interest rates under the new system will change every month.
How will it benefit borrowers?
- It will help better transmission of policy rate cuts i.e. an RBI rate cut will immediately reach the borrower.
- It will make the system more transparent since every borrower will know the fixed interest rate and the spread value decided by the bank.
- It will help borrowers compare loans in a better way from different banks.
- Under the new system, a bank is required to adopt a uniform external benchmark within a loan category.
- This will ensure transparency, standardisation and ease of understanding for the borrowers.
- This would mean that same bank cannot adopt multiple benchmarks within a loan category.
Source: Economic Times
Quick Facts
Interest rate spread
- Spread refers to the difference in borrowing rates and lending rates of financial institutions.
- In other words, it is the interest yield on earning assets such as a loan minus interest rates paid on borrowed funds.
T-Bill Rate
- Treasury Bills are government bonds or debt securities with maturity of less than a year.
- T-Bill Rates are determined by the central bank and used as a primary instrument for regulating money supply and raising funds.
