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Linking interest rate to external benchmark: What does the RBI move mean for you

Banks will have to link interests to external benchmarks instead of internal ones, which is the current norm.

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The biggest problem with the current system is the lack of required transmission of policy rates.
The Reserve Bank of India (RBI) has proposed a major change in the way banks price their loans. It said yesterday that banks will now have to link the interest rates charged by them on different categories of loans to the external benchmarks instead of the used internal benchmarks, which is the norm now.

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 to provide transparency in the transmission of monetary policy decisions. MCLR is an interal 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.

The problem with MCLR-based system
The biggest problem with the current system is the lack of required transmission of policy rates. When the RBI cuts repo rate there is no guarantee a borrower will get the benefit of the rate cut or that it will be transmitted down to him. Due to internal benchmarking of loan price, policy rate cuts often don't reach the borrowers. Secondly, the MCLR system is opaque since its an internal benchmark that depends on the way a bank does its business.

How the new system will work
Under the new system which will come into effect from April 1, 2019, banks will have to link their lending rates with an external benchmark instead of MCLR. The RBI has given these options to banks: RBI repo rate, the 91-day T-bill yield; the 182-day T-bill yield; or 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 it will benefit borrowers
First, it will help better transmission of policy rate cuts which means an RBI rate cut will immediately reach the borrower in the current system in which internal benchmark is not influenced solely by the policy rate cut but depends on a variety of factors. Second, 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 so that there is transparency, standardisation and ease of understanding for the borrowers. This would mean that same bank cannot adopt multiple benchmarks within a loan category.
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