Explained: Home, Auto Loans to get cheaper; RBI mandates Banks to adopt Repo-linked Interest Rates

Explained: Home, Auto Loans to get cheaper; RBI mandates Banks to adopt Repo-linked Interest Rates

Loans to get cheaper: Reserve Bank of India (RBI) mandates all the banks to link new floating-rate Personal, Retail, Housing, Auto and MSMEs loans to External Benchmark based Rate like Repo Rate from October 1, 2019 onwards. With this move, the RBI aims to ensure faster transmission of Policy rate cuts to loan borrowers. The RBI’s Monetary Policy Committee (MPC) recently in its bi-monthly policy review reduced the policy Repo Rate to 5.40 per cent. This was the fourth rate cut in a row by the RBI.

In 2019 itself, the RBI has reduced the Repo Rate by 110 basis points. However, the banks only passed the policy rate cut of 40 basis points to the borrowers. Considering this, the RBI decided to link certain categories of loan to the external benchmark based lending rate system. RBI had previously asked the banks to adopt this lending rate system for all new retail loans and small business loans from April 2019 itself. However, various banks opposed to the decision, citing various concerns.

Note: The State Bank of India (SBI) was the first to link certain loans to the repo rate. Later, few other banks also began linking their loan products to external benchmarks. These banks are state-run Union Bank of India, Central Bank of India, Indian Bank, Punjab National Bank, and private lender Federal Bank.

RBI’s Internal Study Group (ISG)

This move of linking certain loans to External Benchmark was suggested by the Internal Study Group (ISG) of the apex bank. The ISG was constituted in August 2017 by the RBI to examine the working of the Marginal Cost of Funds Based Lending Rate (MCLR) system. The ISG had recommended the External Benchmark based Lending rate system in its Report, which was placed in the public domain in October 2017 for inviting comments and suggestions. After deliberating on the recommendations of the ISG and the responses received on it, the RBI took the final decision on the matter on September 4, 2019.

Reasons behind linking of Loans to External Benchmark

The move came after retail loan borrowers and borrowers from Micro, Small and Medium Enterprises (MSMEs) complained that banks do not pass on the entire benefit of RBI’s Repo Rate reduction to them.

Moreover, RBI observed that the transmission of policy Repo Rate changes, whether fall or hike, to the banks, has not been satisfactory under the Marginal Cost of Funds Based Lending Rate (MCLR) framework.

What is External Benchmark System and what are its types?

Banks or financial institutions cannot lend money below a particular Interest Rate. The interest on a loan is decided on the basis of the benchmark rate. This benchmark rate is often in sync with the external rates (External Benchmark) and cost of bank’s funds (Internal Benchmark). Till now, banks used internal benchmarks to fix the interest rate on loans. However, from October 1, 2019, onwards banks will be required to link their lending rates with the external benchmarks.

Type of External Benchmarks

The RBI, in its circular dated September 4, 2019, lists three external benchmarks for banks to choose from while sanctioning floating rate personal, retail loans (housing, auto, etc.) and loans to Micro and Small Enterprises. These benchmarks are:

– RBI’s Repo Rate

– 3-Months Treasury Bill yield published by Financial Benchmarks India Private Ltd (FBIL)

– 6-Months Treasury Bill yield published by FBIL

– Any other benchmark market interest rate published by the FBIL

The banks are free to choose from these benchmarks.

RBI’s instructions to Banks regarding External Benchmark based Lending rate system

– Banks need to reset interest rate under external benchmark once in three months.

– Banks cannot adopt multiple benchmarks within a loan category. There should be a uniform external benchmark based lending rate within a loan category. This would ensure transparency and easier understanding of loan products by borrowers

– The credit risk premium will undergo a change only when borrower’s credit assessment undergoes a substantial change.

– Banks can alter the operating cost once in three years.

– All the existing loans linked to the MCLR/Base Rate/ Benchmark Prime Lending Rate (BPLR) will continue till the repayment or renewal.

Impact of External Benchmark based Lending rate system

The External Benchmark based Lending rate system is expected to reduce the borrowing cost and increase consumer’s demand. The high lending rates and declining consumer demand is one of the major reasons behind the slowdown in the Indian economy. The automobile sector witnessed a significant drop in auto sales recently.

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