The Reserve Bank of India (RBI) has, in a recent circular, mandated all commercial banks to link their floating rate loans to retail and MSME consumers to an external benchmark rate[1]. The main objective of the circular was to enhance the effectiveness of monetary policy transmission. The circular from RBI follows from the recommendations of an internal task force set up to review the working of the MCLR based interest rate regime[2]. In particular, the task force identified four main factors that were impeding monetary policy transmission[3]:
- Maturity mismatch and interest rate risk due to fixed-rate deposits but floating rate loans
- The rigidity of savings deposit interest rates
- Competition from other financial savings instruments
- Deterioration in the health of the banking sector
In addition, the task force recognised that the internal benchmarks, like base rate and MCLR, have not delivered effective transmission. They opined that this was primarily due to the arbitrariness with which banks were calculating the benchmark and the spread charged over them. To overcome these problems, the task force recommended a switch over to external benchmarks[4].
Evaluating the costs
There is definitely a case to be made for improving monetary policy transmission in India. However, linking only the retail part of a bank’s asset book to an external benchmark has potentially adverse consequences. In particular, we identify some issues that not only prove counterproductive to the circular’s objective but could also adversely impact both banks and their customers.
Costs to Banks
Increasing the interest rate mismatch
The current circular actually exacerbates the interest risk of banks since the circular only mandates the retail portion of the asset side to be linked to external benchmarks while leaving interest rates on liabilities intact. As pointed out by the task force, interest rate risk is a significant impediment in the transmission of rates and the increase in mismatch could further impede monetary policy transmission. In the event of banks not being able to link their deposit rates to an external benchmark, for fear of losing retail deposits or otherwise, this mismatch could increase volatility in their margins.
Cost to Consumers
The rising burden of retail indebtedness in a tightening phase
Existing retail borrowers would see their EMI’s rise during a monetary tightening phase. However, this might not be accompanied by a concurrent and proportionate increase in their deposit rates or wages. This could adversely affect low-income borrowers, who might have to cut down on their essential expenditure to accommodate their rising EMIs. Also, this runs counter to the rationale given by RBI when disallowing SBI from offering teaser loans. To elaborate, SBI had offered teaser home loans in 2011. At that time, these home loans would initially have fixed rates of interest, between 8-8.5 percent, which would then be replaced by floating rates on par with other banks, which were about 10 percent[5]. In this instance, the borrower would have been exposed to a 2 percentage point increase in interest rates over a period of 3 years. In comparison, a home loan linked to the repo rate would have risen 3.75 percentage points in the 2 year period between March 2010 and March 2012[6]. RBI had expressed concerns that the EMIs of teaser loans might become a burden for the borrowers after the initial period when rates start to rise[7]. However, as we have shown above, a similar effect obtains for a repo-rate linked loan product during a tightening cycle.
Deficiencies in the Market
Lack of competition
The task force notes that internal benchmarks used by banks are not transparent and that banks find ways to work around[8]. One reason for this is lack of enough competition in the banking sector. As noted here[9] there has been almost no change in savings deposit rates despite the rates being deregulated almost a decade ago. Also, if indeed there was sufficient competition on the asset side, arbitrage should push loan rates of similar maturities roughly equally across banks. At the very least, market discipline would ensure banks would not indulge in unfair and opaque methods for interest rate setting.
Lack of developed derivative markets
The absence of developed interest futures and swap markets hinder bank’s ability to manage their interest rate risk, discussed previously. While RBI has tried to nudge banks towards participating in the market[10], banks have been reluctant to participate in it, and the markets have remained dormant, pointing to deeper issues that need to be tackled from a regulatory and policy perspective.
Conclusion
In sum, it appears that the circular could enable actions by banks and consumers that would be counterproductive to its intent. In addition, there are potential customer harms that could be exacerbated by the application of the circular. While linking to external benchmarks would ensure greater transparency in the pricing process, it leads to volatility in liabilities for borrowers who are ill-equipped to handle it. In contrast, corporates, who are better equipped to handle such liabilities, have their loans linked to the internal benchmark[11]. The evidence presented by the task force would seem to suggest this. Across some of the major developed economies (like US, EU, UK and Switzerland), the task force finds that around 50% of the business loans are linked to external benchmarks. In contrast, the share of consumer loans linked to external benchmarks is very low[12]. Thus, the RBI would do well to rethink its strategy of improving policy transmission by linking retail loans to external benchmarks.
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[1] See RBI circular, Sep 2019 – https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11677&Mode=0
[2] Ibid
[3] See Report of the Internal Study Group to Review the Working of the Marginal Cost of Funds Based Lending Rate System, RBI, Oct 2017 https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=878
[4] Ibid
[5] See https://www.thehindu.com/business/companies/SBI-withdraws-teaser-home-loan-scheme/article14690393.ece, Retrieved on 20-09-19
[6] See Report of the Internal Study Group to Review the Working of the Marginal Cost of Funds Based Lending Rate System, Table II.5, RBI, Oct 2017 https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=878
[7] See https://www.thehindu.com/business/companies/SBI-withdraws-teaser-home-loan-scheme/article14690393.ece, Retrieved on 20-09-19
[8] See Report of the Internal Study Group to Review the Working of the Marginal Cost of Funds Based Lending Rate System, Chapter 2 Section II.6 RBI, Oct 2017 https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=878
[9] See https://www.moneycontrol.com/news/business/economy/opinion-banks-must-transmit-rates-for-fruitful-financial-inclusion-3030921.html , Retrieved on 13-10-19
[10] See Ex RBI DG Viral Acharya’s speech, Jan 2018 – https://www.rbi.org.in/Scripts/BS_SpeechesView.aspx?Id=1053
[11] Depending on the time when the loan was given this benchmark could be PLR, BPLR or MCLR
[12] See Report of the Internal Study Group to Review the Working of the Marginal Cost of Funds Based Lending Rate System, Table IV.1, RBI, Oct 2017 https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=878
