CONCEPT – PRICING OF BANK LOANS IN INDIA

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 CONCEPT – PRICING OF BANK LOANS IN INDIA

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• Sept 2019 RBI order : The Reserve Bank of India asked banks to link interest rates to external benchmarks. The RBI mandated all banks, including small finance banks, to link new floating rate personal, retail loans and floating rate loans to MSMEs to an external benchmark effective October 1, 2019.
• What happened earlier : Till now, such loans were linked to bank-specific benchmarks - for example, the MCLR (marginal cost of funds based lending rate) that was introduced by ex-Governor Raghuram Rajan. Given that banks have been slow in cutting MCLR and hence lending rates, borrowers did not benefit from reducing repo rates by RBI.
• Story from 2017 onwards : The discussion started in August 2017, when RBI constituted the Internal Study Group (ISG) to examine the efficacy of the MCLR system. It became clear that effective transmission of rate cuts to customers was not happening. So, the RBI decided to mandate a switch-over to an external benchmark for lending rates, as recommended by the ISG. But even before that, several banks, including State Bank of India, Bank of Baroda and Oriental Bank of Commerce had launched repo-linked lending rate products. This was an effort to ensure faster transmission of policy rate cuts to borrowers.
• Repo Rate : The repo (or repurchase) rate is the rate at which the Reserve Bank of India (RBI) lends money to other banks. Hence, cuts in the repo rate should lead to cuts in home loan and other lending rates. Why? Because banks get to borrow money cheaply from the RBI. By pegging the rate to an external benchmark RBI is hoping for a faster transmission of rate cuts than has happened so far under the MCLR system.
• Poor transmission : The RBI’s statement in June 2019 had noted that a 0.5% cumulative cut in February and April resulted in only 0.21% average reduction in fresh rupee loans.  (0.5% = 50 basis points or bps)
• What will change : The new order requires banks to link lending rates on certain loans to “external benchmarks – repo rate, 3-month treasury bill yield or 6-month Treasury Bill yield”. That can possibly lead to lower loan rates immediately. But aside from rates, there are several other aspects that borrowers need to be wary of.
• MCLR and Repo Rate : Banks "peg" their lending rates on loans against a particular benchmark. Until now, each bank was free to decide its own benchmark, based on its own cost of deposits or borrowings. Under the existing MCLR structure (brought in 2015), banks calculate their cost of funds based on the latest rates offered on deposits or borrowings. Given that each bank’s cost is different, MCLR also varies across banks. Ideally when the RBI cuts or hikes repo rate, banks’ MCLR should also move accordingly. But Indian banks only source a very small portion (1 percent) of their deposits at the RBI’s repo rate, banks’ cost of funds reduce or increase by a smaller amount (than the corresponding repo rate movement), thereby limiting the changes in MCLR. So monetary policy transmission is never instantaneous or complete.
• The SBI situation : The SBI introduced the repo-linked loan product for home loans from July 2019. Lending rates are benchmarked against repo rate lending rate (RLLR), which changes every time the RBI tweaks its repo rate (up or down). The RLLR changes from the 1st of the following month in which the RBI changes its repo rate. With the RBI’s 35 bps repo rate cut in August 2019, the SBI’s RLLR reduced to 7.65 per cent since September 1 (from 8 per cent earlier). Hence for home loans upto ₹75 lakhs, the effective lending rate for borrowers with good credit score works out to 8.05 per cent (mark-up of 40 bps over RLLR) currently. The SBI’s MCLR linked home loan has a higher, effective lending rate of 8.65 per cent.
• Cheaper : So, loans under the new external benchmark structure would get cheaper if the RBI continues to cut rates. And when the RBI starts to hike rate, you pay more! There are two big caution marks here.
• Two big caution :

1. Even if banks link lending rates to the same external benchmark, the initial base or benchmark would vary widelyacross banks. Both SBI and IDBI banks have already linked their home loans to repo rate. But their repo rate lending rate (RLLR) varies. For SBI the RLLR is 7.65 per cent and for IDBI Bank it is 8.3 per cent. So, borrowers must compare the underlying benchmark across banks to zero in on the cheapest option.
2. Banks add a margin (spread) to finally arrive at the effective lending rate. This will vary too. For SBI it is 40 bps, but for IDBI Bank it is nil in case of borrowers with a high credit score of 750 and above.

• Don't change spread midway : The RBI has mandated that banks cannot change the spread unless there is a change in borrower’s credit assessment. Will banks follow the rule? So ultimately, a borrower needs to take note of the underlying benchmark and spread at the start of the loan, and then compare.
• How MCLR worked : Under MCLR, lending rates were reset only at intervals corresponding to the tenure of the MCLR. For instance, in the case of home loans benchmarked against the one-year MCLR, lending rates are reset every year. But RBI rules will now ensure loans are reset at least once in three months - if there are changes in the underlying benchmark repo or t-bill yield. This means that your lending rate will be revised much faster. So monetary policy transmission will be much quicker.
• Technical details on EMIs : Under a regular home loan product, one that is linked to your MCLR, your equated monthly instalment (EMI) on your home loan is fairly stable. Even when the lending rate is reset based on the latest MCLR, banks usually change the tenure (lower the tenure in case of fall in rates) of your loan rather than EMI - unless you specify otherwise. This in effect keeps your EMI steady. Under SBI’s RLLR however, a minimum 3 per cent of the principal loan amount is repaid every year. Interest charged on the loan is serviced monthly, based on the lending rate effective at that point in time. Hence your EMI changes every time there is a change in RBI’s repo rate (in the following month). It is unclear how other banks will structure their products under external benchmarks (they could offer a steady EMI).
• Old borrowers : The RBI has allowed existing borrowers under MCLR to move to the external benchmarked-loans, without levy of any charges or fees. Most borrowers will move, unless they're about to end their loans.
• Cost of funds : Ultimately, loan rates need to be linked to the cost of funds, to enable banks to make profits, else they'll lose interest. Also, they need to give good deposit interest rates else they will not attract enough resources to be able to lend. Today, in India the the rate of growth of deposits is relatively slow vis-à-vis the growth in loans. That can easily lead to an asset-liability mismatch.
• Paying poorly : It is also clear that although bank deposits have some distinct advantages in the form of stable returns (vis-à-vis mutual fund schemes) and liquidity (vis-à-vis small saving schemes), they are at a disadvantage in terms of tax-adjusted returns in comparison with these schemes. The rate of growth of deposits has stayed below 10% for nearly two years now whereas loans are growing at a faster pace.
• Problems with external benchmarks : The main challenge in using either T-bill rates or CD rates as the benchmark is that these markets are not deep enough and are therefore vulnerable to manipulation. Moreover, T-bill rates may, on occasion, reflect fiscal risks which will automatically get transmitted to the credit market when used as a benchmark. CD rates are highly sensitive to liquidity conditions, credit cycles, and seasonality. The repo rate, while reflecting the appropriate rate for the economy, suffers from the lack of a term structure; also, banks have limited access to funds at the repo rate.
• Theory behind Financial Benchmarks and FBIL : The rates suggested by the Financial Benchmark India Pvt. Ltd. can be used by Banks now, as per the RBI.

1. These are indices, values or reference rates used for the purpose of pricing, settlement and valuation of financial contracts. Globally huge volumes of financial transactions are referenced to or valued using various such benchmarks. Financial benchmarks play a very critical role in promoting efficient and transparent financial markets and ensuring financial stability.
2. The manipulation and complicity involved in the method of computation of LIBOR and EURIBOR benchmarks in the recent period led to imposition of huge penalties on banks by regulators. It drew global attention to various aspects of the benchmark calculation and administration. The sovereign authorities, central banks and many international bodies are concerned about the governance process of the financial benchmarks and have commissioned working groups and committees to comprehensively look into the existing benchmarks setting process in their respective jurisdictions and suggest policies and procedures for bringing about robust improvement in the benchmark governance framework.
3. The IOSCO has issued Principles on Financial Benchmarks while the Wheatley Review Report has looked into the various aspects of LIBOR setting process and issued ten point proposals for reform of the LIBOR.  (The IOSCO is the "International Organization of Securities Commissions" which is an association of organizations that regulate the world’s securities and futures markets.)
4. The RBI set up a Committee on Financial Benchmarks in June 2013 to review the existing systems governing major financial benchmarks in India. The Committee headed by Shri Vijaya Bhaskar made wide-ranging recommendations to reform the benchmark administration in India. These were accepted by the Reserve Bank of India in early 2014, which identified FIMMDA and FEDAI as the benchmark administrators for the Indian rupee interest rates and Forex benchmarks respectively. It was suggested that these associations may jointly or  independently form a separate entity to administer the benchmarks. This is the first major step for formation of Financial Benchmark India Pvt. Ltd (FBIL) as an independent benchmark administrator for interest rates and foreign exchange.
5. The FBIL, jointly owned by FIMMDA, FEDAI and IBA, was formed in December 2014 as a private limited company under the Companies Act 2013. Its aim is to develop and administer benchmarks relating to money market, government securities and foreign exchange in India. It is responsible for all the aspects relating to the benchmarks to be issued by it, namely, collection and submission of market data and information including polled data , formulation, adoption and periodic review of benchmark calculation methodologies, calculation, publication and administration of benchmarks confirming to the highest standards of integrity, transparency and precision.
6. The FBIL is committed to providing financial benchmarks that are (i) free from bias, (ii) backed by robust data driven research and (iii) compliant with global best practices.
7. The FBIL provides these rates - Overnight MIBOR (Overnight Mumbai Interbank Outright Rate), Market Repo Overnight Rate, Term MIBOR, Reference Rate, Forward Premia Curve, MIFOR Curve (Mumbai Interbank Forward Outright Rate), T-Bill Rate, CD Rate, MIBOR-OIS, FC - Rupee Options Volatility Matrix, and G-Sec Valuation.

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