GDP Growth - Nudging to Pushing: Change in the Rule

The Reserve Bank of India (RBI) has issued a circular making it mandatory for banks to link all new floating rate personal or retail loans and floating rate loans to MSMEs to an external benchmark effective October 1, 2019. The RBI mentioned in the circular that “it has been observed that due to various reasons, the transmission of policy rate changes to the lending rate of banks under the current Marginal Cost of Funds Based Lending Rate (MCLR) framework has not been satisfactory.”The banks are free to choose one of the several benchmarks like repo rate, 3-month treasury bill, 6-month treasury bill or other benchmark as specified. However, this needs to be done in consistent manner. The banks are also free to choose their spread over the benchmark rate, subject to the condition that the credit risk premium may undergo change only when borrower’s credit assessment undergoes a substantial change, as agreed upon in the loan contract. 

The RBI’s objective is to speed up transmission of rate cut by banks so that the wider economy can reap the benefits of the same. Historically, where banks have lagged in transmitting the benefits of lower rates to the larger public. Banks may prefer repo rate as it is less volatile and can be used to benchmark deposit rates. This regulation is applicable to new loans. These are typically ~25-30 per cent of the bank’s overall loan book. Going forward, banks with higher exposure to such loans may be exposed to risk of sharp repo rate cut, converting loans from old to new benchmark and slower fall in the cost of funding. 

So far, the RBI has been nudging banks to shift pricing of floating rate retail loans and SME loans to external benchmarks. Banks had resisted this as their deposits tend to re-price at a slower pace, which affects their ability to transmit and consequently the net margins. Year to date, the repo rate has been reduced by 110 basis points (bps), however, banks have reduced MCLR by a meager 20-25bps.  Going forward, an increasing number of banks are expected to link their lending and deposit rates to the repo rate. It is also expected that deposit rates would then reduce at a much faster clip. Currently, the repo rate is at 5.40 per cent. RBI is in a rate-cutting mode and the market expects another 50 bps rate cut this year. This will provide borrowers with cheaper loans thereby encouraging MSMEs to make more investments in business and incentivising individuals to buy new homes. The purpose is to stoke consumption and growth in the economy. These structural changes would help in giving a clear direction to the market as well. In the short term, it may adversely impact banks, NBFC and Housing Finance Companies. However, the move is likely to reap substantial long-term benefits for the economy.