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External benchmark may not help borrowers

Let market forces play their part in enabling competitive pricing and innovation by banks

Naveen Kukreja 

lending rate, loans
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Since the deregulation of in the mid-1990s, the Reserve Bank of India (RBI) has tried four different rate-setting mechanisms to provide consumers with the best All these mechanisms so far have relied heavily on banks’ internal factors, like the cost of funds, to determine the An internal committee set up by the has now suggested linking bank with an external benchmark in a bid to increase transparency in the lending rate setting system by and quicken the monetary policy transmission. 

The committee has also acknowledged that rate-setting systems like base rate and marginal cost of funds-based (MCLR) — benchmarks to which retail such like home loan and card loan rates are fixed — are not in sync with the global practices of pricing bank

The committee, from 13 possible benchmarks, has recommended 3 – 

• RBI’s repo rate
• Treasury bill rate 
• CD (Certificate of Deposit) rate

These three market-linked benchmarks were selected because of their transparency, correlation with the policy rate and stability.

What led to external benchmarking? may have been sluggish at times in passing off the benefits of policy rate cuts to customers in the forms of lower For example, between April 2016, when the became operational, and October 2016 (pre-demonetisation), the was reduced by 50 basis points (bps) by the but the 1-year median was reduced by only 15 bps. The committee has pointed a finger at the high amount of discretion granted to under the base rate and systems for higher prevailing despite monetary policy going down. 

What is base rate and why did it fail? The adopted the base rate system in July 2010 aiming at improving the transparency of rate-setting mechanism and transmission of policy rates to borrowers. The base rate had to be calculated by each bank after adding their (i) cost of (ii) negative carry on CRR and SLR (iii) unallocatable overhead cost (iv) average return on net worth. However, were allowed to use any other methodology for base rate calculation, provided the method was consistent and subject to review or scrutiny. This flexibility accorded to made most of them less sensitive to policy rate cuts. 

Why is the not convinced with the system? The failure of the base rate system made the to switch over to MCLR-based rate setting system from April 1, 2016. Under this system, the were supposed to fix their interest rates on the basis of the latest rates offered by them on their new deposits.  is calculated by adding (i) marginal cost of funds (ii) negative carry on CRR (iii) operating costs (iv) tenor premium. Unlike the base rate system, is factored in while calculating marginal cost of funds to ensure the transmission of policy rate changes. To enforce transparency, directed to review and publish their every month and specify the interest reset dates while sanctioning the To further bolster transmission, the maximum period between two reset dates was capped at 1 year. 

Although the transmission of policy rates has been much faster than the earlier base rate system, the has found it to be not fast enough to catch up with the policy rate cuts. The competition from other saving alternatives may have forced to keep their deposit rates high, resulting in higher MCLRs. While the fresh borrowers have still somewhat benefited from reduced policy rates, existing borrowers under system continued to pay higher interest rate due to longer reset periods. All these factors have resulted in lower than expected transmission of policy rates.

Challenges with external benchmarks: Now with the proposed new mechanism where an external benchmark may determine lending rates, the benefits of rate cuts are likely to be passed on to home loan borrowers much faster by The Study Group has also suggested quarterly resets of interest rates and full migration of all outstanding to the new benchmark by the end of March 2019 for effective transmission. 

However, the use of RBI’s repo rate, and CD rates as benchmarks will not be without challenges. The main concern with CD rates and T-Bills is their lack of market depth, which makes them susceptible to manipulation. As T-Bill rates also reflect fiscal risks, using them as benchmark may transmit such risks to the loan market. Similarly, CD rates are highly sensitive to credit cycles and liquidity conditions. 


would be a more effective benchmark as directly controls it factoring in the prevalent macro-economic conditions and future outlook. However, as the study group indicated, linking with lending rate may constrain future changes in the monetary policy framework. Also, since these benchmarks are short-term in nature, it would be difficult for to price their long-term on the basis of these benchmarks. 

Lastly, irrespective of the benchmark selected by the RBI, the final decision on pricing of would still rest with the bank. In this scenario, I think it would be best to let market forces play their part in enabling competitive pricing and innovation by the In case, the central bank is unhappy with the pricing decisions by certain banks, it can choose to engage with them on a one-on-one basis. 

The writer is CEO& co-founder,

First Published: Sat, October 14 2017. 23:49 IST