How banks will be impacted in the new lending rate regime

Banks will finally have to align the transmission of interest rates in line with the changes made by the central bank. The Reserve Bank of India (RBI) on Thursday said that from April 1, 2016, banks must review their lending rates frequently, and reflect changes in their cost of borrowing.

So, how does the new guidelines impact banks?

RBI has asked banks to price all new loans sanctioned or renewed from April 2016 based on the Marginal Cost of Funds-based Lending Rate (MCLR). This move sweetens the one proposed in the draft prospectus where the entire loan book of banks was expected to shift to the new mechanism.

What the guidelines mean for a common man is that the change in interest rates made by the central bank will now be based on a scientific method rather than leaving the judgement to the bank management.

Here is how it will work:

In order to arrive at a base rate, banks will have to add the cost of their funds plus other costs and then a spread which will be based on the profit they are will to charge. Risk profile of the client will also be considered to arrive at a final rate. The RBI guideline states: "Actual lending rates will be determined by adding the components of spread to the MCLR. Accordingly, there will be no lending below the MCLR of a particular maturity for all loans linked to that benchmark."

Banks will now have to publish at least five MCLRs - overnight, one month, three months, six months and a year and in some cases even longer.

Banks will be required to review and publish their MCLR of different maturities every month on a pre-announced date. The rate prevailing on the day the loan is sanctioned will be applicable till the next reset date, irrespective of the changes in the benchmark during the interim.

Thus if a borrower has taken a loan before April 1, 2016, they will have to wait for a full year before it is reset.

RBI governor had voiced his displeasure over banks not passing on interest rate reduction despite the central bank cutting it. RBI had cut interest rates by 125 basis points but banks have passed on only 60 basis points of cut this year. While banks have not reduced rates for borrowers they have cut deposit rates by nearly 100 basis points.

This will not be possible after implementation of MCLR. Banks will have to pass the reduction as they will have to take their cost of fund in the calculation. As deposits is what accounts for a major chunk of their cost of fund, benefit of a reduction in deposit rate will have to be passed on to the borrower.

Broking firm Religare in a note says that as the guidelines are applicable only on incremental loans, it will reduce the impact on bank margins. Further, the central bank has also given an option to existing borrowers (currently linked to the base rate) to continue till repayment/renewal of loans or migrate to MCLR – a move which should also cushion bank margins.

The guidelines is good for the economy as banks will not be able to hold back on rate reduction by the central bank, however, their financials will be hit to some extent. Banks with higher level of low cost current account and saving accounts (CASA) deposits will have lower impact.