Floating rates: Arbitrary and discriminatory

I have explained over three previous pieces how banks, aided by a hands-off Reserve Bank of India (RBI), are giving a raw deal to those who have taken home loans. My focus in those pieces was to explain how “floating rates” are a sham. Last week I was chatting with K C Chakrabarty, former chairman of Punjab National Bank and former deputy governor of the RBI. He explained to me that the way the floating rate regime was being implemented was non-transparent and discriminatory. “In a floating rate system, the bank’s interest rate fluctuates with the floating reference rate. Now this floating reference can be an internal floater or external. For example, LIBOR (London Interbank Offered Rate) is an external floater,” he says. According to him, the first mistake (which consumers are paying for) was not to have an external floater. “India has been using the prime lending rate (PLR), then the base rate, and finally marginal cost of fund-based lending rate (MCLR) in that order. These are all internal floaters of the bank. Banks decide on their own what the rate is. There is nobody to oversee how they arrive at it. It is non-transparent.”

This is why when the RBI changes the interest rate, the floater does not change much. “If it’s an external floater there would have been no problem. For example, in the US, everybody’s home loan is linked to the prime rate. So, the moment the Fed rate changes all these rates undergo a change. There is no dispute. In the UK it is linked to the base rate. Individual banks’ rate may be the base rate plus 0.5 per cent, but everything is with reference to the floater. The day the floater changes, everything changes. Had we based our rates on an external floater, it would always have been transparent. Suppose the RBI says it will be linked to the repo rate. Everybody knows what it is,” says Dr Chakrabarty.

If the RBI had used an external floater, banks would have been forced to implement the system fairly. With an external floater “once the floating loan is changed, banks cannot differentiate between a new customer and an old customer, or between the person who has approached the bank to reduce his interest burden and the one who has not. If the rate went down, it would have gone down for everybody,” points our Dr Chakrabarty. The other mistake the RBI made, he argues, is that it changed the floater arbitrarily. “For example, why did the RBI change from the PLR to the base rate? Because banks were not following the PLR floating rate mechanism, there was dissatisfaction. The RBI should have changed all the rates that would have been referenced to the base rate. But the RBI did not do that. Now, when the base rate is not working, why did the RBI launch the MCLR?” asks Dr Chakrabarty.

Worse, the RBI has allowed banks even more latitude — to discriminate. “Even if the floater was arbitrary and opaque, the system would be non-discriminatory if the RBI had followed the principle of asking banks to move their rates up or down by the same extent as the change in reference rate.” Why can’t banks follow this principle? The answer is: Because both the government and the RBI irresponsibly allowed banks to have “floating rates that are different for existing and new customers, which is against the principle of floating”.

These two factors — the arbitrary floating rate and discrimination between borrowers — have hit small borrowers and small and medium enterprises (SMEs) the hardest. “There are two broad categories of borrowers, one is retail and SME, and the other is wholesale and high net worth individuals (HNIs). The latter (wholesale and HNIs) are able to take care of themselves, that is, negotiate with the bank for lower rates. Regulators and policymakers are responsible for making the system transparent and non-discriminatory for the retail and smaller borrowers. This where our system has failed,” concludes Mr Chakrabarty.

Remember, floaters are also applicable to educational loans, auto loans, and small SME loans. All takers of these loans have been denied the automatic benefit of lower rates by banks. Within that, the tenure of home loan is much longer because it runs over 15 to 20 years. If rates do not float lower with lower interest rates, the loss in home loans is much higher. Because of the long tenure, the interest cost will be much higher than the principal itself in home loans. The tenure of other loans is small — often only 3-5 years — and there the loss is less. Ever since floating rates have been introduced, this unfairness and discrimination have been inflicted on borrowers. It is time to force the RBI to fix it. Will the newly formed Economic Advisory Council act on this? One member of the EAC, Surjit Bhalla, wants to see drastic cuts in interest rates. He should find out first what the banks have done with the previous cuts. And once he does that, will he forcefully recommend a true external floater that will end banks’ discrimination between different borrowers?

The writer is the editor of www.moneylife.in 

Twitter: @Moneylifers