Loans Linked to External Benchmarks: How this will impact you

Published: September 30, 2019 at 11:19 am

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From October 1, 2019, RBI has made an external benchmark based interest rate mandatory for certain categories of loans. What does this mean? How will this impact you? Let us find out starting with the basics.

What does an external benchmark based loan mean in simple terms? The interest rate on your home loan/car loan/personal loan/business loan will be lowered much faster by the banks when RBI reduces the interest rate. Also, it would rise as quickly when interest rates are increased by RBI.

RBI issued a notification on 4th September 2019 that all new floating rate personal loans, home loans, auto loans & MSME loans given by the banks are to be linked to an external benchmark by 1st October 2019. The other categories of loans (if desired by the bank) can be linked to the external benchmark.

Existing Structure:New  Structure
BenchmarkInternal:

Currently, retail Loans are linked to MCLR (Marginal Cost of Lending Rate) decided by the individual banks

External:

All new loans to be linked to external benchmark ie RBI Repo rate or any other specified benchmark.

Frequency of interest rate change in your loanGenerally, it changes once a year.Assumed to change at least once in 3 months within reduction/rise in rate by RBI

Examples of external benchmark rate: Repo Rate, 3-month/6-month treasury bill or any one of the external rates published by Financial Benchmarks India Private Ltd (FBIL).

Repo rate is the rate at which banks’ borrow money from RBI by selling securities/bonds (secured borrowing). The current repo rate is 5.40%.

How Loan Interest Rate works with an external benchmark linking

External Benchmark (say REPO Rate): 5.40% plus

Credit Risk Premium (see note below) (borrower specific- high-risk borrowers can be given loans at a higher rate) say: 1 % plus

Spread (see note below) decided by the bank: say: 2 %

Effective rate Home Loan rate(a+b+c): 5.40% + 1% +2%= 8.40%

When RBI reduces the Repo rate from 5.40% to 5%, the Home Loan rate would be: 8%

As per RBI, Banks are allowed to change the credit risk premium if there is a substantial change in the credit assessment of the borrower. Eg.  If the profits of the MSME unit are falling Year on Year by 50%, the ability of the MSME unit to repay gets lower and hence, credit risk increases. In such a case, banks may increase the Credit Risk Premium. (The loan agreement may contain a clause which specifies the periodicity of change in credit risk charged by the bank. Generally, it is yearly)

Spread decided by the bank contains operating costs incurred by the bank towards extending the loan eg. Loan staff, loan branches etc. As per RBI notification, the operating costs component in the banks’ spread can be revised by the bank once in 3 years.

Why is it being done?

RBI felt that banks’ were not passing the interest rate reduction benefits to the borrowers quickly. The Repo rate is a monetary policy tool by RBI for transmitting desired effects in the economy.  RBI lowers the interest rates with the assumption that the interest rates charged by the banks to the borrowers would be lowered and that in turn, would result in to increase in demand in the economy. RBI studied and held consultations with various stakeholders from 2017 on effective transmission of interest rate changes and concluded that linking of retail loans to an external benchmark may be the most effective way to transmit changes in the monetary policy.

Is it good for the borrowers?

Yes: Till the interest rates are falling. When the interest rates are increased by RBI: Your loan outflow would also increase. For extremely leveraged borrowers, this will be a very difficult situation to manage.  Hence, borrowers should always factor in the possibility for times when interest rate/EMIs go up.

What happens to the existing Loan borrowers?

Your loans will continue to be linked to MCLR till repayment or renewal of the loan. Generally, the renewal of all loans is done at yearly intervals. Banks may ask you to sign a fresh set of loan documents containing the new interest rate structure linked to the repo rate. Generally, the month of renewal is the month in which you took the loan. Ex if you took the loan on Jan 19, the loan will be due for renewal on Jan 20. So you can expect your banker to call you for fresh documents in Jan/Feb 20. There can be reasonable legal/administrative cost charged by the bank towards this shift to the new interest rate regime.

The problem for banks

Asset/Liability Mismatch: The liabilities of the banks are not linked to an external benchmark. However, the assets are being linked to the external benchmark.

Explanation: Banks obtain money from depositors and let’s say pay a 7 % interest on FD. This is the Cost of Fund for the bank.   Lets’ assume a scenario where the external benchmark is lowered by the government and the effective rate on loans, reaches to 7 %. In such a scenario, banks would earn 0 % from the loan. In order to avoid such problems, banks may also link the FD rates to external benchmark ie Repo rate. Through this, banks would be able to maintain & manage their interest income. A fall in loan rates, would also automatically lead to a fall in the FD interest rate of the corresponding or a lesser amount. However, senior citizen depositors who live only on fixed monthly interest income can be impacted by this frequent fluctuation in interest rates. Hence, banks may initially link only bulk FDs (ie FDs above a certain limit) to the external benchmark in order to avoid hardship to the small depositor. Banks will have to hedge the interest rate risk owing to this switch over to the new regime. Note: Your loans against FD’s may not be linked to the external benchmark as of now.

Disclaimer: All the figures used are hypothetical and only for illustrative purpose.

This post was written in collaboration with a commissioned content writer from the banking industry.

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