Bankers not enthused by new price formula for lending rate

External benchmark could lead to extreme volatility in the interest rate process, say lenders

Bankers are not convinced that linking an external benchmark to the lending rate will lead to some great operational efficiency in how loans are priced. If assets pricing is linked to external benchmark, liabilities also have to move in tandem.  

Instead, they say an external benchmark could lead to extreme volatility in the interest rate process. Customers may or may not benefit in securing finer rates, as the risk premium will still be determined by banks. In some cases, such as home loans, there is hardly any individual risk premium, as bankers pass on the low delinquency benefit to customers at large. But with the new methodology in place, home loans may also turn out to be an individual-driven exercise and that may drive up rates for many customers.

A top public sector banker said the proposal was fraught with social risk.

“Such a move could open a Pandora’s Box of rates on deposits also moving in tandem. In a country like India, where social security is limited, this could be a matter of grave concern,” said the senior banker.

Other bankers say taking an external rate as a benchmark does not make much sense in a market where there is no established term money market.

“The external rate is not my cost of funds. My lending rate cannot be linked to an external benchmark,” said a senior banker.

“I cannot tell a customer that the Reserve Bank of India (RBI) has reduced the policy rate and therefore your deposit rate stands revised. She will immediately move her deposit,” the banker said.

An internal study group of the RBI suggested on Wednesday that one of the three external benchmarks – Treasury bills, certificates of deposits of banks, or the RBI policy rate – should be taken into consideration for setting the bank lending rate.

The risk premium can be kept separate and determined by banks, but once set the premium cannot be changed. Besides, the loans being floating rate, these should be reset every quarter, instead of the present practice of resetting once a year.

While agreeing that the new methodology will improve transparency, bankers say that the central bank should not try and change the methodology frequently.

“The marginal cost of funds-based lending rate (MCLR) system is in function for only one year. It already takes into account the changes in policy rates to a large extent. The RBI should be more patient with it,” said another banker.

Bankers argue that the MCLR system already offers banks the freedom to link the lending rate to an external benchmark, such as the Mumbai Interbank Offered Rate (Mibor), but no bank does it as it does not reflect the cost of funds.

However, the discussion paper said linking lending rates with external benchmarks was the standard practice in advanced economy markets.

Bankers say the same cannot be applicable for India as there are no markets from where a bank can borrow a chunk of money at a short notice.

“First we need to develop an effective term money market before we can take external rates as benchmarks,” said one of the bankers quoted above.

“None of the three external rates has the features to become a true benchmark for loan pricing, given the low maturity of the money and bond market in India,” said the head of global markets with a foreign bank.

Still, according to the banker, Treasury bills are better as a benchmark due to frequent issuances and substantial trading volumes. As for the policy repo rate, very small amounts were lent by the RBI to banks using this rate, he said. Similarly, on certificate of deposit (CD) rates, there is a wide divergence between the CD rate of, say, State Bank of India and that issued by older private sector banks and, hence, this cannot be taken as a benchmark.

Bankers also refuted any allegation that their lending rates were high even as their cost of deposits had fallen.

“If you see the net interest margin of any bank, it has remained flat in the past year. If the cost of deposits had fallen and lending rates were high, the margins would be risen steadily,” argued a banker quoted above.

Not all bankers are against the system though. A senior official of a private sector bank said banks also wanted transparency in lending rates and hence any measure to improve transparency was a welcome step. Indian banks in foreign markets already work under conditions where external benchmarks are used. Besides, because of the low sovereign rating, Indian banks cannot borrow from the local term money market. Still, Indian banks have managed well.

The banker said since 70 per cent of the banking industry was owned by the government, any hit on spreads and profitability would ultimately affect the dividend to the government, which neither the RBI would want nor the government would appreciate.

“It is a consultation paper and not a guideline. Ultimately, a consultative process will determine how all the parties benefit in the process. Customers are important, but banks also need to make profits for the good of the economy,” said the banker.