RBI's sudden love for floating-rate borrowers

The Reserve Bank of India (RBI) on December 5 announced a change in the way banks and finance companies priced their floating rates for retail loans (home, cars, etc.) and small businesses. Beginning April 1, 2019, banks will have to link the interest rates on such loans to an external benchmark instead of using their own internal benchmarks. Every publication has cheered this without a hint of the enormous irony — that the regulator had allowed banks to fleece floating-rate borrowers for two decades with useless tweaks to enable it. So why this move now?

First, let me explain the issue. Under the floating-rate system, when interest rates go up, banks are quick to increase the rate, but when interest rates drop, borrowers have to go to the bank branch and haggle and pay to reduce the rates. What was the banks’ logic for not reducing interest rates? That a home loan is a contract and banks cannot reduce the interest rate unilaterally. Nice excuse. Why would this not apply when interest rates increased? And why would any borrower not want a cut in her interest rate? So the headlines that you read every few months when rates declined — “now your home loan is going to cost less” — were largely false. Banks were playing the game heads I win, tails you lose.

Looting for 20 years

The RBI has tacitly supported this loot for almost 20 years. In its academic lingo: “[T]he first regime of (the) Prime Lending Rate… introduced in 1994… continued to be rigid and inflexible in relation to the overall direction of interest rates…” Translation: Banks were overcharging customers. A decade later, in April 2003, the RBI “advised” banks and finance companies to lend on the basis of a “benchmark PLR” (BPLR). Did it work? Here’s what the RBI concluded: “In essence, both (the) PLR and BPLR did not produce adequate monetary transmission to the real economy. This defeated the very purpose for which these benchmarks were introduced.” That sounds bland; it was actually daylight robbery of ordinary people struggling to own a home.

The PLR, or benchmark rate, is the rate at which a bank lends money to its most preferred prime customer — think of a cash-rich company, which does not really need to borrow. The PLR would obviously be the bank’s lowest rate. Others should be charged higher. But in fact, everyone was being charged a rate lower than the PLR! The PLR was a scam. It was set artificially high so that everyone was offered a rate lower than the PLR! When the rates went up, the PLR went up and so did your interest rate, while continuing to remain below the PLR! Further, in blatant discrimination, new borrowers were offered loans at an even lower rate. Banks had it too easy, as the RBI looked on.

It took seven years for the RBI to make another feeble, half-hearted attempt to stop this plunder. But even after knowing that internal rates — the PLR or BPLR — were being blatantly manipulated, the RBI never gave up on unworkable internal benchmarks, which were the crux of this unfair system. In 2010, the RBI introduced a system called the base rate, the rate for a prime customer. Banks were told not to lend below it. (By the way, finance companies were still allowed to use the PLR.) Here is the RBI’s confession about the outcome of this experiment with an internal benchmark: “[T]he flexibility accorded to banks in the determination of (the) cost of funds resulted in opacity … banks often changed over time the spread over the base rate for some borrowers, even without any change in credit quality of borrowers, while leaving the base rate unchanged.”

Time for the superstar economist from Chicago, Raghuram Rajan, to enter the scene. Mr Rajan had warned about an economic crash in the US, after closely witnessing regulatory capture by banks. He also knew that the 2008 crash had correctly turned financial regulation more pro-consumer in the UK, the US, and Australia. No such luck for us. Under Mr Rajan, six years after the base rate, the RBI introduced the marginal cost of funds-based lending (MCLR). The idea was that transmission of interest rates to borrowers would be swift, since marginal rates of deposits would move up and down in line with the RBI repo rate. This was all academic twaddle, of course. The MCLR is also an internal rate and so it gave the banks the chance to fix and move their goalposts at will. 

The December 5 move, finally, does something obvious. It makes the benchmark external but 20 years late. Imagine mutual funds reporting their performance for 20 years based on internal benchmarks, which no one audits! Oh, one more thing. The 2010 base rate circular had said, “Banks, however, should not charge any fee for such switch-over.” Under Dr Rajan’s MCLR, the loot was complete when even this protection was dropped and banks and finance companies were allowed to charge customers on “mutually negotiated” terms, something that customers should have got as a matter of right. Well, customers were in no position to negotiate with a lender, so they were forced to pay up. Most were so grateful to get a reduction that they didn’t even realise they were being fleeced. 

Did the RBI have a sudden change of heart after 20 years? No way. It was reacting to a PIL (public interest litigation) petition filed by Moneylife Foundation, which came up in October, leading to an order by the Supreme Court asking the RBI to respond in six weeks. The petition highlighted the injustice described above and prayed for restitution of overcharged interest, among other things. The RBI has yet to respond to Moneylife but it has now mandated an external benchmark — which was one of our prayers in the petition. That begs a bigger question: Why do we have to go to court each time for the regulator to play fair with us?

The writer is the editor of www.moneylife.in

Twitter: @Moneylifers