Benchmarking lending will translate into good times ahead for borrowers

Less than a month after the third bi-monthly Monetary Policy Statement for FY2019-20 (August 2019)was announced, the RBI made it mandatory for banks to link all their fresh retail loans to an external benchmark, effective October 1, 2019. The central bank suggested that this benchmark rate could be the RBI’s policy repo rate, the Government of India’s three-month and six-month treasury bill yields published by the Financial Benchmarks India Private (FBIL), or any other benchmark market interest rate published by FBIL.

Policy transmission

The reason cited for this mandate was, “it has been observed that due to various reasons, the transmission of policy rate changes to the lending rate of banks under the current MCLR framework has not been satisfactory”.

The RBI has been referring to the financial sector’s response to its rate movements as the ‘transmission’ of the policy action. Until recently, it has been disappointed with the response of various financial market participants. However, during the most recent MPC meet, the RBI governor remarked, “The transmission of policy repo rate cuts to the weighted average lending rates (WALRs) on fresh rupee loans of banks has improved marginally since the last meeting of the MPC. Overall, banks reduced their WALR on fresh rupee loans by 29 bps during the current easing phase so far (February-June 2019).” But apparently, this was not good enough.

RBI rates on a downtrend

At the August 2019Monetary Policy Committee (MPC),the RBI reduced the repo rate by 35 bps to 5.4%. This was the fourth consecutive repo rate cut since the beginning of the calendar year. More pertinently, the MPCdecided to maintain the accommodative stance of the monetary policy.

Repo rate has been cut 4 times since January 2019

The rate cut was not unexpected. The MPC has been working its broad mandate to ‘keep the medium-term target for consumer price index (CPI) inflation at around 4% (within a band of +/-2) while supporting growth’. Both domestic and international macro-economic variables called for a rate cut.

Global signals

·         The US Federal Reserve has cut its benchmark rate after a decade.

·         Global economic activity has slowed and trade and geo-political tensions have escalated.

·         Economic growth in leading emerging economies outside India – China, Russia, Brazil and South Africa – is flagging.

·         Crude oil prices have dipped since May 2019 while the price of Gold and Silver have begun to rise.

Domestic triggers

·         GDP Growth has dipped to a five year low of 5.8% and the MPC has reduced its growth forecast for FY2019-20 from 7.0 per cent (projected in June 2019) to a range of 6.4-6.7% for H1 FY2019-20 and 7.2-7.5% for H2 FY2019-20.

·         Retail inflation has remained below 4% for over a year, giving the RBI the elbow room to reduce interest rates.

·         Industrial activity has moderated and business investments are sluggish.

To give a fillip to the economic scenario without compromising inflation control, the MPC – as expected by markets and economists – reduced the repo rate and stays committed to a dovish monetary stance.

Implications of better transmission in a reducing rate scenario

When the RBI led with a rate cut, until now, it simply sent out a signal to the financial sector that institutions should reduce their rates too. The transmission was expected to follow as the RBI facilitated banks and NBFCs by cutting its rate and thereby, to some extent, enabling them to access funds at a lower rate. It could not, however, mandate that the financial sector ‘must’ cut their rates too.

With this new mandate, banks can choose their benchmark and will still be free to decide the spread over the external benchmark. However, it will ensure transparency, standardisation and ease of understanding of loan products by borrowers.

In the months ahead, borrowers can look forward to lower rates of interest that translate into smaller EMIs or shorter terms or other positive credit indicators. At the same time, due to various measures by the RBI to strengthen the position of lenders, they can look forward to more streamlined risk management and more robust financial health.