Communication of any relaxation in lending rates is one of the cornerstones of the monetary policy of the Reserve Bank of India (RBI). One reason for this is that unless the benefit of any relaxation in rates reaches the end consumer (usually retail borrowers and small and medium enterprises), the usefulness of such relaxations is moot. To ensure effective communication, the RBI has introduced various mechanisms such as the base rate methodology to replace the prime- lending rate, and the marginal cost of lending rate (MCLR) methodology to replace the base rate.
The RBI’s internal working group submitted its report on the working of the MCLR methodology in October 2017, and one of its recommendations included linking loan rates to external benchmarks to ensure more effective application of monetary policy measures of the RBI. Subsequently, the RBI’s statement on developmental and regulatory policies of December 2018 referred to the report and proposed to link all floating rate loans to retail, and micro, small and medium enterprises (MSMEs) to certain specified external benchmarks. The RBI also proposed that the spread over the benchmark rate would remain unchanged through the maturity of the loan unless there was a substantial change in the borrower’s credit assessment. While the statement mentioned that final directions would be issued by December 2018, this was delayed until September 2019, probably to avoid any potential disruption due to India’s national elections and the resulting settling down period of the new government.
The September 2019 directions on external benchmark lending require that, from October 1, all new floating rate personal or retail loans (such as housing or auto loans), and all new floating rate loans to MSMEs by banks should be linked to the RBI’s repo rate, the government of India (GOI) 91-day treasury bill yield disseminated by Financial Benchmarks India Private Limited (FBIL), the GOI 182-day treasury bill yield disseminated by FBIL, or any other benchmark rate produced by FBIL. To ensure transparency and ease of understanding, the directions require banks to adopt a uniform benchmark within a loan category.
The use of multiple benchmarks in the same loan category is disallowed by the directions. Interest payable on an external benchmark-linked loan should be reset at least once every three months. Banks can offer these external benchmark-linked loans to other borrowers as well.
Banks can decide the spread payable on an external benchmark on any loan. However, such a spread or credit-risk premium can change only where there is a substantial change in the borrower’s credit profile. The directions also provide a framework for existing borrowers to switch to an external benchmark-linked interest rate. Existing borrowers that are entitled to prepay loans without prepayment charges can switch to an external benchmark-linked interest rate without payment of fees or charges except for reasonable administrative and legal costs. The final interest rate charged to such a borrower must be the same rate that would have been applicable had such a loan been made under the external benchmark-linked methodology. Other existing borrowers can move to external benchmark-linked loans at terms that are mutually agreed with the banks. The directions also provide that such a switch of interest rate determination methodology shall not be construed as a foreclosure of a loan. It would have been useful had the directions also clarified that such a switch over would not be construed as a restructuring given that the current definition of this term applies the concept of concessions provided by a bank to a borrower. Given the regulatory intent, such a switch over should ideally not be construed as a restructuring.
These directions are currently applicable to banks only and have not been made applicable to non-banking financial companies (NBFCs). Substantial credit offerings to retail and MSME borrowers now take place through NBFCs, which often link their lending rates to a bank’s rates (to reflect their cost of borrowing). To ensure onward communication, it would be useful if the RBI came up with a roadmap and eventual directions that link external benchmarks to loans offered by NBFCs as well. Overall, the issuance of the directions is a welcome move and displays positive regulatory intent to alleviate currently prevailing tensions in the financial sector. These directions also reflect good coordination between the Ministry of Finance and sector regulators, an auspicious sign of upcoming positive regulatory developments for the financial market.
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