Effective from 1st October 2019, all your loans will be linked to the External Benchmark Lending Rate. Hence, it is important for you to understand what is the meaning of external benchmark lending rate and how it is different from the earlier rate regime.
Before understanding the External Benchmark Lending Rate, let us first understand the current situation or what type of lending rates banks used to follow and why it was felt necessary to move to an external benchmark lending rate.
Many of us already aware that there are two categories of lending rate. One is the fixed interest rate and another is a floating interest rate. Fixed interest rate means your interest rate during the loan tenure will be fixed (irrespective of the up and downs in the interest rate).
Under floating rate interest rates based loans, the interest rate will change as and when the banks change the rate. Now all loans are floating-rate loans. Hence, let us now dwell upon the basic concept of how banks used to lend us.
What is Internal Benchmark Lending Rate?
What is Internal Benchmark Lending Rate? RBI will give certain guidelines to banks and based on which the banks will decide their own lending rate. As banks have authority to decide the lending rate, such method of lending rate is called Internal Benchmark Lending Rate. Earlier there are three types of lending rates which banks used to follow and they are as below.
# Primary Lending Rate (PLR)
This was the oldest practice of lending rate. Banks were given freehand to fix their lending rate to their customers. Obviously, banks taking advantage of this, use to fix high lending rate for a borrower whose credit rating is not so trustworthy and at the same time used to offer a discount to a borrower whose credit rating is good.
Hence, there was a big difference in lending rate which banks used to offer to the borrowers. To avoid this parity in lending rates, RBI introduced the Base Rate Regime or BRR.
# Base Rate Regime (BRR)
In the Base Rate Regime of lending rate, RBI instructed the banks to follow certain parameters before deciding the base rate lending rates. The lending rate at any cost should be below this base rate. This RBI felt that will remove the mismatch which is there in PLR based interest rate regime. The parameters set by RBI are as below.
1. Cost of Funds (COF)-Banks usually borrows money from RBI, Household Individuals and from the companies. Hence, once banks borrows the money from these entities, definitely bank has to give certain interest rate on these deposits right? Hence, assume your bank is giving you a 7% interest on your FD, then the bank has to consider this cost of 7% while deciding the lending rate.
2. Operational Expenses (OE)-When bank lend money to a borrower or collect money from depositors, the bank will incurre certain expenses. Obviously, such expenses should be part of the lending rate and have to incurred by the borrower.
3. Cost of CRR (Cash Reserve Ratio which Banks keeps with RBI)-Assume that Bank collected Rs.100 Crore from the bank. As per RBI guidelines, Bank has to keep certain portion of this with the RBI, which in finance world called as CRR or Cash Reserve Ratio. Assume that this is around 4%. Hence, if the bank collected Rs.100 Cr from the depositors, then bank has to keep Rs.4 Cr with RBI.
This Rs.4 Crore which is RBI will not earn a single interest to Bank. Because RBI will not give any interest on CRR. Hence, if the Bank collected Rs.100 Cr at the promise of giving an interest rate of 7% to individuals, then this cost of Rs.4 Cr which is IDLE with the RBI is also the cost of the Bank itself. Bank has to bear this 7% interest on Rs.4 Cr from its pocket and give to the depositor.
This is called as Cost of CRR. Hence, RBI guidelines included considering this Cost of CRR while deciding the lending rate.
4. The margin of Profit-After considering the above expenses, bank at the end of the day has to run it’s show as a business entity right? Hence, they have to consider what margin of profit they are looking at in their business. Such a margin of profit also is part of the lending rate.
Combined all the four parameters, banks used to fix their lending rate under the Base Rate Regime (BRR).
Hence, as per RBI guidelines, the lending should not be at any cost below this base rate. Do remember that banks were also allowed to charge certain additional interest rate over and above this base rate. Such additional rate is called as SPREAD or PREMIUM. This usually be lower to high creditworthy borrowers and obviously high for lower creditworthy borrowers.
The spread or premium is introduced because the bank giving a loan to an individual is entirely different than a loan to business entity. Hence, based on the risk in lending, banks can set their spread or premium to the borrower.
# Marginal Cost of Lending Rate (MCLR)
With the introduction of Base Rate based lending regime, RBI thought whenever there is a change in policy rate by RBI, the lending rate will also reduce in the same proportion. Such change is called a Monitory Policy Tranmission or MPT. Bank expected that if the rate has fallen, then the lending rate also must fall equally.
Assume that RBI reduced the interest rate for around 50 BPS (100 BPS-1%), then RBI expects banks will also reduce the lending rate by 50 BPS. If banks reduce it, then it is called as the efficient transmission of RBI policy. If not, then it is called inefficient transmission.
What RBI noticed is that such efficient transmission is not happening in the Base Rate pricing method of lending. Hence, RBI introduced the MCLR effective from 1st April 2016. I have written a detailed post on this “All about MCLR lending rates in layman terms“.
With the introduction of MCLR, RBI modified certain guidelines to arrive at lending rates by banks. RBI specifically mentioned that rather than considering just COST OF FUNDING, banks must consider the MARGINAL COST OF FUNDING.
As I told earlier, Banks usually get the money from the Public, Companies, and RBI. Hence, if RBI reduced the interest rate, then Banks started to consider the cost of the money they collected from Public and Companies. Just because RBI reduced the interest rate, does not mean there is a reducing in cost of acquiring the fund from Public and Companies right? Hence, Banks used to argue that just because RBI reduced the interest does not mean there is a cost of funding is reduced to us. Because there is no cost of reduction from the money they collected from the Public or Companies.
However, RBI argued and brought the MCLR saying if RBI reduces the interest rate, then obviously there is no overall reduction in the cost of borrowing for the bank. However, there is definitely a cost of reduction MARGINALLY. This is how the MCLR used to calculate.
MCLR is usually arrived at based on below mentioned four considerations.
1) Marginal Cost of Funds: This is the cost of CURRENT borrowing to the bank. You noticed in based rate system that banks used to arrive at the cost of the fund as per their comfort. Also, they used to consider the existing deposits rates as if the cost of fund. However, in the case of MCLR based loans, the last month deposit rates (current, savings, term deposits etc) will be considered to arrive the cost of funds.
Banks not only consider the current borrowing cost but also their margin of profit is also included in this Marginal Cost of Funds. This is called as the Return on Networth. The return on net worth is nothing but the bank’s profit they want to earn from their lending business.
You might be noticed that in the case of base rate system, the cost of fund and margin was used to calculate separately. However, in case of MCLR based loans, both cost of fund and margin (return on net worth) are together are called Marginal Cost of Funds.
The calculation of this Marginal Cost of Funds is as below.
Marginal cost of funds = Marginal cost of Borrowing X 92% + Return on Net worth X 8%
Notice the above formula, the stress or the higher priority to arrive at Marginal Cost of Funds is to cost of borrowings (the deposits banks accepted) than the return on net worth or margin.
2) Negative Carry on Cash Reserve Ratio-
As I pointed above, banks have to keep a certain level of their deposits with reserve bank. This is the safety measure and banks will not earn any interest on this amount. Banks have to keep a certain level (4% as on April 5, 2016) of their deposits with the Reserve Bank. This ratio is the Cash Reserve Ratio (CRR). Banks don’t earn any interest on the amount. Essentially, they can use 96% of the deposits for lending and the remaining 4% does not earn the bank anything. RBI allows some leeway for this with adjustment to the
Hence, such cost is also considered to arrive at MCLR calculation.
3) Operating Costs-
Apart from the cost of deposit and CRR, banks also have to incur some expenses. Such expenses are called as Operating costs. Such cost may include salaries, rent or other overhead expenses.
4) Tenor Premium/Discount- If the bank is lending for higher tensors (like home loans), then there are uncertainties associated which are not factored in the MCLR calculated based on (say) 1-year MCLR. Therefore, the banks will charge a premium to the borrower for the risk (uncertainty) associated with lending for higher tenor loans.
Hence, this tenor premium is usually higher for long tenure loans.
Considering all the above four factors, Banks arrive at the MCLR rate.
I hope now you got a clear picture of historical events that happened in banking space when it comes to the lending rate and internal benchmark lending rate.
All about External Benchmark Lending Rate in a layman terms
After the introduction of MCLR, RBI was skeptical about the implementation of MCLR by banks. Hence, RBI set up a committee which is known as Janak Raj Committee. Janak Raj Committee came out with certain interesting findings and they are as below.
- Shifting of loans from BRR to MCLR was not done by all Banks. There are certain loans which are still under BRR regime and banks are enjoying the higher profit.
- MCLR rate used to be recalculated frequently. However, many banks used to revise MCLR only either once in 6 months or 12 months.
- Assumed that RBI reduced its rate on Jan 2019 and banks following the revision of MCLR on a yearly basis, then Banks may revise their MCLR in December 2019. The reduction in MCLR in Jan 2019 will not be going to affect to the borrower immediately. Hence, there is a big lagging in policy implementation effectively.
Hence, considering all these aspects, the Committee recommended shifting to external benchmark lending rate rather than banks internally decide their benchmark. This is where the RBI acted now and introduced all loans be under external benchmark lending rate effective from 1st October 2019.
As per the committee, to judge the external benchmark lending rate, banks are allowed to follow the below external benchmarks.
– Reserve Bank of India policy repo rate
– Government of India 3-Months Treasury Bill yield published by the Financial Benchmarks India Private Ltd (FBIL)
– Government of India 6-Months Treasury Bill yield published by the FBIL
– Any other benchmark market interest rate published by the FBIL.
The banks have to calculate their lending rate based on cost of CRR, Operational Expenses and Profit Margin. Now if banks set Repo Rate as their external benchmark to fix the lending rate, then the below situation will happen.
Assume that the cost of CRR, Operational Expenses and Profit Margin is around 8%. Assume also that Repo Rate is 6%. Then the base rate for the banks to lend should be (Cost of CRR+Operational Expenses+Profit Margin)+Repo Rate.
Certain points to be noted:-
- Banks are free to offer such external benchmark linked loans to other types of borrowers as well.
- In order to ensure transparency, standardization, and ease of understanding of loan products by borrowers, a bank must adopt a uniform external benchmark within a loan category; in other words, the adoption of multiple benchmarks by the same bank is not allowed within a loan category.
- The interest rate under the external benchmark shall be reset at least once in three months.
- Existing loans and credit limits linked to the MCLR/Base Rate/BPLR shall continue till repayment or renewal, as the case may be.
- Existing borrowers shall have the option to move to External Benchmark at mutually acceptable terms.
- Banks are free to decide the spread over the external benchmark. However, credit risk premium may undergo change only when borrower’s credit assessment undergoes a substantial change, as agreed upon in the loan contract. Further, other components of spread including operating cost could be altered once in three years.
Let me explain the same from the below image.
Note:-Only the external benchmark lending rate will change throughout your loan tenure. Rest of the everything will remain the same (until and unless there is a big change in your credit rating).
Advantages of External Benchmark Lending Rates
Your lending rate usually changes at least once in 3 months. This was not the case with MCLR regime as banks set their own terms to change the interest rates.
Monetary Transmission is efficient and there is transparency in lending rates.
Disadvantages of External Benchmark Lending Rates
Benchmark set for external benchmark lending rates are high in volatility. Hence, be ready to digest the frequent change in your lending rates.
Banks usually earn interest on lending the money. At the same time, when someone books an FD with the bank, then the bank has to pay the interest. Banks always strive to earn more than what they give it to depositors. This difference between interest earned and interest payout is called Net Interest Margin.
What banks are fearing is that their cost of borrowing will be fixed and their earning on interest is volatility in the sense. Hence, it may impact their Net Interest Margin.
Conclusion:-Going by the whole post, you might have noticed that even RBI itself not sure of what to do to bring in transparency or effective monetary transmission. It is still at trial and error mode. Hence, expecting a big change just because of setting an external benchmark lending rate is not a solution.