Linking Lending Rate to External Benchmark Must for New Loans; Old Borrowers Can Switch To the New System
The long struggle to get the banks to charge customers of floating rate loans appropriately and transparently has now come to a happy end. Under severe political pressure to ensure that policy rate cuts are reflected in the new lending rates, the Reserve Bank India (RBI) has now made it mandatory for banks to link their loans to retail and small businesses, to an external benchmark.
This will bring in transparency and is expected to lead to a decline in lending rates for home, car and personal loans, etc, when repo rates fall.
Most importantly, millions of borrowers who have been denied the benefit of lower rates so far, will no longer be short-changed. They can demand that they be shifted to the externally-linked benchmark along with the new borrowers.
Of course, it remains to be seen how banks actually react to such requests.
The RBI circular says, “All new floating rate personal or retail loans (housing, auto, etc.) and floating rate loans extended by banks to Micro and Small Enterprises (MSEs) from 1 October 2019 shall be benchmarked…”
RBI circular also says, “Existing loans and credit limits linked to the marginal cost of funds based lending rate (MCLR_/base rate/ benchmark prime lending rate (BPLR) shall continue till repayment or renewal, as the case may be. Provided that floating rate term loans sanctioned to borrowers who, in terms of extant guidelines, are eligible to prepay a floating rate loan without pre-payment charges, shall be eligible for switchover to the external benchmark without any charges/fees, except reasonable administrative/ legal costs. The final rate charged to this category of borrowers, post switchover to the external benchmark, shall be the same as the rate charged for a new loan of the same category, type, tenor and amount, at the time of origination of the loan.”
According to RBI, "In order to ensure transparency, standardisation, and ease of understanding of loan products by borrowers, a bank must adopt uniform external benchmarks within a loan category; in other words, the adoption of multiple benchmarks by the same bank is not allowed within a loan category.”
The RBI has been trying for many years to ensure that its interest rate cuts get transmitted to the borrowers. For this, it has experimented with the benchmark prime lending rate, the base rate and finally MCLR which was based on the cost structure of the bank which was not audited by RBI for compliance.
Each of these experiments failed because not only were these formulae flawed but RBI allowed banks to dictate terms to borrowers, no matter what its policy stated.
Because of this attitude of the banking regulator, Moneylife Foundation has been relentlessly campaigning against arbitrary and opaque bank policies with respect to floating rate loans. We have estimated that banks have gained tens of thousands of crores of rupees in higher interest by not reducing rates in sync with policy rates.
Borrowers, who have taken loans on a floating rate basis, suffer an immediate increase when interest rates are hiked by RBI but do not get much relief when rates go down. This makes a mockery of the very concept of ‘floating’ rates.
An RBI-owned internal study had highlighted how banks deviated in an ad hoc manner from the specified methodologies for calculating the base rate and the MCLR, to either inflate the base rate or prevent the base rate from falling in line with the cost of funds.
It says, “Banks have been quite slow in migrating their existing customers to the MCLR regime. Most of the base rate customers are retail or small and medium enterprise (SME) borrowers. Hence, the banking sector’s weak pass-through to the base rate is turning out to be deleterious to the retail and SME borrowers in an easy monetary cycle.”
Moneylife Foundation wrote to Dr Urjit Patel, the then governor of RBI, requesting him to direct banks to calculate the excess interest they have charged (through arbitrary and ad hoc calculations of base rate or MCLR) and refund the money to borrowers, especially retail borrowers and SMEs. (See Excess Interest Charged by Banks under Base Rate and MCLR Regime
) Since RBI refused to act on it, we then had to file a public interest litigation in the Supreme Court.
The Supreme Court, on 8 October 2018 directed RBI to respond within six weeks to representations made by Moneylife Foundation on the unfair practice of banks regarding floating loans.
RBI did not comply with this order but in December 2018, it suggested that banks should use an external benchmark such as 91-day treasury bill yield or 182-days treasury bill yield.
Dr Patel had said, "The spread over the benchmark rate—to be decided wholly at the banks’ discretion at the inception of the loan—should remain unchanged through the life of the loan, unless the borrower’s credit assessment undergoes a substantial change and as agreed upon in the loan contract.” This, in other words, means that, with the spread remaining fixed, banks will have to adjust interest rates as per the changes in external benchmark.
While the RBI policy was supposed to turn operational in April 2019, Dr Patel resigned and the new governor Shaktikanta Das decided to postpone it, as banks were opposed to it.
However, it seems that the political pressure to transmit lower rates was too much and RBI had to fall in line.
So, if you have a floating rate loan, ask your banker to move you from MCLR to the new system.