Sunday, December 27, 2015

RBIs New Interest Rate Formula for Loans

Ever since Mr. Raghuram Rajan took over as the head of the Reserve Bank, economists and experts from world over expected him to help transform the Indian Banking Industry into a world class one. For almost 2 decades now, we have been considered an Emerging Market for all intents and purposes and unless we did radical improvements, we are going to stay that way for the foreseeable future. 

This all starts with changes to monetary policies that can help us move forward as a powerhouse. The purpose of this article is to review a recent ruling by our Central Bank that can help make lending rates more responsive to policy rate changes. 

So, What is Lending Rate and How is it Usually Determined? 

Lending Rate is nothing but the rate of interest charged by a Bank (or Financial Institution) for any loan that you might want to avail from them. It could be a Home Loan or a Car Loan or even a Personal Cash Loan. 

Banks currently set their lending rates based on the average cost of funds on deposits outstanding. i.e., Banks take the rate at which it is borrowing money (mainly from Deposits), add a "Spread" and then arrive at the loan interest rates. This Spread basically covers their operating costs, profit margins, risk coverage for loans that might not be repaid etc. However, there isnt much clarity on how the rates are arrived at and even if the central bank reduces the rates, the impact on end customers isnt much. 

Why RBI Has Passed this New Ruling?

The RBI governor Raghuram Rajan has repeatedly emphasized the need for banks to pass on the benefits of Central Bank interest rate cuts to the public however that isnt the case and customers have barely gotten 50% of the benefit this year. 

While RBI has cut its benchmark rate by 125 basis points in 2015, lending rates have come down only by 60 basis points, RBI said in its December monetary policy review. 100 Basis points translates to 1% in rate of interest. So, while the RBI Cut its rates by 1.25% the benefit passed on to the customers was only 0.6% 

The purpose of this new ruling is to make sure that the lending rates from banks are more responsive to policy changes. 

So, What is this New Ruling by RBI?

RBI has asked banks to do the following:

For all loans sanctioned from April 1st 2016, the interest rate will be set with reference to their Marginal Cost of Funds based Lending Rate or MCLR. This MCLR is something banks will calculate based on the banks deposit rates, their internal spread etc. 

Banks will publish an MCLR for overnight loans, one-month, three-months, six-months and one-year loans. This MCLR will act as the minimum or base lending rate for that tenor of loans irrespective of the borrower. The final lending rate will be MCLR plus the spread that banks will charge for individual categories of borrowers. 

Banks will also have an option to periodically reset their MCLR rate and for any loans that are offered, the MCLR Prevailing on the day the loan is sanctioned will be applicable until the next day the MCLR gets reset. 

The RBI has brought out the draft guidelines on banks adopting this Marginal Cost of Funds methodology for calculating base rates on the 1st of September 2015. 

I already have a Loan - How does this Impact me?

If you are on a Fixed Rate Loan, this ruling has no impact on you. This ruling is only for floating rate loans. In case of hybrid loans where the interest rates are partly fixed and partly floating, interest rate on the floating portion should adhere to the new MCLR guidelines.

Existing borrowers will have the option to move to this MCLR based loan at mutually acceptable terms. But, this is one area where I have my doubts because mutually acceptable basically means Banks have to accept and the current lending formula is in favor of Banks and they will lose a lot of money by allowing existing loan customers to move over to this new formula. 

What If My Bank isnt Helping Me to Move over to the MCLR Based Loan?

The new RBI Ruling applies to all new loans granted by banks. You may be an existing loan customer for X Bank but they wont be able to stop you from moving over to Y Bank if they offer you a better deal - right?

With the new MCLR Based pricing, the loan rates are expected to come down and bank would want to attract new customers to increase the sales volume to offset the reduction in rates. So, as a customer you are free to switch to a new bank and all X Bank can do is watch you move on. They might as well allow you to switch on to their MCLR based loan - right?

What are the Benefits of this New MCLR Based Lending?

This helps improve the transmission of policy rates (set by the RBI) into the lending rates of banks. It improves transparency and RBI would have better control over the rates at which borrowers get money. With the inclusion of even short term MCLR Rates, banks can even compete with the Commercial Paper market. 

This will be beneficial to banks too because banks can now price their loans based on the rates offered on deposits of corresponding tenor. Usually only short-term deposits of 3-6 months are used for computing base rates for loans. This new rule will greatly reduce the cost of borrowing funds for not just individuals but also companies. 

Lets see how things go...

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