Before we discuss the changes coming into effect from April 1st, 2019, let us understand some related concepts.
1. RBI Repo Rate
It is the interest rate at which RBI lends money to commercial banks based on a repurchase agreement of financial securities at a predefined date. So, Repo is a repurchase agreement and the Repo Rate is based on collateral. Repo agreements are used by commercial banks for short term fund requirements.
2. Bank Rate
Though similar to Repo Rate, Bank Rate does not involve any collateral or repurchase agreement and applicable to long term fund requirements. It is the rate at which RBI lends money to commercial banks without any collateral. Bank Rate is more influential to the lending rates and higher than the Repo Rate.
3. Base Rate
Base Rate is the minimum rate set by RBI below which banks are not allowed to lend. Before April 1st 2016 (from 2010) all loans were issued based on the Base Rates.
4. Marginal Cost Based Lending Rate (MCLR)
From April 1st 2016, floating rate loans were issued based on the MCLR of the banks. Banks need to borrow funds themselves to be able to extend loans. The funds raised by the banks can be in the form of deposits such as fixed deposits, current accounts, savings account etc. and borrowing such as short term and long term borrowings. The MCLR is based on marginal cost of funds which is based on the following formula
Marginal cost of funds = 92% x Marginal cost of borrowings + 8% x Return on networth
MCLR corresponds to the tenor of the funds raised.
Note that MCLR regime is NOT applicable to fixed-rate loans.
The Base Rate or MCLR component of the lending rate is the minimum lending rate based on RBI rules but the actual rate payable by the borrower is higher than that. Difference between the actual lending rate and the Base or MCLR rate is called the spread. Banks decide the spread for each borrower based on Bank's own policies.
The policies to affect spread are decided by banks based on business strategy (market competition or embedded options in the loans), Credit Risk premium charged by a bank and availability of collateral etc.
In a floating rate loan, the Base or MCLR rate changes with the market conditions but the Spread generally remains fixed for the life of the loan.
SO, WHAT IS CHANGING FROM APRIL 1st 2019
It is a common concern of the borrowers that banks are quick to increase their lending rates when the policy rates increase but slow to reflect any decrease in any policy rates. The implementation of MCLR was intended to solve this problem. Unfortunately, the experiment has failed and RBI is doing away with the MCLR regime.
From April 1st 2019, the lending rates are to be linked with external benchmarks. As per RBI Statement on Developmental and Regulatory Policies dated 5th December 2018, floating rate loans has to be linked with external benchmarks instead of current way of linking with internal benchmarks such as Prime Lending Rate (PLR), Benchmark Prime Lending Rate (BPLR), Base rate and Marginal Cost of Funds based Lending Rate (MCLR) etc.
The acceptable external benchmarks are
- Reserve Bank of India policy repo rate, or
- Government of India 91 days Treasury Bill yield produced by the Financial Benchmarks India Private Ltd (FBIL), or
- Government of India 182 days Treasury Bill yield produced by the FBIL, or
- Any other benchmark market interest rate produced by the FBIL.
Every bank has to choose only one external benchmark i.e. a single bank cannot use multiple benchmarks.
Banks are free to decide the Spread and the Spread will be unchanged for the whole life of the bank unless the borrower’s credit assessment goes through a substantial change.