What this benchmarking shift really means?
When banks lend to borrowers, there has to be a basis for pricing these loans. Of course, the best the RBI can do is to help banks set a benchmark. The actual lending rate will depend on the risk score of the client which determines the spread. But, the big question is how this benchmark gets set. For a long time, benchmarking was done based on cost of funds of the banks which included their cost of deposits and the cost of reserves. However, this tended to pass on the pricing inefficiency of banks to customers. This led to a shift to the MCLR method which was based on the marginal cost rather than the average cost.
However, the MCLR was based on cost of deposits. Since deposit rates were sticky, banks were not cutting lending rates in sync with rate cuts. That impelled the RBI to shift to external benchmarking. Fresh loans will now be linked to an external benchmark like the repo rate, T-bill yield, etc. so rate cuts are passed on seamlessly to customers.
What does the shift to external benchmark mean to you?
As banks shift to the new system, borrowers have a number of queries about the implications of this shift to external benchmarking.
Does this rate cut apply to all loans?
According to RBI regulations, this new system of external benchmarking will only apply to fresh loans sanctioned and disbursed after October 01, 2019 and not to existing loans. In case of existing floating rate loans, borrowers have a choice to shift their loans to external benchmarking. But, RBI has authorized banks to charge a transfer fee for the same. Hence, you will have to do a cost-benefit analysis. Secondly, this shifit only applies to floating rate loans like home loans and business loans and not to fixed loans like car loans and personal loans. If you are planning to buy a new car this Diwali; nothing much will change. Also, this will apply only to banks and not to NBFC loans. So your home loan from HDFC or Bajaj Finance will not be impacted.
Will there be a substantial reduction in the rates?
At the current juncturer, the benefit is estimated at 20-30 basis points, which will not make a material difference to your EMI. Of course, if repo rates are cut further by RBI then you will benefit. But, repo rates are already at a 15 year low, so it is hard see rates going much lower from these levels. Also this benefit will be limited as banks will compensate part of the cut through higher individual loan spreads. Net impact at this point will be quite limited. But one thing is certain that the reset to your EMI will be much faster; probably within a few days of each repo rate cut.
Will the deposit rates also move with the external benchmarks?
That is unfortunately true. If banks cut lending rates but don’t cut deposit rates then they would run into an asset liability mismatch. To avoid that situation, banks will have no choice but to cut deposit rates also in sync with the repo rates. A lot more of FDs will now move to mandatory rate resets and that could have an impact on retired people relying on regular FD income.
What happens if the rates rise from here?
Clearly, the borrowing rates on your loans will rise too. In fact, the hike in your EMI will now be much quicker than before. Alternatively, you may find that your tenure of home loan has been extended accordingly. In previous repo rate spikes in 2006 and 2010, the rise in lending rates was lower than the rise in repo rates. However, this time around, that is unlikely to happen with lending rates floating up in tandem with the repo rates.
These are early days and we need to see how this system evolves. However, external benchmarking at a time when rates are at a 15-year low may be genuinely risky.