Cheaper loans are coming in October

The government and RBI expect bank lending rates to come down, and more borrowing from retail segment/micro and small enterprises for the revival of economic growth. The existing bank borrowers are aggrieved since they feel that the benefit of fall in interest rates are not fully given to them and limited to fresh loans. Banks are blamed for the slow and incomplete transmission of policy rates. The RBI’s circular to benchmark lending rates to market-determined ‘external benchmarks’, instead of individual bank’s Marginal Cost of funds-based Lending Rates (MCLR), from October 1, 2019, partially addresses these issues.

There was a divergence in banks’ computation of MCLR and Spread and transmission of policy rates was higher to fresh loans than to existing loans. Presently, for floating rate outstanding loans, banks reset the interest rates on a yearly basis at the revised MCLR while keeping the Spread levied over the MCLR at the time of disbursement unchanged. For operational convenience, EMI is not modified by many banks, but the residual period changes. A mere 1% rate reduction (from 9.5% to 8.5%) for a loan with 25 years residual period will result in the closure of the loan within 19 years 8 months.

For prompt transmission of policy rates, the RBI Internal Study Group (2017) suggested benchmarking to external rates and resetting the rates for existing borrowers on a quarterly basis. In December 2018, RBI announced these modifications to be made operative from April 1, but deferred the implementation. Banks have now been directed to link all new floating rate personal or retail loans (housing, auto, etc.) and floating rate loans to micro and small enterprises with effect from October 1 to external benchmarks (RBI repo rate, 3 or 6-months treasury bill yield, or any other benchmark market interest rate published by the FBIL (Financial Benchmarks India Private Ltd). Offering such external benchmark-linked loans to other types of borrowers is at the option of banks.

The selection of external benchmarks, too, is at the option of banks (probably, banks may opt to benchmark against repo rates, as adopted by SBI). Further, banks are required to adopt a uniform external benchmark within a loan category. The freedom given to banks to decide the Spread is retained but rates have to be reset on a quarterly basis, not yearly. To retain profitability, banks may jack up the Spread from the current levels as there is a significant difference between the ‘external benchmarks’ and MCLR-based rates (Repo - 5.4%, 91-day T-bills - 5.37% & 182-day T-bills - 5.61% against MCLR (overnight) – 7.9-8.40%).

There is no foreclosure charges/prepayment penalties on floating rate term loans (home and other non-business loans) to individual borrowers. It is expected that linking lending rates to external benchmarks will reduce lending rates. To avail the benefit of rate reductions and quarterly resetting of rates, it is desirable for individual borrowers to shift to new rates linked to the external benchmarks.

Borrowers under floating rate loans eligible for prepayment (without pre-payment charges) can switch to external benchmark without any charges (except reasonable administrative/legal costs). The final rate charged will be the rate charged for a new loan of the same category, type, tenor and amount, at the time of origination of the loan.

Even if an individual has availed loans under fixed rates, he can switch to floating rates by payment charges as per the policy/rules of the bank where the loan is maintained if the bank is providing the same type of loan under floating rates also.

The RBI Bulletin of August indicates Rs 11.87 lakh crore in housing loans (where almost all banks provide fixed and floating rate options), Rs 2 lakh crore in vehicle loans and Rs 6.2 lakh crore in other personal loans (where only some banks provide both fixed and floating rate options).

The option is provided to other existing borrowers to switch to external benchmarks at mutually acceptable terms (that is, as per their bank’s policy) and the switch will not be treated as a foreclosure of the existing loan.

In case of fixed rate outstanding rupee loans, there cannot be a prompt transmission of interest rates as there is no compulsion on the banks to reset the interest rates. Around one-fifth of outstanding bank credits are at fixed rates. The banks’ freedom to offer all categories of advances on fixed or floating interest rates has not been withdrawn. Some banks, especially private sector banks, offer loans to individuals other than home loans (auto loans, personal loans, gold loans, etc) only under fixed rates (where prepayment or foreclosure is with applicable charges) and, therefore, these borrowers cannot fully avail the benefit of the present guidelines on benchmarking lending rates to external rates. To ensure prompt transmission of interest rates, RBI may consider directing all banks to offer loans to individuals or retail loans and to micro and small enterprises both under floating and fixed rates.

(The writer teaches banking at ICICI Manipal Academy, Bengaluru)