HYDERABAD: Banking customers will soon witness first-hand what they have known all along. That pain and gain goes hand-in-hand.Next month, home, auto and personal floating loan rates will be further decreased, but the downside is, even rates on bank deposits will likely start their descent.
Last week, RBI mandated banks to link all new floating rate retail (home and auto) and SME loans to any of the three designated external benchmarks like repo rate, Treasury Bills or any other benchmark published by Financial Benchmarks India from October 1.
Interestingly, existing borrowers too can switch without any prepayment charges. Home and auto loans will see faster transmission of rates, though experts believe that the transmission may not be as fast as one would expect.“It’s likely that the initial rates under external benchmark will be closer to what is being offered under MCLR to tide over any near-term impact,” said Nilanjan Karfa, Equity Analyst, Jefferies India. He added that going further, RBI may mandate external benchmark for all other products and that banks will have to offer floating rate savings accounts to avoid volatility in Net Interest Margins. “Educating customers will be the key,” he explained.
In the long term, if the external benchmark achieves its desired objective, it could be extended to all other categories. But given that deposit rates are yet to be moved towards external benchmarks and that interest rate swap market is quite shallow, one may have to watch if the actual product has higher through-the-cycle interest rates than before, as discussions on interest rate pass-through tend to gather steam during an economic slowdown.
“Transmission is likely to be even slower as it is applicable prospectively. MCLR, where the transmission was probably the fastest, took two years to fully reflect to its maximum potential in the books of banks,” said M B Mahesh of Kotak Institutional Equities Research.
How banks set rates
Interest rates until recently were set internally based on MCLR (marginal cost of funds based lending rate). For instance, for a Rs 30 lakh home loan, SBI charges an effective interest rate of 8.60 per cent. This included one-year MCLR of 8.25 per cent, plus an additional spread of 35 bps. MCLR itself is derived based on RBI’s repo rate (6.5 per cent then), plus banks’ cost of funds.In July, however, SBI voluntarily linked floating home loan rates to a repo rate (as external benchmark) and now offers a repo rate linked rate (RRLR) of 7.65 per cent. It includes repo rate (currently 5.4 per cent) and a spread of 225 bps. It also charges a spread of 40-50 bps based on borrower’s credit score and loan size.
Customer is king, but not yet
The upshot is that interest rates will henceforth become transparent. Importantly, in a rate easing cycle, EMIs will swiftly reduce, unlike in the MCLR regime, where transmission is lagged and opaque with banks offsetting repo rate reductions by increasing the spread. As a result, borrowers see only a marginal reduction in overall EMIs.While in a falling interest rate regime, any reduction in repo rate will be directly and instantly passed on to borrowers. Likewise, in an interest tightening cycle, rates will automatically go up.Typically, auto loans bear fixed interest, but probably to boost consumption, banks are even linking auto loans to an external benchmark.
For borrowers, the benchmark has to be uniform for all loans under a particular loan product offered by the bank. Interest rate will be reset at least once in three months. Banks can decide the spread over the benchmark and it can only be changed when borrower’s credit assessment changes substantially, and as agreed upon in the loan contract. Other components of the spread like operating cost can be altered once in three years. There shall be no lending below the benchmark rate for a particular maturity for all loans linked to that benchmark.
Existing floating rate loans linked to internal benchmarks including MCLR, base rate or BPLR (benchmark prime lending rate) shall continue till repayment or renewal although existing borrowers can switch to an external benchmark, provided that they are eligible to prepay, without any prepayment charges, except for reasonable administrative and legal costs. The final rate charged to this category of borrowers, post switchover, shall be same as the rate charged for a new loan of the same category, type, tenor and amount and time of origination of the loan. Other existing borrowers can also switch to external benchmarks on mutually acceptable terms.
WHAT’S A SPREAD?
It is the additional cost that banks include while determining interest rates on various loans. The spread varies from bank to bank and product to product. There’s no regulation on how much banks can charge as spread, which is arrived at considering the cost of bank deposits and other operational and loan servicing costs.
