Will the shift to external benchmarking benefit borrowers?
During the week, the RBI announced that all banks will shift to pricing their loans based on an external benchmark like the RBI repo rates or the RBI MSF rate so that any rate cuts can be seamlessly passed on. This shift will be effective from October 01st and will apply to all loans extended to retail customers as well as to small and medium enterprises (SMEs). Effectively, all home loans that are of a floating rate nature will now be linked to these external benchmarks and the rates will be adjusted accordingly. What does this mean and will it benefit the borrowers?
Average cost of funds formula
For a long time, the base PLR (BPLR) formula was used by the banks to price their loans. The BPLR considered the average cost of funds of the bank and hence the historical cost of funds of the bank also got factored into the cost of funds calculation. That would mean; even if the RBI cut rates but the average cost of funds did not fall, the impact on loan costs would be minimal. That explains why, despite the RBI cutting rates, the transmission of these rate cuts to the end borrower was not entirely seamless. Higher historical cost of funds stemmed from factors like higher interest cost on old borrowings, lower yields on SLR & zero yields on the CRR, unwieldy administrative structures etc. In the process, the end customer or borrower ended up paying a steep cost for such higher average cost of funds.
MCLR has not really worked
In the last few years, the banks had shifted to the MCLR based pricing. The difference in this method was that the marginal or incremental cost of funds was considered instead of the average cost of funds. The assumption was that this would automatically ensure the transmission of any rate cuts by the RBI to the final borrower. However, the MCLR is dependent too much on the cost of deposits, which is the largest component of MCLR. Unless the banks reduce their deposit rates, the MCLR would not come down and hence rate cuts would not be passed on. In a competitive market, most banks are wary of losing their CASA deposits and hence continued to hold deposit rates even when the repo rates are cut. This results in the MCLR becoming sticky and also being unable to pass on rate cuts seamlessly to the final borrowers.
It is in this light that the government has decided to shift to external benchmark based pricing for retail and SME loans. This will ring-fence the loan rates from either the average cost of funds or the incremental cost of funds. However, banks are skeptical whether such benchmarking would really work in practice because it would make rates and yields too volatile. Cost of deposits will still be the key issue and that could be the limitation of this approach!