As a borrower, have you felt short-changed when banks drag their feet on reducing lending rates; despite the Reserve Bank of India reducing its policy rates? This may soon change with the new set of lending rate norms becoming effective from April this year. The new method to calculate a bank’s benchmark lending rate will force banks to cut rates more sharply in a downward rate cycle.
Issue of transmission
While there is usually a lot of fanfare and expectation when the RBI reviews its monetary policy, in reality, banks have been reluctant to pass on to borrowers the interest rate changes the central bank is signalling.
But hold on. There isn’t anything sinister about banks delaying the pass-through of rate cuts to borrowers. There are structural reasons to this.
At the broader level, there are two main reasons. One, though the repo rate — the rate at which banks borrow short term funds form the RBI — is the policy rate, banks actually source only a minuscule portion of their funds from the repo window. With banks relying significantly on longer-term deposits, changes to interest rates don’t immediately reduce their costs. Hence, with the bulk of their deposits untouched by the rate changes, banks are reluctant to re-price their loans.
Two, the liquidity situation also determines the pace of transmission. If banks are short of funds to lend, they will need to rely on more expensive market borrowings to fund their business. Thus they may choose not to respond to RBI’s signals.
To tackle some of these issues the RBI introduced a new tool for short-term borrowing by banks — the term repo — in 2013. Instead of providing funds at a fixed rate (repo), the RBI auctioned off the funds, with banks bidding for the rates at which they would borrow. By providing funds at market-determined rates, the RBI can control both the liquidity as well as the rate at which it provides such funds.
At the micro level, though, the RBI also felt it vital to streamline the computation of banks’ cost of funds to smoothen the transmission process. This is because banks decide their lending rates based on their base rates, which they are free to determine. Earlier, banks were free to set their base rates using either the average or marginal cost of funds method. With most banks following the former method, the bulk of their deposits are unaffected by rate changes. When the RBI cuts rates, banks trim rates on incremental term deposits; older depositors continue to earn higher rates. This limits the cut in lending rates by banks.
Dispensing with the erstwhile base rate, the RBI has now asked banks to fix lending rates benchmarked against the Marginal Cost of Funds-based Lending Rate (MCLR). The MCLR differs from the existing base rate primarily in two ways. One, of course, is the calculation of the cost of funds. Under the new method, the latest (at the time of review) rates offered on deposits or borrowings is taken into account.
But there’s more to the new norms than just this. The RBI has also recognised that the benchmark rate requires an associated tenor and, hence, allowed banks to have different MCLRs for different tenors. This allows banks to factor in the tenor premium, which arises from loan commitments with longer tenors.
Let us understand this with the help of an example. If a bank funds its one year-loans with a three-month deposit, then it will face a liquidity risk if it doesn’t get funding after three months. This is priced as tenor premium.
Hence, banks can have different MCLRs across various tenors — overnight, one-month, three-month, six-month and one-year. Loans can be benchmarked against a particular MCLR.
How do you gain?
So, as a borrower, how do you gain from the new norms? For one, since banks will have to calculate their cost of funds under the marginal cost of funds method, it will ensure that deposit rate hikes or decreases immediately reflect on the banks’ cost of funds and, hence, on lending rates.
The use of different MCLRs can also work to your favour. Since the MCLR is a tenor-based benchmark rather than a single rate, this will allow banks to price loans more competitively based on different MCLRs. If a bank is able to raise one-month deposits easily — at, say, 6.5 per cent — then it can lend at 8 per cent for one-to-three months. So, as a short-term borrower you can gain from banks offering you better rates. This was not possible under the base rate system.
While the new norms bring you, as borrowers, good tidings, banks have to now work harder to keep their margins intact and manage asset-liability mismatches. Why?
We already know that banks run into liquidity issues when their loans and deposits do not come up for payment at the same time. This is termed as an ‘asset liability mismatch’. Let’s say a bank funds a 10-year loan with a six-month deposit. After six months, the bank will have to again raise funds for the loan. This creates liquidity mismatches.
Many banks are unable to match their loans and deposits across time periods.
The new lending norms have only made it tougher for banks. Under the new method banks will also have to manage their asset-liability mismatches from an interest rate perspective to reduce volatility in earnings.
For instance, imagine that a bank’s 10-year loan is benchmarked against the three-month MCLR, but funded by six-month deposit. The loan will be re-priced if the MCLR changes, but not the six-month deposit. This means that in a downward rate cycle the bank will have to lower its rate on the loan faster than on the deposit — before it gains from lower cost of funds. This will impact the bank’s margins.
Hence, to manage margins, banks will have to ensure that deposits get re-priced faster than loans. But to manage liquidity mismatches, banks will have to match longer-term loans with longer duration deposits.
Thus banks will have to be nimble-footed in managing their asset-liability mismatches, if they want to stay in the game, offering competitive rates, while safeguarding margins.
As borrowers though, you can expect a lot of action on lending rates from here on. But remember, if a quicker pass-through works in your favour now, in this falling rate cycle, the odds will be stacked against you in a rising rate scenario!