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Interesting, but risky: On RBI’s floating rate loans diktat

RBI’s diktat (an order imposed by someone in power without popular consent) to banks could spur (encourage) borrowing but may pressure lenders’ margins

The Reserve Bank of India (RBI) has finally decided that it needs to address the problem of inadequate (too small in amount) interest rate transmission head on (with direct confrontation). In a circular to banks on Wednesday, it directed lenders to link all new floating rate (an interest rate that moves up and down with the rest of the market or along with an index) loans given to borrowers in the personal, retail and micro, small and medium enterprise (MSME) categories to external benchmarks (level of quality that can be used as a standard when comparing other things), including the repo rate, with effect from October 1. While giving banks the relative freedom to choose the specific external benchmark, including yields on the 3-month and 6-month Treasury Bills published by the Financial Benchmarks India Pvt. Ltd., the central bank made it clear that lenders would need to adopt a uniform benchmark within a loan category. Banks have also, crucially (extremely important), been given the leeway (freedom to act within particular limits) to determine their spread over the benchmark rate with a caveat (warning) that changes to the credit risk premium can only be made when the borrower’s credit assessment undergoes a substantial (large in value or importance) change. That the inadequate transmission of policy rate moves has been an abiding (permanent) conundrum (a problem that is difficult to deal with) for the RBI is well known. In 2015, then Governor Raghuram Rajan decided that the system used by banks to price their loans needed to be changed and so introduced the Marginal Cost of Funds based Lending Rate (MCLR) (the minimum interest rate of a bank below which it cannot lend, except in some cases allowed by the RBI) regime. In October 2017, an internal study group of the RBI recommended the adoption of external benchmarks to ensure effective policy transmission, after observing that the MCLR too had failed to deliver.

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Policymakers, in fact, have been so vexed (difficult to deal and causing a lot of disagreement) with poor transmission — against a total of 75 basis points (bps) reduction in the RBI’s repo rate between February and June, the weighted average lending rate on fresh rupee loans at banks eased only by 29 bps — that Monetary Policy Committee member Chetan Ghate in August cited the issue as reason to oppose the proposed 35-bps cut and instead voted for a 25-bps reduction. “By a large cut (35 bps) I feel we will be burning through monetary policy space without much to show for it. While the real economy needs some support, we should wait for more transmission to happen,” he said at the MPC’s rate setting meeting, the minutes show. Though the latest move will surely lower the interest cost on new floating rate loans availed by borrowers to buy cars or homes, it may force banks to start cutting the interest rate they pay deposit holders or risk seeing their margins shrink. And while the RBI wants to try and nudge (to push someone or something gently) an uptick (an increase in something) in credit for becalmed (not progressing though it should be) personal consumption and borrowing by beleaguered (experiencing difficulties) MSMEs, the success of the measure will ultimately be determined by a regaining of confidence by consumers to spend and a conviction by industry to invest.

We hope that such editorials will be helpful to you while you are preparing for the major government, banking and insurance exams.

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