Linking small loans to external benchmark after further talks

  1. The Reserve Bank has said that it will hold further discussions with banks on linking interest rates on personal,home,auto and MSME loans with the external benchmark rates.
  2. In December 2018,Reserve Bank of India (RBI) had proposed a major change in the way banks price their loans.It had said that banks will have to link the interest rates charged by them on different categories of loans to the external benchmark like Repo rate or Treasury Bill rate.
  3. At present,all loans are linked to the Marginal Cost of Fund based Lending Rate (MCLR).MCLR is an internal benchmark rate that depends on various factors such as fixed deposit rates,source of funds and savings rate.The price of loan comprises the MCLR and the spread or the bank’s profit margin.Spread refers to the difference in borrowing rates and lending rates of financial institutions.
  4. The biggest problem with the MCLR system was lack of required transmission of policy rates to the borrowers.The new system of linking interest rate to repo rate is expected to bring in more transparency in fixing rates and faster transmission of rates.
  5. However,Banks has opposed the move to link loan rate to an external benchmark on the grounds that lending rates are a function of cost of funds and change in an external benchmark like repo rate does not have much impact on their cost of funds.
  6. Cost of funds is a reference to the interest rate paid by financial institutions for the funds that they use in their business.The cost of funds is one of the most important input costs for a financial institution since a lower cost will end up generating better returns when the funds are used for short-term and long-term loans to borrowers.