Making bank loans cheaper

All the rupee loans sanctioned and credit limits renewed from April 1, 2016 will carry interest rates that will be decided based on Marginal Cost of Funds based Lending Rate (MCLR) which will be the internal benchmark for such purposes. The new system will quickly make loans cheaper when interest rates, as at present, are on a diminishing curve; but loans can become dearer when markets are on a rising interest rate curve

In a bid to address the issue of tardy transmission of monetary policy signals to markets, particularly in respect of passing on lower interest rates to borrowers, several steps have been taken. Every segment of borrower seeks loans at lower interest rate, but banks mired with asset quality issues are unable to reduce base rates. As a regulator, Reserve Bank of India (RBI) has been keen to ensure that banks follow uniform computation procedure in arriving at their base rates. In order to rationalize methodology and to improve the efficiency of monetary policy transmission, the RBI has recently issued final guidelines directing banks to move to ‘marginal-cost-of-funds-based determination of their base rate’. This will ensure that the major load of cost of funds in base rate is made more realistic.

RBI observes that though it front-loaded cut in repo rate to the extent of 125 basis points during 2015, banks have only partially passed on such rate cut. In computing base rate, banks contend that whenever deposit rates are reduced, the cost of deposits do not immediately come down. This is due to the fact that fixed deposits of banks carry past rates till their maturity whereas base rate reduction immediately brings down the pricing of loans and reduces interest inflows. As a result, cost of deposits does not come down but yield on advances comes down, hitting their net interest margin. This method becomes a limitation for banks in bringing down base rate.

New loan pricing norms

In order to overcome some of such constraints, all rupee loans sanctioned and credit limits renewed w.e.f. April 1, 2016 will be priced by banks with reference to the Marginal Cost of Funds based Lending Rate (MCLR) which will be the internal benchmark for such purposes. The MCLR will comprise of (a) Marginal cost of funds; (b) Negative carry on account of CRR (c) Operating costs (d) Tenor premium. Besides these costs, banks should have a board approved policy delineating the components of spread charged to a customer.

The policy shall include principles to (a) Determine the quantum of each component of spread (b) Determine the range of spread for a given category of borrower / type of loan. (c) Delegate powers in respect of loan pricing. This new loan pricing policy based on MCLR can improve transparency and disclosure standards.

Existing norms of base rate

At present, banks follow different methodologies for computing their base rate. While some use the average cost of funds method, some have adopted the marginal cost of funds while others use the blended cost of funds (liabilities) method. It was observed that base rates based on marginal cost of funds are more sensitive to changes in the policy rates. Method of base rate computation in banks was introduced on July 1, 2010 under which banks were required to arrive at their base rates by combining (a) Cost of deposits/funds, (b) Regulatory cost of maintaining mandatory liquidity ratios known as ‘Negative Carry’ on Cash Reserve Ratio (CRR) and statutory liquidity ratios (SLR) (c) Un-allocated Overhead Costs (d) Average Return on Net Worth. A sum total of these costs put together used to form the base rate of individual banks. Different banks arrive at different base rates depending on their cost of deposits. Again cost of deposits of banks depends on their business mix and tenor distribution of total liabilities.

The difference in computation methods

The new change brought in by the RBI mostly relates to the major portion of base rate comprising actual cost of deposits – it is now replaced by marginal cost of deposits. The underlying change enables banks to factor any reduction in deposit rates by computing cost of deposits on marginal cost rather than actual cost. The cost will be calculated at new cost and will take into consideration cost of deposits/borrowing cost at new rates. The disadvantage of baggage of higher interest rates on pre-existing fixed deposits at old interest (may be at higher interest rates) can be done away with. Many banks currently follow average cost of funds or 'blended cost of funds (liabilities) method' for calculating the base rate, while a few already take into account the proposed measure of 'marginal cost of funds'. This will be an improved method of computing costs.

How new norms impact

Banks will have to review and publish their MCLR of different maturities every month on a pre-announced date. This will need an appropriate strengthening of internal competencies in banks to gather management information system in respect of marginal cost of deposits at more frequent periodicity. Any changes in the composition or costs collate and compute new MCLR or review it at same rate. Banks may specify interest reset dates on their floating rate loans too. This will enable banks to offer loans with reset dates linked either to the date of sanction of the loan/credit limits or to the date of review of MCLR. The periodicity of reset shall be one year or lower. This will result in some of the existing loans continuing at old MCLR based base rate till the reset date.

In order to begin with the new method of computation, reset of MCLR base rate can be done on quarterly basis now but in future, banks have to build capability to do it on monthly basis. The new dispensation will quickly make loans cheaper when interest rates are on diminishing curve as of now but loans can become dearer when markets are on a rising interest rate curve at a different point of time. But the improved computation of base rate on marginal costing is definitely is a better model to price the base rates of banks. It is more pragmatic, realistic and can create a level playing field for both lenders and borrowers. But quality of business and operational efficiency will continue to be a major differentiating factor in offering competitive MCLR base rate. When the new system becomes operational, the pace of transmission of repo rate signals will improve to help spur the economy.

Dr K Srinivasa Rao (The author teaches at the National Institute of Bank Management (NIBM), Pune. The views are his own)