ICYMI: How Shaktikanta Das is fixing the problem of wayward bank interest rates

Latest RBI data showed 58% of all floating rate loans were pegged to such external benchmark rates by the end of FY24, aiding transmission for millions of retail and small business borrowers. This is an increase from 50% at the end of FY23.

In September 2019, the regulator had directed banks to link interest rates on retail loans and loans to some small businesses to the repo rate and the treasury bill yields. This means that whenever these external benchmarks rose or fell, banks would be compelled to make a corresponding change in their loan rates, quickly passing on changes in the central bank’s repo rate to borrowers.

The RBI action came after years of nudging banks which were reluctant to pass on rate cuts to borrowers but were quicker to pass on rate hikes. 

In the new External Benchmark based Lending Rate (EBLR) regime, banks are free to choose from the RBI policy repo rate, the three-month treasury bill yield, six-month treasury bill yield or any other benchmark market interest rate produced by the Financial Benchmarks India Pvt. Ltd. Most banks have taken to the repo rate as their external benchmark, though.

Also read: RBI Monetary Policy: Governor Shaktikanta Das says repo rate unchanged at 6.5%, stance at ‘withdrawal of accommodation’

Among lenders, foreign and private banks lead the pack with over 80% of floating rate loans on external benchmarks, while state-run banks are lower than the system average at 39%. In fact, foreign banks had 91% of their floating rate loans pegged to external benchmarks, while private banks were at 83%, showed data from RBI.

Lag in transmission 

Quicker transmission, while beneficial to borrowers in a falling interest rate scenario, hurts when the cycle reverses. But even as a majority of floating loans are under external benchmarks, transmission still lags changes in the repo. As against the 250 basis point (bps) hike in repo rate by RBI between May 2022 and February 2023, the weighted average lending rate on new loans rose 204 bps between May 2022 and April 2024.

The chief financial officer of a bank said that the lender had not passed on the entire 250 bps hike to its borrowers, fearing higher default rates. According to him, the bank passed on about 180 bps and absorbed the rest.

“This was done by adjusting the spread on the loan. We were concerned that if the entire rate hike was passed on immediately, then some weaker borrowers might not have the wherewithal to deal with higher EMIs (equated monthly instalments)," the CFO said on the condition of anonymity.

The bank, he said, tried to extend the repayment period by keeping the EMI the same or giving them a mix of longer tenure and higher EMI. For some borrowers, the longer tenure became tricky too. Mint reported in March 2023 how home loan tenures got significantly longer owing to the rate hikes.

“The reason why PSU banks have lower EBLR loans than the rest is because they have more agriculture loans than others, and such loans are still on the MCLR or marginal cost of funds-based lending rate," the banker said, adding that while a majority of corporate loans are on MCLR—an internal benchmark where transmission is slower—many have urged banks to switch to external benchmarks. “We provide repo linked short-term loans at rates starting 7.15% to corporates too, but only to top-rated public sector undertakings (PSUs)."

Also read: RBI dividend boost to help in improving budget math

Luring depositors

Quicker transmission is not limited to lending rates, though. Banks have raised fresh deposit rates by 245 basis points between May 2022 and April 2024, showed data from RBI. That said, banks were also forced to raise rates to lure depositors who were increasingly finding other investment avenues more attractive. Despite raising rates, deposit growth continues to lag growth in credit.

Experts said that while the usage of external benchmarks improves monetary transmission, it also results in greater variability on net interest margins (NIMs) for banks.

“For banks, this is because of the way the assets side and liabilities side are structured," said Subha Sri Narayanan, director, Crisil Ratings Ltd.

Narayanan explained that with a rising share of EBLR loans (as a percentage of floating rate loans), the assets side of banks re-prices rapidly as rates change. On the other hand, the liabilities side—comprising primarily deposits—is slower to re-price as any revised rates are only for fresh deposits and existing deposits get re-priced only when they come up for renewal.

“This results in higher benefit to bank NIMs in a rising interest rate cycle, but also results in faster compression in NIMs in a falling rate cycle," said Narayanan.

Also read: RBI projects further moderation in bank NPA to 2.5%

Crisil Ratings expects banking sector NIMs to compress 10-20 bps this fiscal to 3-3.1%, primarily on account of higher cost of deposits driven by continued re-pricing at higher rates. Deposit costs, as per Crisil, are expected to increase 25-30 bps this fiscal after having risen 140 bps since the start of the rate tightening cycle.

Others said that even as EBLR connects the cost of the loan directly to the market, for some borrowers, volatility may be a challenging factor. “Frequent changes in loan rates could make budgeting challenging," said Pankaj Bansal, chief business officer of financial services marketplace BankBazaar.com. “Also, during a tightening monetary cycle, the direct linkage to the repo rate could lead to significant increases in EMIs and, consequently, and unexpected increase in the debt burden."