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Understanding the Concept of External Benchmark Based Lending Rates
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The Reserve Bank of India is the central authority that regulates the lending rates provided by the banks to their customers. For this, they use various tools like Repo Rate, Statutory Liquidity Ratio, and Cash Reserve Ratio. Among them, Repo Rate is the rate at which other banks borrow from RBI, so it standardises the interest rates. In April 2016, RBI incorporated a new scale called as Marginal Cost of Fund Based Lending Rate (MCLR) to make the interest rates more transparent. MCLR also gives the assurance of the well-organised transmission of cut in the interest rates on loans.
In reality, the framework of MCLR did not work satisfactorily, as home loan buyers did not receive the benefits of the rate change. In August 2019, RBI declared that despite them bringing down the repo rate, the MCLR of banks did not decrease proportionately. According to banks, the lending rates take a certain time to decrease because different banks have different borrowing patterns and total cost of funds for banks does not decrease proportionate to decrease in repo rate. Therefore, the home loan buyers did not get to enjoy the benefits of RBI cutting down the repo rate.
As a result, RBI introduced an external benchmark lending rate system and made it mandatory for all banks to link all new floating interest loans to it. According to this change, banks will get to select from one of the four benchmarks, namely,
Most banks have decided to choose the external benchmark of the Repo Rate to link the interest rates on loans. From 1st October 2019, all new floating rate loans like home loans or personal loans will be connected to the external benchmark. The goal of this change is to speed up the transmission of monetary policy rates. By introducing an external benchmark based lending rate, RBI is hoping that loan buyers will get the benefit of repo rate cut faster than MCLR and which will eventually be reflected positively on home loan interest rates.
The Effect of External Benchmark on the Interest Rates
The newly introduced policy will impact the floating interest rates, as they fluctuate with the market. The EMIs of the loans with floating interest rates will also be affected. On the other hand, the EMIs of the fixed interest rates loans remain same throughout the tenure. Therefore, they will not be impacted by external benchmark policies.
The individual who has taken loans linked to MCLR will have a choice to switch to an external benchmark linked lending rate.
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