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External benchmark rates

Topics Covered:

Indian Economy and issues relating to planning, mobilization of resources, growth, development and employment.

External benchmark rates

 

What to study?

For Prelims: What are EBR?

For Mains: Significance and the rationale behind RBI’s move.

 

Context: The RBI has made it compulsory for banks to link their new floating rate home, auto and MSME loans to an external benchmark from October 1 so that the borrowers can enjoy lower rate of interest.

Banks can choose from one of the four external benchmarks — repo rate, three-month treasury bill yield, six-month treasury bill yield or any other benchmark interest rate published by Financial Benchmarks India Private Ltd.

 

Current scenario:

At present, interest rates on loans are linked to a bank’s marginal cost of fund-based interest rate, known as the Marginal Cost of Lending Rate (MCLR).

Existing loans and credit limits linked to the MCLR, base rate or Benchmark Prime Lending Rate, would continue till repayment or renewal.

 

What is external benchmarking of loans?
When you borrow money from a bank, be it for purchasing a house, car or for business purposes, interest is levied based on certain methodologies approved by the Reserve Bank of India (RBI). At present, banks use Marginal Cost-based Lending Rate (MCLR) to arrive at their lending rate. Prior to this, it was the Base Rate method and the Benchmark Prime Lending Rate (BPLR). These were all internal benchmarks. Banks have been allowed to use RBI’s policy rate among other market-driven options to calculate lending rates.

 

Why the need for a new method?
For faster transmission. Since February, RBI cut its policy rate by 110 basis points (100 bps=1 percentage point), including the higher-than-expected reduction of 35 bps in its August policy review. However, banks have not been so generous. Until August, they had only passed on 29 bps in rate cuts to borrowers, which the RBI thought was unfair. Hence, the regulator has now made it compulsory for banks to link their new floating rate home, auto and MSME loans to an external benchmark from October 1 so that the borrowers can enjoy a lower interest rate.

 

Sources: the Hindu.