A blog on financial markets and their regulation
Reserve Bank of India’s flip-flops on floating rate benchmarks
September 6, 2019Posted by on
Earlier this week, the Reserve Bank of India (RBI) issued a circular asking banks to shift from internal to external benchmarks for pricing their floating rate loans. This is the latest in a series of flip-flops by the regulator on this issue over the last two decades:
- External benchmarks (2001 to 2010): The RBI Working Group of 2009 on Benchmark Prime Lending Rate described this period as follows in Chapter 4 of its report:
In … 2000-01, banks were allowed to charge fixed/floating rate on their lending for credit limit of over Rs. 2 lakh. … banks should use only external or market-based rupee benchmark interest rates for pricing of their floating rate loan products, in order to ensure transparency. … Banks should not offer floating rate loans linked to their own internal benchmarks or any other derived rate based on the underlying.
- Internal benchmarks (2010-2019): Under the RBI Master Directions on Interest Rate on Advances floating rate rupee loans not linked to a market determined external benchmark used the following internal benchmarks:
- Between July 1, 2010 and March 31, 2016: the Base Rate.
Between April 1, 2016 and September 30, 2019 the Marginal Cost of Funds based Lending Rate (MCLR).
External benchmarks (2019 till next flip-flop?): This week’s circular states:
All new floating rate personal or retail loans (housing, auto, etc.) and floating rate loans to Micro and Small Enterprises extended by banks from October 01, 2019 shall be benchmarked to one of the following:
– Reserve Bank of India policy repo rate
– Government of India 3-Months Treasury Bill yield published by the Financial Benchmarks India Private Ltd (FBIL)
– Government of India 6-Months Treasury Bill yield published by the FBIL
– Any other benchmark market interest rate published by the FBIL.
These flip-flops reflect the failure of the central bank on two dimensions:
- The failure to create a vibrant term money market with liquid benchmark rates creates dissatisfaction with external benchmarks. In 2009, the RBI Working Group justified the shift to internal benchmarks as follows:
Banks are finding it difficult to use external benchmarks for pricing their loan products, as the available external market benchmarks (MIBOR, G-Sec) are mainly driven by liquidity conditions in the market, and do not reflect the cost of funds of the banks. … Besides, the yields on some of the instruments may not suggest any representative pricing yardsticks given that they have limited volumes compared to the overall size of the financial market.
- The failure to create a sufficiently competitive banking system means that internal benchmarks do not work well because in the absence of strong market discipline, banks do not use fair and transparent pricing of floating rate loans. The RBI Study Group that recommended the shift back to external benchmarks described the problem as follows:
First, the experiences with the PLR, the BPLR, the base rate and the MCLR systems suggest that interest rate setting based on an internal benchmark is not transparent as banks find ways to work around. Second, the interest rate setting based on an internal benchmark such as MCLR is not in sync with the practices followed in the modern banking system.
In the next few years, India needs to work on creating both a better banking system and better financial markets. One of the pre-requisites for this is that regulators should step back from excessive micro-management. For example, the RBI Master Directions require the interest rate under external benchmark to be reset at least once in three months while elementary finance theory tells us that if the floating rate benchmark is a 6-Months Treasury Bill yield, it should reset only once in six months. Either banks will refrain from using the six month benchmark (eroding liquidity in that benchmark) or they will end up with a highly exotic and hard to value floating rate loan resetting every three months to a six month rate. Neither is a good outcome.