In an attempt to improve the transmission of monetary policy, the Reserve Bank of India (RBI) has mandated banks to link all new floating rate loans extended to both retail consumers as well as micro and small enterprises to an external benchmark next month onwards. Banks have the option of choosing the external benchmark which could be either the repo rate or the yield on the three- or six-month treasury bill or any other benchmark interest rate published by the Financial Benchmarks India Private Limited (FBIL). This move comes after repeated attempts by the RBI, such as the shift to the marginal cost of funds based lending rate regime, have failed to improve the transmission of monetary policy in India. As was pointed out by the monetary policy committee in its last meeting, even as the policy rate was slashed by 75 basis points between February and June 2019, lending rates (weighted average) declined by only 29 basis points during the same period. While the shift to this new framework might lead to faster transmission, it poses significant challenges.
For banks, mandating external benchmarking of lending rates could lead to interest rate risks. As external benchmarking will sever the link between bank deposit and lending rates, banks interest margins will come under pressure in a scenario where interest rates are falling, as lending rates will fall faster than deposit rates. Banks may thus want to price in this risk by increasing the spread they have been allowed to charge over the benchmark rate. This may lower the expected benefit from shifting to external benchmarking. The new framework may also lead to banks wanting to link their deposit rates to an external benchmark. This will not please depositors as they may prefer the option of having fixed rates. There is also the issue of small savings instruments to contend with. As rates on these instruments tend to be more sticky in nature compared to bank deposit rates, banks will face greater competition when interest rates are on a downward trajectory, which could lead to a flight of deposits. Then there is also the issue of which benchmark to adopt. There may be a preference for the repo rate as yields on T-bills tend to be more volatile in nature. Sudden shocks to the system could push up short-term yields sharply, which will then have to be transmitted to borrowers.
Instead of mandating external benchmarking, a preferable option would have been to allow banks to gradually move towards this framework. The State Bank of India has already linked its savings deposit and short-term loans to the repo rate. Proposals for linking bulk deposits have also been mooted. Such voluntary moves could have, over time, forced others to follow suit.