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RBI declares ‘floating rate loans to Medium Enterprises’ to be linked to External Benchmark

After noting down the success of linkage of an external benchmark to new floating rate loans availed by retail, Micro and Small Enterprises (MSEs), the apex bank (RBI) has decided to extend its earlier direction. Now, to further enhance the monetary policy transmission, the floating rate loans given to Medium Enterprises shall also be linked to the external benchmark.

Effective from 1^st April 2020, the banks that lend floating rate loans to medium enterprises will have to link the interest rates on these loans to external benchmarks.

A floating rate loan is one where the interest rate is subject to variations over the duration of the loan instrument. Also, the term ‘external benchmark’ can be inferred to mean the benchmark of a financial factor, which acts as the standard reference rate to use as the basis for applying for adjustable-rate loans.

For MSEs, floating rate loans are already linked with external benchmarks

An earlier circular of the RBI ‘DBR.DIR.BC.No.14/13.03.00/2019-20’ dated September 04, 2019, was issued stating that all new floating rate personal or retail loans (such as housing, auto, etc.) and floating rate loans to Micro and Small Enterprises (MSEs) offered by banks with effect from October 01, 2019, were to be linked to external benchmarks. Pursuant to the introduction of the external benchmark system, the monetary policy transmission has noticed a significant improvement in respect of the sectors where new variable rate loans have been linked to the external benchmarks.

Floating rate loans to Medium Enterprises will be linked with external benchmarks

With a view to further strengthen the transmission of monetary policy, it has been now provided that floating rate loans to Medium Enterprises will also be linked to reference rates of external benchmarks, as indicated in the aforesaid circular. For this purpose, the RBI has issued a notification ‘RBI/2019-20/167-DOR.DIR.BC.No.39/13.03.00/2019-20’ on 26^th February 2020 for tweaking the existing lending norms. By virtue of invoking this notification, it has now been provided that all new floating rate loans to the Medium Enterprises offered by banks from April 01, 2020, shall also be linked to the external benchmarks. 

The circular is applicable to loans extended by all scheduled commercial banks (excluding RRBs), all small finance banks, and all local area banks.

What is External Benchmark?

Bank loans are commonly benchmarked to the marginal cost-based lending rate (MCLR), which is a function of the cost of funds (i.e., deposit rates) of a particular bank. The deposit cost is decided by that specific bank without any direct intervention of the RBI or any other agency; hence it is an internal benchmark. On the contrary, the external benchmark is one that is not influenced by the individual’s bank decisions. The most common external parameter is the repo rate, which is decided by the Monetary Policy Committee of the RBI. 

The external benchmark can be any one of the following:

• Reserve Bank of India policy repo rate (the rate at which RBI extends loans to commercial banks to meet the shortfall of funds)
• 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

RBI’s clarifications in this regard

The external benchmark linked loans may be offered by banks to other types of borrowers as well (i.e., other than MSEs and Medium Enterprises) who are not notified in the circular.

The RBI has also clarified that in order to ensure transparency and standardization of loan products offered by borrowers, the banks must adopt a uniform external benchmark within a particular loan category. In simple words, the adoption of multiple benchmarks by the same bank within a particular loan category is not acceptable.

Possible favourable effects of linking loans to External Benchmark

Akin to micro and small enterprises, the RBI’s move of linking floating rate loans to the external benchmark will be beneficial. This is so because the advantages of reduction in key lending rate or repo rate to borrowers would be passed on to medium enterprises as well. In spite of a bank’s margin, the mechanism of external benchmarking, such as repo rate for the purposes of lending would be favourable for a borrower because the rate resets will be fair. As a matter of fact, the central bank had reduced repo rate, also known as the short-term lending rate, by 135 basis points since February 2019.

The initiative of linking floating rate loans to external benchmark is expected to expand the outreach of the loan schemes considerably, which in turn shall help address the crucial requirement of access to finance of the Micro, Small & Medium Enterprises (MSME) sector.

However, the existing loans which are actually linked to the internal benchmarks like the Marginal Cost of Funds based Lending Rate (MCLR) or base rate or Benchmark Prime Lending Rate (BPLR) shall continue till maturity. 

Previously, banks have been using the internal benchmarks like the base rate or Marginal Cost of Funds based Lending Rate system for the pricing of loan products, which has been ineffective so far in better transmission of money. 

Indubitably, the usage of external benchmarking will improve monetary transmission, i.e., changes in the policy repo rate will be meaningfully reflected in the banks’ lending rate as well. Banks have also not been able to reduce the lending rates despite the fallen policy rates due to deterioration in the health of the banking sector. 

In addition, banks will now be exposed to huge interest rate risk, and consequently, the margin will become highly volatile if they continue to borrow fixed and lend using the variable rate linked to an external benchmark. 

Official Notification:

NOT167D1928275E5B34287AD44E1D5DFDB6561

Also read: Reserve Bank of India to Observe the Lending Rate Mechanism of NBFCs