External Benchmark System

External Benchmark System

This article deals with ‘External Benchmark System .’ This is part of our series on ‘Economics’ which is important pillar of GS-3 syllabus . For more articles , you can click here

Issue

When RBI decreases Repo Rate, Banks don’t decrease their interest rates proportionately.

Incomplete Transmission of Rate Cut by Banks

Why banks don’t transmit Repo Rate cuts to borrowers?

a. Banks don’t depend on RBI

  • In India(& all developing countries ) ,RBI is not the main source of money to banks . Common people are main supplier(mainly because people don’t have much option to invest money in alternate investment facilities eg mutual funds etc )

b. Small saving schemes  rate not reduced

  • Transmission is limited by high small savings rates. Banks worry that if they cut their deposit rates, customers will flee to small savings instruments. 

c. High Statutory Liquidity Ratio

  • Large money has to be kept idle as SLR which banks cant lend
  • This reduces their ability to pass the benefit to consumers .

d. Banks increasing their Spread

  • Due to losses incurred to banks as a result of high NPAs & lowering of Credit Demand , Banks are increasing their Spread  in order to maintain their profits in absolute term.
  • This has reduced the capacity of banks to decrease Lending Rates.

To deal with inadequate transfer of Repo Rate cuts by banks to borrowers , RBI Came up with MCLR and External Benchmark  Rate System 

How Banks decide their Interest Rate

Timeline

How Banks decide their Interest Rate
1969 Government began nationalization of private banks, and ‘administered interest rates’ on them.  
1991 M.Narsimhan suggested deregulation: Government should not dictate / administer individual banks’ interest rates & RBI should only give methodology to banks.  
2003 RBI introduced Benchmark Prime Lending Rate  (BPLR).  
2010 RBI introduced BASE Rate + Spread system; update frequency was on individual banks’ discretion.  
2016-17 RBI introduced Marginal Cost of Funds based Lending Rate  (MCLR) +Spread system.
2019RBI introduced External Benchmark Rate System.

Marginal Cost of Funds based Lending Rate  (MCLR)

  • Banks to calculate lending rate on monthly basis.
  • Lending Rate to be calculated using CRR Cost, Operating Cost, Marginal cost of funds (calculated using Repo Rate) (don’t need to go into detail. Just remember, MCLR has Repo Rate as component)

Lending Rate = MCLR + Spread (to be decided by banks)

Benefits?

  • Better transmission of Monetary Policy
  • Transparency & accountability to borrowers.

RBI’s Janak Raj internal study group(2017) showed MCLR did not yield all benefits . Banks keep on increasing ‘Spread’ based on their discretion .

So new method  was introduced

External Benchmark System

  • Applicable from April 2019 (on recommendations of Dr. Janak Raj Committee)
  • NEW loans to be linked with External Benchmark  system.

In this system

  • Bank will be asked to choose any benchmark like
    • Repo rate   or
    • 91-day T-bill yield  or
    • 182-day T-bill yield   or
    • any other benchmarks by Financial Benchmarks India Pvt. Ltd.
  • It has to be updated atleast every 3 months.
  • Lending Rate of Bank will be External Benchmark + Spread (eg if Bank choose Repo Rate as External Benchmark, then Interest Rate will be Repo Rate + Spread)

Benefits?

  • Better transmission of Monetary Policy
  • Better transparency and accountability

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