Can a borrower’s EMI be reset following RBIs decision linking loans to external benchmarks?

If you are planning to take a personal, housing or vehicle loan, then you must keep in mind that any loan taken from October, 1, 2019, will be benchmarked to four external benchmarks as specified by the Reserve Bank of India (RBI). On September 4, 2019, the RBI issued a circular stating that banks, both private and public sector units, have to benchmark the interest charge on loans on the following:

• RBIs policy repo rate. Repo rate is the rate at which the central bank lends money to other banks.
• Government of India three-month Treasury Bill Yield published by the Financial Benchmarks India Private Ltd (FBIL).
• Government of India six-month Treasury Bill Yield published by the FBIL.
• Any other benchmark market interest rate published by the FBIL.

These loans include new floating rate personal or retail loans like housing, auto, etc. and floating rate loans to Micro and Small Enterprises (MSMEs) extended by banks. The RBI also made it clear that in order to ensure transparency, standardisation, and ease of understanding of loan products by borrowers, a bank must adopt a uniform external benchmark within a loan category. This simply means that the adoption of multiple benchmarks by the same bank is not allowed within a loan category.

Understanding the benchmarking process: When a bank lends money to a borrower under any loan category, it charges an interest rate on the basis of standards or methodologies prescribed by the RBI. Before this circular, banks used 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). All these methodologies were internal and not market-driven.

Why did the RBI shift to an external benchmark?

The apex bank had constituted an Internal Study Group (ISG) to examine various aspects of the existing Marginal Cost of funds-based Lending Rate (MCLR) system. The final report of the ISG was published in October 2017 for public feedback. The ISG observed that internal benchmarks such as the base rate/MCLR have not delivered effective transmission of monetary policy to end borrowers. The study group had, therefore, recommended a switchover to an external benchmark in a time-bound manner. You must understand that external benchmarks are market-driven, and translate into faster policy rate transmission to end borrowers.

How will the changes affect existing borrowers?

If you are existing borrower, then you have to approach the bank for switching the existing loan from MCLR to external benchmarks. As per the RBIs circular, in the case of loans which do not have a prepayment penalty, borrowers can switch to benchmark-based lending without any additional charges. But, a borrower has to pay for administrative and legal costs.

How will the changes affect borrowings?

Repo rate changes: In the last six months, the RBI had reduced its policy rate by 110 basis points (bps), including a reduction of 35 bps in August. But banks were reluctant to pass the benefits of the reduction in repo rates to borrowers. Till August 2019, a mere 29 bps in rate cuts was provided to borrowers. With the new benchmark process, a borrower can enjoy lower interest rate whenever there is a reduction in the policy rate by the RBI. Most PSU banks have already started providing personal, home loans and vehicle loans which are directly linked to RBI’s repo rate.

EMI to be reset after every three months: As per the RBIs circular, interest rate linked to an external benchmark has to be revised after every three months. The aim of this decision is to ensure that policy transmission occurs at a faster speed. As the banks have to compulsorily reset interest rates, once every three months, this will ensure faster policy transmission for majority of end borrowers.

• Operating costs: While the circular prohibits banks to lend at a rate below the external benchmark rate, it allows banks to charge a spread over the external benchmark. This means that changes in the operating cost of the bank would affect the spread charged on the loan. But, to prevent misuse of the clause, the apex bank has allowed the reset the spread charges, including operating costs, only once every three years.
• Credit risk: The circular has stated that the credit risk premium could change if the borrower’s credit assessment underwent a substantial change. This means that if your credit risk goes up for reasons like defaulting on payments, your cost of borrowing will also increase.

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