The current lending rate system
The lending by banks is currently based on an internal benchmark system of MCLR (Marginal cost of funds-based lending rate). MCLR is the minimum interest rate below which a bank cannot lend. Marginal cost of Funds refers to the additional or incremental cost for which banks to raise more funds for prospective borrowers. It is calculated on four major components i.e. marginal cost of funds, negative carry on CRR, operating Cost and Tenor Premium. Further the actual lending rates will be determined by adding the components of spread to the MCLR. Spread means that banks can charge higher interest rate depending upon the riskiness of the borrower. This system lacked the direct transmission effect of monetary policies as the internal benchmark system led to an opaque system of deciding lending rates.
The change from MCLR to Repo rate
According to a recent study by ISG (Internal Study Group) on MCLR (Marginal cost of funds-based lending rate) system, it was found that the effect transmission of monetary policy (such as cut in repo-rate) was lacking.
Thus RBI recently mandated linking retail loans, personal loans, MSME i.e. micro small and medium enterprise loan rates to an external benchmark system from October 1, 2019 to enhance the timely benefit of monetary policies to borrowers. The three external benchmarks specified by RBI are India policy Repo-rate, Govt. of India 3 month and 6 month Treasury Bill Yields and any other benchmark market interest rate published by FBIL (Financial Benchmarks India Private Ltd). Linking lending rates with an external benchmark will directly transfer the benefit of rate-cuts by RBI to the borrowers as now the process of deciding lending rates will become more transparent.
Faster transmission leading to reduction in interest rate for borrowers
The current economic slowdown has impacted the investment and consumption expenditure sentiment in the economy. To boost the economic activities and improve consumption activities the RBI has cut repo-rate (Rate at which RBI lends money to commercial banks) to a 5.4% by August 2019. Cutting repo-rate makes borrowing cheap, hence boosting consumer sentiment for expenditure and reviving the slowdown in the economic activities. Thus linking the lending rates to an external benchmark will have a faster impact and boost customer expenditure more quickly.
SBI leading the road
SBI became the first bank to adopt the mandate and the home loan rate has been cut to 8.05% from 8.4%, passing the 35 basis point cut that that RBI slashed in last MPC meeting. PNB, Bank of Baroda also joined the same. At present the repo rate is 5.4%.