What could be implications of RBI’s mandate to link lending rates to an external benchmark?

The Reserve Bank of India, in a recent announcement, has mandated the banks to link their lending rates for loans to an external benchmark. This has made it mandatory for the banks to pass on the benefits of rate cuts on the loans to the banks immediately.

Significance of the RBI’s Announcement

• This is significant as the RBI has lowered the repo rate by over 110 basis points (bps) since January 2019.
• This is important as the profit margins of the banks are gonna suffer as they will now have to pass on the benefits of all rate cuts to the consumers of the financial products.
• This is even more significant as the small retail and business loan portfolio of private banks will be affected. The private banks had a competitive edge over the various public sector banks will be affected as the interest rates are falling fast.

Current Status

• Of all the private sector banks in India, only the Federal Bank and the IDBI Bank have linked their lending rates to the external benchmark.
• The RBI has mandated the banks to choose either of the repo rate, the government’s three-month and six-month treasury bill yield published by the Financial Benchmarks India Pvt. Ltd (FBIL), or any other benchmark market interest rate published by FBIL as an external benchmark.
• Analysts believe that the banks may choose the repo rate due to its lesser volatility and use it to benchmark deposit rates.

The RBI’s announcement will have a significant impact on all banks with a higher share of housing and small business loans while the impact will be dull for banks with less exposure to these loans.