The Reserve Bank of India headquarters in Mumbai. Photo: AFP
The Reserve Bank of India headquarters in Mumbai. Photo: AFP

In order to boost consumer spending, the Indian central bank has directed banks, when making fresh loans to retail and small business borrowers, to link interest rates to an external benchmark.

Although Reserve Bank of India has cut the benchmark rate many times this year, most banks have been reluctant to pass the cuts on to customers due to various reasons, including high provision for bad debts and a squeeze on margins.

The new rule will come into effect from October 1 and will aid effective downward transmission of the central bank’s policy rate changes. For borrowers, it will mean faster transmission during either the rise or the fall of interest rates.

The facility will be available to new borrowers, while existing customers can switch to a repo-linked rate on “mutually accepted” terms with their bankers.

The central bank said in a statement on Wednesday that the transmission of policy rate changes to the lending rate of banks under the current marginal-cost-of funds-based lending rate (MCLR) framework has not been satisfactory. Since April 2016, banks have been pricing all new loans using that framework.

The banks have been under pressure to improve monetary policy transmission. Reserve Bank Governor Shaktikanta Das on August 19 pointed out that the transmission to borrowers of policy rates by just 29 basis points this year compared with a combined repo rate cut of 75bps (excluding the 35bps cut in August) did not meet RBI’s expectations.

He also called for formalizing an external benchmark for lending to ensure effective transmission of policy rates.

Under the new norm, banks have been allowed to choose among the repo rate, the government’s three-month and six-month treasury bill yield published by the Financial Benchmarks India Pvt. Ltd, or any other benchmark market interest rate published by FBIL.

Some state-run banks including State Bank of India and Punjab National Bank have already begun linking their lending rates to an external benchmark and customers can expect other banks to fall in line.

With the country’s gross domestic product growth touching a six-year low of 5% in the June quarter, the central bank is pushing for easy availability of credit at low rates to push growth in consumption. This year the central bank has so far cut repo rates by 110 basis points.

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