Banking Sector Reforms

Banks may set repo rate as benchmark for lending

Note4students

Mains Paper 3: Economy | Mobilization of resources

From the UPSC perspective, the following things are important:

Prelims level: MCLR, Repo Rate

Mains level: Role of RBI & various functions performed by it.


News

  • Most commercial banks in India are likely to select RBI’s repo rate as the external benchmark to decide their lending rates, from April 1.
  • The repo rate is the key policy rate of the Reserve Bank of India (RBI).

Deciding lending rates

  • Banks had four options from which to choose the external benchmark: the repo rate, the 91-day Treasury bill, the 182-day T-bill or any other benchmark interest rate produced by the Financial Benchmarks India Private Ltd (FBIL).
  • A few other banks confirmed that the repo rate is the ideal candidate for the external benchmark. At present, the repo rate is 6.25%.
  • The marginal cost of fund based lending rate (MCLR) is currently the benchmark for all loan rates.
  • Banks typically add a spread to the MCLR while pricing loans for homes and automobiles.

Why repo?

  • The RBI has mandated that the spread over the benchmark rate to be decided by banks at the inception of the loan should remain unchanged through the life of the loan.
  • It should remain unchanged unless the borrower’s credit assessment undergoes a substantial change and as agreed upon in the loan contract.
  • If the lending rates are linked to the repo rate, any change in the repo rate will immediately impact the home and auto loan rates, since RBI has mandated the spread to remain fixed over the life of the loan.

Benefits of Repo Rate

  • It will make the system more transparent since every borrower will know the fixed interest rate and the spread value decided by the bank.
  • It will help borrowers compare loans in a better way from different banks.
  • Under the new system, a bank is required to adopt a uniform external benchmark within a loan category so that there is transparency, standardisation and ease of understanding for the borrowers.
  • This would mean that same bank cannot adopt multiple benchmarks within a loan category.

Back2Basics

Repo Rate

  • Technically, Repo stands for ‘Repurchasing Option’.
  • It refers to the rate at which commercial banks borrow money from the RBI in case of shortage of funds. It is one of the main tools of RBI to keep inflation under control.
  • When we borrow money from the bank, they charge an interest on the principal. Basically, it is cost of credit.
  • Similarly, banks too can borrow money from RBI during cash crunch on which they must pay pay interest to the Central Bank. This interest rate is repo rate.

MCLR

  • Marginal Cost of Funds based Lending Rate (MCLR) is the minimum interest rate, below which a bank is not permitted to lend. RBI can give authorization for the same in exceptional cases.
  • MCLR replaced the earlier base rate system to determine the lending rates for commercial banks.
  • RBI implemented it on 1 April 2016 to determine rates of interests for loans.
  • It is an internal reference rate for banks to decide what interest they can levy on loans.
  • For this, they take into account the additional or incremental cost of arranging additional rupee for a prospective buyer.
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