Lending Rate

  • May 6, 2022
  • Posted by: OptimizeIAS Team
  • Category: DPN Topics
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Lending Rate

Subject: Economy

Section: Monetary Policy

Context:

Close on the heels of the Reserve Bank of India’s decision to hike the policy repo rate and cash reserve ratio, banks have started hiking lending rates with ICICI Bank and Bank of Baroda (BoB) kicking off the exercise.

Details:

  • Bank of Baroda has hiked repo-linked lending rate (RLLR) by 40 basis points to 6.9 per cent.
  • Bank of India and Central Bank of India also raised RLLR by 40 basis points to 7.25 per cent.
  • Several banks announced deposit rate hikes across multiple tenor baskets for retail customers.

Cause:

Hike in Repo Rate- As per an October 2019 circular from RBI, banks linked their retail loans to external benchmark lending rates (EBLR). As a result, most banks have adopted the repo rate as their benchmark. As banks borrow money from the RBI at the repo rate, any change in the repo rate affects the lending rate of banks.

Impact of Repo Rate hike:

  • Monthly installments (EMIs) on home, vehicle and other personal and corporate loans are likely to go up, due rise in lending rate.
  • Deposit rates, mainly fixed term rates, are also set to rise.
  • Reduce liquidity and inflation
  • Reduce growth and increase unemployment
Okun’s Law:

Okun’s law is an observed relationship between a country’s GDP (or GNP) and employment levels. It was coined by Arthur Okun, a Yale economist who served on President Kennedy’s council of economic advisors.

Okun’s law predicts that a 1% drop in employment tends to be accompanied by a drop in GDP of around 2%. Likewise, a 1% increase in employment is associated with a 2% GDP increase.

In the case of India– data on unemployment rate and real GDP growth from 1980-81 to 2019-20 suggest that a decline in GDP growth by one percentage point increases the unemployment rate by around 0.13 percentage points.

Repo rate linked Lending rate:

Banks offer loans at a certain rate of interest. If this interest rate is linked to the repo rate, it is called repo linked lending rate (RLLR).

From 1st October 2019 onwards, all the new floating retail loans interest rates like personal loans, education loans, car loans, home loans etc., sanctioned by the financial institutions got linked to the external benchmark wherein one of the benchmarks is the central bank’s repo rate. Each and every bank has its own RLLR, which keeps differing every time the RBI revises its repo rate.

RLLR = RBI’s repo rate + Margin/spread charged by the bank

Banks may address RLLR by other terms, such as EBLR (External Benchmark Linked Rate), RBLR (Revised Repo Rate Lending Rate) etc.

The margin or spread that the bank charges stays the same for all the loan applicants. However, based on the RBI circular, banks have the permission to charge their borrowers risk premium. The risk premium that the banks charge to the borrower is based on their risk analysis considering a particular applicant and differs from one applicant to another.

MCLR linked lending rate:

The marginal costs of the funds-based lending rate (MCLR) is an internal benchmark that determines the interest rate on loans based on the marginal cost of funds, loan tenure premium, operating costs, and the Cash Reserve Ratio (CRR).

MCLR = Rate of interest offered by the bank on one-year term deposit + tenure premium + CRR + operating costs. 

MCLR linked interest rates get affected whenever the repo rate is revised by the RBI. Banks can increase or decrease the MCLR depending upon the changes in the repo rate.

Before the introduction of MCLR in 2016, banks did not use to consider the repo rate for base calculations. They relied on CASA (Current accounts and Savings accounts) for calculating the lending rates. MCLR was the first attempt to link the repo rate to the loan interest rates closely.

However, it has been observed that borrowers are often late in receiving the benefits of repo rate cuts in the form of lower interest due to time lag in implementing these changes. As a result, the entire benefit of repo rate cuts might not pass on to a borrower in the MCLR linked interest rate format.

Why has RLLR replaced MCLR?

  • RLLR based loans were introduced by RBI to make sure that the loan applicants have accessibility to a completely transparent benchmark. 
  • Quicker rate cuts transmission plays a major role among many applicants to opt for the RLLR option instead of MCLR.
Repo rate linked lending rateMCLR linked lending rate
RLLR is an external benchmark, wherein the bank’s own funds cost does not have any impact directly when the repo rate rises or fallsMCLR is banks’ internal benchmark where their own funds’ cost decides their MCLR i.e.  g-sec rates, low-cost deposits, the liquidity in the banking system, etc., determines its MCLR.
RLLR linked loans, the reset period of rates is at least 3 months.MCLR’s reset period is usually 12 months, whereas few lenders reset it every 6 months. It gives time lag to the MCLR linked loans.
The spread is based on the risk group of the applicants and the loan amount opted for.Lenders are permitted to charge spread, margin or mark up. For instance, if the MCLR of a bank equals 7 %, then it might lend at 8 % after factoring in 100 basis points of mark upcharge.
Borrowers can track the benchmark rates themselves.Borrowers have to rely on their bank to inform them about rate changes.
Loan interest rates are volatile.Loan interest rates are relatively stable.
economy Lending Rate