New base rate system will help banks’ margins: Moody’s

The Reserve Bank of India’s new guidelines for banks to calculate their lending rates will reduce pressure on their net interest margins (NIMs), which is credit-positive, according to global credit rating agency Moody’s Investors Service.

Under the finalised guidelines, banks will gradually adopt the marginal cost of funds lending rate (MCLR) to price their loans. The components of MCLR are the marginal cost of funds, negative carry on the cash reserve ratio, operating costs and tenor premium.

Moody’s said the new calculation methodology will apply only to new loans after April 1, 2016 instead of all existing loans, and banks will have a tenor-based benchmark instead of a single base rate.

“Indian banks currently set their base rates on either their average cost of funds, or marginal cost of funds. However, because the marginal cost of funds would result in lower cost of funds amid declining policy rates, banks have not used it,” it said.

Lower rates? The RBI lowered policy rates by 125 basis points year-to-date, while banks have reduced their base rates by 60 bps. The RBI expects the shift towards the MCLR calculation to result in lower lending rates for borrowers.

“MCLR will be a tenor-based benchmark instead of a single rate. This allows banks to more efficiently price loans at different tenors based on different MCLRs, according to their funding composition and strategies.

“To illustrate, if a bank intends to fund a five-year loan based on its one-year deposits base by pricing it off the one-year MCLR, there will be lower mismatch between yields and the cost of the bank’s intended funding base if policy rates were to change,” Moody’s explained.

For new loans approved from April 1, banks will be allowed to specify interest reset dates, which are linked either to the date the loan was approved or the date of MCLR review.

In its report, Moody’s noted that, “The interval between rate resets can be up to one year. This provides an additional layer of flexibility for banks to align their overall portfolio lending rates to their overall portfolio deposit costs.”

Existing loans Existing loans will continue to be priced off a base rate until they are repaid or renewed, giving banks ample time to transition to the new methodology without affecting their NIMs.

Under the existing base-rate framework, banks can use any appropriate benchmark to determine their cost of funds, including the average cost of funds method.

Credit rating agency ICRA, in a note, said it expects banks’ short-tenure median MCLR to be lower than their current base rates by 80-90 basis points.

This, in turn, would allow banks to offer short-tenure loans at competitive rates vis-à-vis the discount rates (interest rates) prevailing in the commercial paper market.

As on September 30, 2015, banks’ credit portfolios grew by a mere 8.8 per cent (year-on-year) while credit through bonds and commercial papers reported growth rates of 19 per cent and 46 per cent, respectively.

ICRA said that since the interest rate reset would be applicable only to new borrowings with immediate effect, with (reset for) working capital borrowers with a lag, there may not be a significant negative impact on NIMs of banks.

The new norms, according to the agency, hold the potential of improving the efficiency of monetary policy transmission for new borrowings, and will impact new borrowers immediately — they will benefit in a declining interest rate scenario and take a dent when interest rates rise. ICRA assessed that existing borrowers with floating rate liabilities would bear the impact with a lag of up to one year.

Switching to MCLR During the transition, it is likely that some customers with relatively better credit profiles would want to switch from the base rate to MCLR, which in turn could improve policy transmission,

Complete transmission would be linked to the extent of reduction in term deposit rates as well as the proportion of term deposits in the overall funding profile of banks.

For instance, if a reduction in banks’ deposit rates matches the repo rate reduction and term deposits constitute 60 per cent of the funding, reduction in MCLR would be limited to 60 per cent of the repo rate cut, the agency added.