In a bid to increase participation in interest rate derivatives in the domestic market, a panel set up by the Reserve Bank of India has proposed a slew of measures, including asking banks to review the possibility of pricing small-ticket advances based on market-determined benchmarks. The panel has mooted transitioning to a new benchmark reflective of the current market dynamics.
Banks are increasingly linking their portfolio of personal, retail and MSME loans to the policy repo rate. However, cross-country evidence suggests that loans are typically priced based on interbank money market rates and not policy rates, which are not strictly external market-determined benchmarks. While this may not be of significance, if the interbank rates are closely aligned to the policy rate, there could be challenges if the two rates diverge leading to basis risk.
“The Committee noted that the pricing of loans based on policy rates may expose the borrowers as well as banks to interest rate risks especially when interbank rates diverge from the policy rate. Therefore, the Committee felt the need for popularising market-determined benchmarks for linking of loans, including small-ticket advances, to facilitate the hedging of the underlying interest rate risk,” the panel report said.
New benchmark
At present, Mumbai Interbank Outright Rate (MIBOR) based overnight indexed swap (OIS) contracts are the most widely used interest rate derivatives (IRDs) in the onshore market. But the participation in MIBOR OIS is concentrated amongst select foreign banks, private sector banks and PDs, while the interest from other banks and clients (corporates, mutual funds, NBFCs etc.) has remained limited. In January 2024, the top six participants accounted for close to half of the total outstanding MIBOR OIS contracts in the interbank segment. “The Committee felt that the current bouquet of IRDs transacted in Indian markets remains insufficient to meet the hedging requirements of financial and nonfinancial participants, should such need arise. Accordingly, there is a case for promoting the development of more hedging based on evolving market conditions,” the report stated.
The Committee noted that the MIBOR which is computed based on call money market transactions, is drawing on a progressively lower number and volume of transactions. The Committee felt that increasing the computation window of MIBOR rate from extant one hour to three hours will enhance the representativeness of the benchmark, as around 80 per cent of the deals in the call money market are transacted during this window.
Going forward, the Committee observed that there may be a need to review the existing benchmarks based on the overnight money market. “As benchmarks should be reflective of the current market dynamics, Financial Benchmarks India (FBIL) may develop a benchmark based on the secured money market (both basket repo and TREP), i.e., a Secured Overnight Rupee Rate (SORR),” the panel said.