A New Dawn

Now before we dissect this story, we need some context. Currently, you could walk into a bank and ask
for a home loan and banks will set you up with one, after asking if you’d prefer a fixed-rate interest or a
floating rate, more commonly referred to as the Marginal Cost of Funds based Lending Rate (MCLR)

Now the MCLR is a tricky little bugger. It’s like a bare minimum rate below which banks can’t lend. Now
obviously banks add a nice little top up on the MCLR to maintain their margins. But they do a review of
the MCLR every once in a while and change it if they think there is scope for change.

In the off chance that the MCLR is lowered, your home loan EMI immediately turns cheaper as well. And
so, unlike a fixed-rate loan, where the interest rate remains constant throughout the repayment
period. MCLR offers flexibility.

Unfortunately, the way banks calculate this funny little thing, most of the flexibility, accrues to the bank
and not to the end customer.

In fact, the reason why RBI mandated banks to use MCLR in the first place was because they had hoped
banks would be more flexible in cutting interest rates when RBI cuts its rates.

Because obviously, if banks can now borrow at cheaper rates from the RBI you’d expect to see some
of that benefits trickle down to the customers as well. Right?

However, that did not happen because banks calculate MCLR by considering their total cost of
borrowing, not just the cost of borrowing from the RBI i.e. the interest they’ll have to pay on the money
they borrow.

In fact, a significant part of the bank’s borrowings comes from you lot, when you tie up money in a fixed
deposit. And banks can always contest that reducing rates is simply not feasible because they’re
offering a pretty high return on all those FD’s. So your loan EMI continue to stay high despite repeated
rate cuts by the RBI.

The Fix

Now, this does not bode well for anybody, especially if you’re trying to stimulate the economy by
enticing people to borrow more. RBI needs to see more action when it cuts interest rates. And it doesn’t
want to wait for a year to see a tiny 0.05% cut on your home loan EMI when it has already cut rates by
about 0.5%.

So, it’s been thinking about fixing this.

And the best way to do it is to simply force banks to link all floating loans to an external benchmark, like
the RBI’s repo rate (the rate RBI charges banks when it lends to them for short durations)

Now there are some obvious upsides to the move. For one, banks will almost certainly have to cut rates
when the RBI does it. Banks can no longer be saying that they’ll be doing a 0.1% cut when the RBI does a
0.25% cut. Cut 0.25% now.
Second, the review period is now fixed. The banks will have to reset interest rates every 3 months. So if
at the end of that period they find out the RBI has done a 0.25% cut, they’ve got to go with that as well

Now, technically banks can link interest on these loans to a couple other things as well like certain
government bonds. But these bonds, more or less take their cue from the RBI repo rate as well. So yeah,
can't escape this.

And sure, this will almost certainly hurt banks a little. Especially considering all that lost flexibility and
the terrible shape that they are already in. But customers can rejoice I suppose?

Well, we don’t know. Hopefully, it all works out well in the end.