Banks may set repo rate as benchmark for lending

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Context: 

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).

Current scenario:

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 setting Repo Rate as benchmark
for lending:

  • 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.
  • There shall be standardisation and
    ease of understanding for the borrowers. This would mean that same bank
    cannot adopt multiple benchmarks within a loan category.

What is Repo Rate?

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.

 What is MCLR?

  • The Marginal Cost of Funds based
    Lending Rate (MCLR) system was introduced by the Reserve Bank to provide loans
    on minimal rates as well as market rate fluctuation benefit to customers.
  • This system has modified the existing
    base rate system of providing home loans. In this system, banks have to set
    various benchmark rates for specific time periods starting from an overnight to
    one month, quarterly, semi-annually and annually.
  • 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.

MCLR aims:

  • To improve the transmission of
    policy rates into the lending rates of banks.
  • To bring transparency in the methodology
    followed by banks for determining interest rates on advances.
  • To ensure availability of bank
    credit at interest rates which are fair to borrowers as well as banks
  • To enable banks to become more
    competitive and enhance their long run value and contribution to economic
    growth.

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