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Event update: Financials; External benchmarking – Negative specially for private banks and HFCs

Following the FinMin’s advice to state banks to link lending rates to external benchmarks and RBI’s own view that the transmission of policy rate cuts by banks is weak, the RBI has now made it mandatory for banks to link all new floating rate retail and MSME loans to an external benchmark.

1. Banks could link lending rates on these categories to one of the following benchmarks:
2. Reserve Bank of India policy Repo Rate
3. Government of India 3-Months and 6-Months Treasury Bill yields published by Financial Benchmarks India Private Ltd (FBIL)
4. Any other benchmark market interest rate published by FBIL
5. The interest rate under external benchmark shall be reset at least once in three months. Interest rates on fixed rate loans of tenor below 3 years shall not be less than the benchmark rate for similar tenor
6. Banks are free to decide the spread over the external benchmark. However, the spread can change only when borrower’s credit assessment undergoes a substantial change, as agreed upon in the loan contract. Further, other components of spread including operating cost could be altered once in three years.
7. The adoption of multiple benchmarks by the same bank is not allowed within a loan category
8. Existing loans and credit limits linked to the MCLR/Base Rate/BPLR will continue till repayment or renewal.

Impact: Negative on margins and earnings especially for private banks. Pre-tax earnings will fall by 2-3% in year one and 4-5% in subsequent years

We had highlighted in our note dated Aug 23, 2019 titled “Macro Sops – Positive for growth, negative for margins” that if external benchmarking is enforced it will be negative for margins of banks specially private banks.

• The repricing in repo-linked rates or rates linked to external benchmarks is much faster than other MCLR based loans because repo-linked rate changes are applicable from the beginning of the month following the repo rate cut.
• Given the quick repricing of repo based loans, these loans will be negative for banks in a falling rate environment. In a rising rate environment, while theoretically banks can enjoy higher rates, practically as we saw in the last cycle, retail NPLs could rise or some home loans could become perpetual loans as borrowers have the choice of keeping EMIs the same and extending the tenor of loans.
• Banks can offset the negative impact partly by cutting deposit rates or linking savings / term deposits to the same benchmark. However given pressure on deposit growth for the system, deposit rate cuts will likely be limited.
• Bank earnings in year one (FY20) would not be impacted much as only the new retail and MSME loans will come under the scheme. As earlier MCLR loans mature and get converted to repo-linked loans in subsequent years, the earnings impact would be higher. The pre-tax earnings impact in year one would be low at 2-3%. In subsequent years it would be higher at 4-5%.
• This would be the earnings impact only for retail and MSME loans, if external benchmarking is enforced for all loans (which is not the case right now) the earnings impact would be thrice as much
• The impact will be less pronounced / smoother for banks that have a higher proportion of fixed loans (HDFC Bank and IIB).
• Deposit growth is a challenge for the entire sector especially the private banks. The spread between repo and savings is lower for private banks specially the new private banks that are offering higher rates on their savings.
• On the other hand, state banks while losing loan market share continue to enjoy passive deposit market share.
• Due to deposit constraints, the negative impact of shifting to repo-linked rates will be higher for private banks compared to state banks.
• SBI has taken the lead in offering repo-linked loans. However as of now there is a catch in the repo-rate linked mortgage product of SBI which is that the EMI for the repo linked product is higher than that of the MCLR based product (because of shorter tenor)  making the repo rate product less attractive. Therefore the off take of repo linked mortgages has been low. Only Rs2bn of mortgages have been disbursed under this scheme that started from July 1. SBI’s current MCLR is 8.25% (last cut in August) while its repo linked lending rate is 225 bps above the repo rate. Given that the RBI and the government have taken a firm stance on transmission of policy rates, we believe SBI will have to alter the product. Union and BoB that launched these products after SBI have made sure that the EMIs are lower.

The negative impact of external benchmarking can be seen from the difference between SBI’s repo lending rate and MCLR:

• was 8.00% as on 1 July 2019. From September 1, after the RBI's 35 bps cut on 6th August, SBI's RLLR has fallen to 7.65%. SBI then charges a spread, depending on the borrower's credit score (RLLR+40 bps or RLLR +55 bps) for home loans up to INR7.5M. So, from September 1, for borrowers with good credit score, SBI charges 8.05% (RLLR of 7.65% + 40 basis points) on repo based home loans (8.4% before September 1)
• Against this repo based home loan rate of 8.05% effective September 1, SBI’s MCLR based rate on home loans upto Rs7.5M is 8.6% (highest rated woman borrower)
• So there is a big difference in the repo based rate and MCLR.

HFCs will also be impacted: While this circular is only for banks, lower mortgage rates by banks will force HFCs to lower their lending rates especially in an environment where demand for new home loans is slowing down. This would lead to pressure on HFC margins.