Will RBI's External Benchmarking Make MSME Loans Cheaper? Linking lending rates to an external benchmark will increase transparency and transmission but interest rates may not reduce sharply

Lending rate on MSME loans could get cheaper, beginning October 1. The Reserve Bank of India (RBI) has mandated banks to link all new floating rate loans given to retail borrowers and micro and small enterprises to external benchmarks, such as the repo rate.

Related Read: Difference Between Floating Rate and Fixed Rate Loans

Until now, lending rates were linked to banks' own reference rate, MCLR (marginal cost of funds based lending rate). Even though MCLR is supposed to move in tandem with the RBI's cut or hike in policy rates, the recent cuts in the repo rate have not been transmitted satisfactorily to borrowers, as the RBI circular said.

Industry experts have welcomed the move saying external benchmarking will bring in more transparency to an otherwise opaque interest rate-setting mechanism followed by banks. "A borrower will have a common reference rate to look at while choosing from different products offered by different banks. So transparency for the borrower will increase," says Rahul Sanklecha, Senior VP – Operations and Credit, Lendingkart.

Better transparency, faster transmission

RBI has also asked the banks to reset rates under external benchmark every three months. This move will ensure that any change in policy rates is transmitted to loans immediately, which was not the case under MLCR. RBI has cut its benchmark repo rate by 110 basis points in the past eight months but MSME loan rates linked to MCLR have largely remained unchanged or have come down by a few basis points (bps). Banks source a small margin of their deposits from RBI's repo rates because of which change in policy rates do not affect MCLR substantially. Now, with the lending rates pinned to an external benchmark, changes in policy rates will be passed faster to borrowers.

Not so cheap loans

While faster transmission is laudable, borrowers should keep their expectations regarding cheap loans in check as the lending rates may not be reduced sharply. "While the banks will have to pass the interest rates immediately, they have limited power to reduce deposit and retail CASA (current and savings account) rates in the short terms as it will bring volatility in their financials. Hence, they may look at increasing spreads to protect their margins," says Manish Lunia, Co-founder, Flexiloans.com. Sanklecha concurs. "What banks finally offer will depend on how they manage their internal costs," he says. The RBI has said in its circular that banks are free to set the spread over the external benchmark.

However, new borrowers looking to take a loan for the short term stand to gain from this shift as market experts feel that interest rates will fall further in the coming months. "It is likely that banks may not tinker much with the spreads right now and offer cheaper loans to help with economic growth" says Lunia.

As on the date of filing this story, only Indian Overseas Bank has announced to link MSME loans to repo rate but has not specified interest rate details of the new product.

Problem for MSMEs continue

It should be noted that non-banking finance companies (NBFCs) have been kept out of this move.

NBFCs are increasingly becoming the go-to lenders for small and micro enterprises, as can be seen in a recent study by TransUnion Cibil that states that market share of NBFCs has increased from 10 per cent in 2010 to 13 per cent in 2018. The reason for this is that borrowers with average credit score often don't get approved for loans from banks. Additionally, banks insist on collaterals as they consider small and micro ventures to be risky, which is usually difficult for them to produce. Lengthy documentation and slow approval process can also be pain points for small businesses in need of credit fast. Fintech companies and other NBFCs address these gaps.

So keeping NBFCs out will not pass on the intended benefits to several borrowers who largely rely on NBFCs for their credit needs.