External Benchmark: Formula Components: Flashcards
What is an external benchmark in relation to bank loan interest rates?
An external benchmark is a reference interest rate determined by an independent body outside the bank.
Examples include the repo rate (set by the RBI in India), Treasury bill yields, or rates published by Financial Benchmarks India Private Ltd.
Banks are required to link floating-rate loans to these external benchmarks for greater transparency.
Why did the RBI mandate the use of external benchmarks for loan interest rates?
The previous system (likely MCLR) was considered an “epic fail” because it didn’t quickly and accurately reflect changes made by the RBI to key policy rates.
External benchmarks were implemented to improve the transmission of monetary policy decisions, ensuring that borrowers benefit more directly from interest rate changes.
Explain the formula: External Benchmark + Spread (Profit) + Risk Premium = Bank’s Loan Interest Rate
External Benchmark: The base interest rate determined outside the bank.
Spread (Profit): An additional percentage the bank adds to cover their costs and generate profit.
Risk Premium: An extra percentage based on the borrower’s creditworthiness. Riskier borrowers pay a higher premium.
When did the RBI’s mandate for external benchmarks on floating-rate loans take effect?
October 1st, 2019
What are the different external benchmarks a bank can choose from?
RBI repo rate
91-day Treasury Bill yield
182-day Treasury Bill yield
Benchmarks published by the Financial Benchmarks India Ltd.
How often are banks required to update the external benchmark component of their loan interest rate formula?
Banks must update the external benchmark data at least once every three months.
Why is it important for banks to regularly update the external benchmark in their loan interest formulas?
Regular updates ensure that changes in market interest rates (like the repo rate) are accurately reflected in the interest rates borrowers pay. This creates greater transparency and fairness in the lending process.
Who benefits when an external benchmark, such as the repo rate, decreases?
Both new borrowers (taking fresh loans) and existing borrowers (with loans linked to the external benchmark) benefit when the benchmark decreases. Their interest rates will adjust downwards accordingly.
