Floating rate loans: Why RBI wants proper lending conduct by banks
Context- The Reserve Bank of India (RBI) has decided to stop the rampant elongation of the tenor of floating rate loans and resetting of the tenor by banks without informing borrowers. The RBI announced on August 10 that it will bring a framework of transparency and proper rules while resetting equated monthly installments- (EMI-) based floating rate loans.
(Credits- GeeksforGeeks)
Why the decision?
- Supervisory reviews by the central bank, and feedback and references from the public have revealed several instances of unreasonable elongation of tenor of floating rate loans by lenders without proper communication and consent from borrowers.
- Banks can change the interest rate by changing the internal benchmark rate and the spread during the term of the loan — potentially harming borrowers’ interests and impairing monetary transmission.
- Borrowers have complained that banks change or reset EMIs arbitrarily, and extend tenors without informing them.
- Borrowers are also not informed about foreclosure charges. The RBI has also observed that unduly long elongation of tenors has camouflaged stress in banks. The borrower can in theory refinance the floating rate loan by going to another bank, but this does not work well in practice.
- Floating rate loans of different banks with internal benchmarks are not identical even if spreads are identical at loan origination and in the future, given that different banks change or reset internal benchmarks differently.
- The borrower in such a situation is often left with no choice but to remain captive to the original bank, and pay higher charges on existing loans.
So what has the RBI planned?
- A proper conduct framework will have to be implemented by all regulated entities (including banks and non-banking financial companies) to address issues faced by borrowers.
- The framework envisages that lenders should communicate clearly with borrowers on resetting the tenor and/ or EMI, provide options of switching to fixed rate loans or foreclosure of loans, make transparent disclosure of various charges incidental to the exercise of these options, and properly communicate key information to borrowers.
- Banks increase the tenor of the loan when interest rates go up in the floating rate system. Sometimes this is done to maintain EMIs at the same level. However, many banks have been extending tenors and raising EMIs without informing the borrower.
And what do the banks say?
- According to banks, when an external benchmark rate — banks use the repo rate now — is adopted for fixing the lending rate, the reset period should be linked to the tenor of the underlying external benchmark.
- While longer reset periods increase transmission lags, shorter resets increase interest rate risk for banks. Banks have indicated that retail customers would resist a shorter (quarterly) reset, particularly in a rising interest rate cycle, because of the increase in EMIs or longer repayment period with uniform EMIs. Conversely, in a falling interest rate regime, borrowers prefer shorter resets.
Conclusion- Transparency on the tenor of loans will help increase trust and build public confidence in the long run . It will also increase banking systems resilience going forward.
Syllabus – GS-3; RBI
Source- Indian Express
