Reading the spread: what external benchmarks mean for your borrowing cost
Since 2019, floating-rate MSME loans have been priced off an external benchmark. The benchmark moves with policy; the spread is where your negotiation lives.
When the Reserve Bank changes the policy repo rate, many business owners expect their loan rate to follow within weeks. Whether it does depends on how the loan is priced — and many companies are paying more than they need to simply because they have never looked.
The 2019 shift
By its circular of 4 September 2019, the Reserve Bank required all new floating-rate loans to micro and small enterprises, along with personal and retail loans, to be linked to an external benchmark from 1 October 2019. The benchmark may be the policy repo rate, the three- or six-month Treasury bill yield, or another benchmark published by Financial Benchmarks India. The interest rate must be reset at least once every three months. The requirement was subsequently extended to loans to medium enterprises.
The aim was faster transmission. Under the earlier internal benchmarks — base rate and, later, the marginal cost of funds based lending rate — changes in policy rates reached borrowers slowly and incompletely.
Rate equals benchmark plus spread
An external benchmark lending rate has two parts: the benchmark, which the borrower cannot influence, and the bank's spread over it, which reflects operating costs and the credit risk premium for that borrower. Under the Reserve Bank's rules, the credit risk premium may change only when the borrower's credit assessment undergoes a substantial change, as agreed in the loan contract.
That cuts both ways. A company whose credit profile has strengthened materially — through deleveraging, a rating upgrade or consistently clean conduct — has a legitimate basis to request a lower spread. Without that request, the premium set on the day of sanction may simply persist.
Where optimisation begins
The first step is an inventory: which facilities are on an external benchmark, which remain on MCLR or base rate, what each spread is and when each resets. The second is to compare that against what the company's current profile would command in the market today.
Sometimes the answer is a conversation with the existing bank. Sometimes, particularly now that pre-payment charges on floating-rate loans to small enterprises have been prohibited, it is a takeover. Either way, the saving is found in the spread, not in waiting for the benchmark to fall.
This article is general information about the financing landscape, current as of its publication date. It is not financial, legal or tax advice; regulations change, and every company’s position is different.
