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Will a new mechanism for lending rate work?

The Reserve Bank of India has proposed to link bank lending ..

The Reserve Bank of India has proposed to link bank lending rates to market benchmarks with a special committee recommending the same. The central aims to hasten monetary policy transmission so that the benefits of rate actions (cut or rise) reach borrowers/depositors in time. Final guidelines are expected in the new year.

Bank loans are now priced in kilter with the marginal cost of funds-based lending rate. Instead, loans could be linked to a market-determined benchmark rates, say certificate of deposits (CDs), Treasury bills (sovereign papers with less than one-year maturities) or the repo, the rate at which banks borrow short term money from RBI.

But, banks need to shift to floating rate deposits before they start pricing loans in the proposed new format. Without that, lenders may end up incurring losses with a mis-match between assets (loans) and liabilities (deposits).

Floating rate deposits may pose a new challenge to banks, which will have to defuse depositors concern over interest income.

Globally, the practice of floating rate loans and deposits are quite in the vogue.

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