Citi not to exit India finance business

In the strange vocabulary of India's home loan market, the term "floating rate" does not quite mean what it would in plain English. You might think that a floating rate means the interest rate on your home loan will fall when there is a decline in interest rates and rise when they go up. You couldn't be more wrong.

Experience has taught existing borrowers that rates float upwards quite rapidly, but are only very reluctantly pegged down. Thus, every time headlines announce an increase in home loan rates, existing borrowers are the first to feel the pinch, while the banks will continue to offer lower rates to new borrowers in a bid to attract them. On the other hand, when a cut in interest rates is announced, it is made immediately applicable to new customers, but the existing customers continue to pay the old higher rates.

How does this happen? One key reason is that all floating rates are fixed in terms of a benchmark rate, normally termed as the floating reference rate (FRR). The actual rate offered is at a discount to the FRR. For instance, ICICI Bank's FRR is at 12.75% at present. However the rate it charges from customers was 11.5% till recently and is now 11%.

When you read in newspapers that home loan rates have been cut - or hear it on TV - typically it does not mean the FRR has been cut. All the banks do is to issue instructions to their branch managers to offer a larger discount on the FRR. Thus, in the case of ICICI the discount was increased from 1.25 percentage points to 1.75 percentage points. The same is true of other banks as well, though the exact amount of the discount and the FRR may vary slightly from bank to bank.

The practice of changing the discount rate allows lenders the leeway to offer new customers the discounted rate while continuing with the old rate for existing borrowers. This would not be possible if they had formally announced a cut in the FRR itself, since they would then be bound by their contract with the existing borrowers to charge them no more than the FRR. When rates go up, it is not the discount that is reduced. Rather, the FRR itself is hiked, allowing higher rates to be passed on to existing customers.

In essence, therefore, existing customers are unaffected by changes in the discount rate. They gain only if the FRR itself is reduced, which has not happened even once in the last three years.

But why do banks follow such a discriminatory practice? One reason is that while new customers have many potential lenders to choose from, existing ones are already in bag. Any thoughts existing borrowers may have of shifting to a different lender are dampened by the pre-payment charge - about 2% of the outstanding amount - that they will have to pay to close their loan.

Another reason is that existing customers now form a much larger base than the numbers that can be added to them over short term. So, giving existing customers any concessions erodes the bank's profit margins. You might think that the desire to compete against each other would be enough to ensure that banks are willing to forego windfall profits in a bid to capture more customers. Textbook economics would suggest that this should happen. What we see in real world of home loans is a tacit agreement among banks - including the state-owned ones - to follow this dubious practice.

So, what is RBI doing about what would appear to be a case of cartelisation? RBI's response to questions of this nature is to wash its hands off the affair and say that since banks and customers have agreed to terms and conditions of the loan, it has no role to play in it.

Source: Times Of India

Apply Here