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Switch from floating to fixed rate regime

The Reserve Bank of India (RBI) asked all regulated entities (REs),Switch from floating to fixed rate regime............

Why in News?

  • The Reserve Bank of India (RBI) asked all regulated entities (REs),including banks and NBFCs, to give personal loan borrowers an option to switch over from a floating rate to a fixed rate regime at the time of resetting interest rates.

What are the new changes?

  • Clear communication: At the time of sanction, REs will have to clearly communicate to the borrowers about the possible impact of a change in benchmark interest rate on the loan leading to changes in EMI and/or tenor or both.
    • Any increase in the EMI/ tenor or both will have to be communicated to the borrower immediately through appropriate channels.
  • Switchover: At the time of reset of interest rates, REs will have to give the option to borrowers to switch over to a fixed rate as per their board-approved policy. The policy will also specify the number of times a borrower will be allowed to switch during the tenor of the loan.
    • REs will have to disclose all applicable charges for switching loans from floating to fixed rate and any other service charges/ administrative costs in the sanction letter and also at the time of revision of charges or costs from time to time.
  • Elongation:The borrowers will also be given the choice to opt for enhancement in EMI or elongation of tenor or for a combination of both options, and to prepay, either in part or in full, at any point during the tenor of the loan, with foreclosure charges.

What is a Fixed Exchange Rate?

A fixed exchange rate is an exchange rate where the currency of one country is linked to the currency of another country or a commonly traded commodity like gold or oil. Nowadays, countries usually link their currencies to their trading partners like the United States dollar.

For example, the United Arab Emirates pegs its currency, the UAE dirham, to 0.27 United States dollar. In other words, for 1 USD, you will always get 3.67 dirhams. It was done to provide stability in the oil trade between the two countries.

Advantages of a Fixed Exchange Rate

  • Setting a fixed exchange rate with your trading partner will provide currency rate certainty to importers and exporters.
  • When a small country fixes its currency to a superpower like the United States and the European Union, they protect themselves from paying more when importing products from the developed countries. This appreciation happens when the U.S. economy grows, which strengthens the dollar, thereby making it expensive for the smaller countries to import. Hence, a fixed exchange rate hedges them from such a risk.
  • A fixed exchange rate helps to ensure the smooth flow of money from one country to another. It helps smaller and less developed countries to attract foreign investment. It also helps the smaller countries to avoid devaluation of their currency and keep inflation stable.

Why has RBI issued new regulations?

  • Unreasonable elongation of tenor:The supervisory reviews undertaken by the RBI and the feedback and references from members of the public have revealed several instances of unreasonable elongation of tenor of floating rate loans by lenders without proper consent and communication to the borrowers.
  • Banks can change the interest rate by changing the internal benchmark rate and the spread during the term of the loan which could harm the interest of the borrower and also impair monetary transmission. 
  • The borrower can refinance the floating rate loan by going to another bank, but in practice, this does not work well. Floating rate loans of different banks with internal benchmarks are not identical even if spreads are identical at loan origination and in future, given that different banks change or reset internal benchmarks differently.
    • The borrower in such a situation is more often left with no choice, but to remain captive to the original bank and pay higher charges on existing loans rather than refinance.

Benefits of Fixed rate regime:

For borrowers:
  • Protection from Rate Hikes: Shifting to a fixed rate provides protection against potential future increases in interest rates. This can be particularly beneficial if interest rates are expected to rise in the near future.
  • Budgeting and Financial Planning: Fixed payments make it easier for borrowers to budget and plan their finances since they know exactly how much they need to allocate for their loan payments.
  • Potential Cost: Fixed interest rates tend to be initially higher than prevailing floating rates. Borrowers opting for a fixed rate might end up paying more initially compared to what they would have paid with a floating rate if rates remain relatively stable or decrease.
For lenders:
  • Interest Rate Risk Mitigation: Lenders are less exposed to interest rate risks when borrowers opt for fixed rates. They can better manage their own interest rate risk since they know the interest income they’ll receive remains constant.
  • Lending Profitability: Fixed-rate loans typically come with higher initial interest rates compared to floating-rate loans. This can lead to increased lending profitability for lenders, especially if rates remain stable or decline.
  • Potential Lower Loan Demand: Higher initial fixed rates might deter some potential borrowers who are attracted to lower initial payments offered by floating rates.
  • Limited Flexibility: Lenders might have less flexibility in adjusting loan terms for borrowers with fixed-rate loans, as the interest rate remains constant regardless of market conditions.

Read also:- Public Tech Platform for Frictionless Credit

Switch from floating to fixed rate regime,Switch from floating to fixed rate regime

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