Uncertainty in the New Base Rate

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BANK Negara Malaysia announced in March that it would no longer use the base lending rate (BLR) as its main reference rate for retail floating rate loans. Effective Jan 2 next year, it will be replaced by the base rate (BR).

The move is expected to impact mortgage loan products the most, as floating rates are used more prevalently with such products, compared with car or personal loans.

The reason for the change, according to the central bank, is because even though the BLR framework has served as the main reference rate since 1983, it no longer holds any relevance.

“In the recent period, the BLR has become less relevant as a reference rate for loan pricing, as lending rates on new retail loans are being offered at substantial discounts to the BLR. The BLR also lacks transparency, which makes it difficult for consumers to make an informed decision,” Bank Negara says in a press statement.

“The new Reference Rate Framework aims to provide a more transparent reference rate to enable better decision-making by consumers [when] making choices among the many loan products offered by financial institutions. [It] will also better reflect changes in cost arising from monetary policy and market funding conditions while encouraging greater discipline and efficiency among financial institutions in the pricing of retail financing products.”

The current practice by banks in terms of lending rates is BLR minus a spread, compared with Bank Negara’s proposed formula of BR plus a spread.

Banks have been allowed to price their own BLRs since April 2004, which takes into account the overnight policy rate (OPR), their cost structure (which includes their cost of funds) and business strategy. A bank’s spread is the difference between its yield from loans and the rate it pays on deposits and borrowings.

Yet, banks tend to have similar BLRs in order to stay competitive, even though they should be different as they have differing operating costs.

This, combined with the fact that BLRs have quite a substantial margin from the actual lending rate after factoring in its negative spread, renders the BLR irrelevant. Currently, the BLR for most major banks stands at 6.85%, compared with the prevailing lending rate of about 4.4% to more than 5% for home loans.

Other criticisms of the current framework is that there is no bottom to the BLR’s negative spread, and that it does not reveal what exactly its spread covers, including a bank’s cost of deposit and operational cost.

With the new reference rate framework using the BR, however, spreads will always be positive as it won’t be possible for banks to offer lending rates below the reference rate, says Bank Negara. The BR itself will be determined by a bank’s benchmark cost of funds and the statutory reserve requirement (SRR), which is the amount of liquid assets a bank must hold to remain solvent, and is usually set by the central bank.

“Other components of loan pricing, such as borrower credit risk, liquidity risk premium, operating costs and profit margin, will be reflected in a spread above the BR. This increases the visibility of the factors underlying the changes to the BR,” Bank Negara says in its statement. “The greater transparency in turn will enable more informed decision-making by consumers.”

The central bank added that the new reference framework should not impact the effective lending rate to loan borrowers: “[These rates] are determined by various factors, including a financial institution’s assessment of a borrower’s credit standing, market funding rates and competitive considerations.”

At what cost?

As for what the benchmark cost of funds is, however, the central bank did not specify. Financial institutions are given the flexibility to determine their respective benchmark rates, which many speculate will be the Kuala Lumpur Interbank Offered Rate (Klibor), as it is more reflective of a bank’s cost of funds.

The Klibor is the interest rate at which banks borrow from each other on the interbank market. It is determined by a daily poll carried out on behalf of the Financial Markets Association of Malaysia, asking 12 banks to estimate their cost of borrowing from one another. The highest and lowest submissions are excluded, and the remaining entries are calculated to set the rate at 11am local time.

The Klibor is seen as more transparent as well, as the rates are published in major newspapers every day. “The Klibor is more ideal for use as a benchmark rate. When adopting this, banks will probably wait for the leading banks to make the first move,” opines a Malaysian banking industry expert. “I don’t think banks will use their actual cost of funds [as a benchmark rate], as they wouldn’t want to divulge it for competitive reasons.”

While banks in Singapore and Hong Kong have been using their respective interbank offered rates to price their mortgage loans (the Singapore Interbank Offered Rate and Hong Kong Interbank Offered Rate), only two banks in Malaysia offer Klibor-based loans. Standard Chartered Bank and Hong Leong Bank offer housing loans pegged to the three-month (3M) Klibor. Hong Leong’s Klibor-based housing loan was only introduced this year.

“Klibor-based loans are fairly new [in the Malaysian market], but I think its use would be a more efficient transmission mechanism of higher funding costs to borrowers,” says the industry expert. “For instance, the 3M Klibor has risen to 3.6% from 3.3% since the beginning of the year, compared with the OPR, which only went up by 25 basis points (bps) during the same period.”

While this means that using the Klibor will be more reflective of current market rates, it also means that it will be more volatile than the BLR. “The Klibor will be more volatile, but banks may implement tolerance levels, whereby lending rates won’t change if the Klibor fluctuates within a certain band. This way, rates would only be adjusted if the Klibor moves outside the band,” suggests the industry expert.

This is how the 3M Klibor-based loans offered by Hong Leong Bank and Standard Chartered Bank work. The interest rates are reviewed every three months. When a borrower takes out a loan, the first rate will be fixed on the business day immediately before the first loan disbursement date, and will last for three months. The next three-month rate will be set on the last business day of the first three-month period. This way, the interest rate imposed on the loan changes in tandem with the Klibor every three months.

However, banks are allowed to determine when they wish to fix the three-month rates, as Bank Negara does not specify when they should do this.
In view of this, would fixed-rate loans be a better option for borrowers? Perhaps, if you are looking to avoid volatility, but not necessarily so in terms of paying lower interest rates.

“The interest rate on a fixed-rate loan is usually set slightly above what you would be quoted for a floating rate. So if financial institutions expect rates to rise, they would quote higher fixed rates too,” the industry expert says. “But based on where we are today and with regard to how much more interest rates will rise, which perhaps is not much more, getting a fixed-rate loan may not be worthwhile.

“For consumers, fixed-rate loans may be preferred if rates are anticipated to go up, and if there’s still a fair bit of room for rates to rise to reach normalised levels,” he continues. “For example, if the OPR were at 2% and a normalised level at 3.5%, fixed-rate loans would appear more attractive at these levels, as compared with a situation where the OPR is 3.25% and the potential rise is just another 25bps to a normalised level, which isn’t much.”

What loan borrowers can do to address this is to maintain a cash flow buffer for when interest rates go up and keep abreast of market conditions when taking out a loan in order to make a more informed decision.

 

This article was first published in the September 2014 issue of Personal Money — a personal finance magazine published by The Edge Communications.