Base Rate – Old Wine in New Bottle

Latest Indian Business News Financial World - Latest Articles Latest World News

Base Rate – Old Wine in New Bottle

NSN REDDY*

email id: nsn6507@yahoo.com ; Mobile 09490213002

Banks play a catalyst role in economic development by providing adequate credit to the needy sectors on an ongoing basis. Besides availability of credit, its affordability (Interest Rate) also plays a decisive role in determining the credit flow in the country. Interest rates veering too high or dipping too low may spell a trouble to the credit quality and ultimately be a cause of concern for financial stability of the banks as well as for development of the country. Further, the lending rates of banks are expected to conform to the changes in the Monetary Policy of RBI from time to time.

The evolution of Interest Rates on loans and advances in India can broadly be classified in to two phases viz. Regulated and Deregulated regimes.

Regulated Interest Rate Regime:

Till late 1980s, the interest rate structure on loans and advances extended by commercial banks was largely administered by the RBI and banks did not have any freedom to fix the interest on loan products, irrespective of the nature of advance and the amount lent. Banks were simply advised to follow the interest rate prescription of RBI, primarily to ensure the flow of adequate credit to the desired productive sectors of the economy.

Deregulated Interest Rate Regime:

RBI has initiated a number of steps to simplify and rationalize the complex interest rate structure as well as to bring in transparency in the loan pricing system. The important changes in lending rates post reform era, are as under:

Year	Key changes
Sep 1990	The structure of lending rates was rationalized into six size-wise slabs. The slabs were reduced to four in the year 1992 and further reduced to three in the year 1993. Of these, banks were free to set interest rates on loans of over Rs.2 lakh with minimum lending rates prescribed by RBI.
Oct 1994	Lending rates for loans with credit limits of over Rs.2 lakh deregulated. Banks were required to declare their Prime lending rates (PLRs).
Feb 1997	Banks were allowed to prescribe separate PLRs and spreads over PLRs, both for loan and cash credit components.
Oct 1997	For term loans of 3 years and above, separate Prime Term Lending Rates (PTLRs) were required to be announced by banks.
April 1998	PLR converted as a ceiling rate on loans up to Rs.2 lakh.
April 1999	Tenor-linked Prime Lending Rates (TPLRs) introduced.
Oct 1999	Banks were given flexibility to charge interest rates without reference to the PLR in respect of certain categories of loans/credit.
April 2000	Banks allowed charging fixed/floating rate on their lending for credit limits of over Rs.2 lakh.
April 2001	The PLR ceased to be the floor rate for loans above Rs.2 lakh and banks were allowed to lend at sub-PLR rate for loans above Rs.2 lakhs.
April 2002	Dissemination of range of interest rates through the Reserve Bank’s website was introduced.
April 2003	Benchmark PLR (BPLR) system introduced and tenor-linked PLRs discontinued.

(Source: Speech of Deepak Mohanty, Executive Director, RBI on 11.06.2010)

Impact of Deregulated Interest Rates:

The introduction of BPLR and deregulation of interest rate was a major initiative taken by RBI to achieve the competitive loan pricing in the market.

Extending credit at BPLR implies that the borrower is AAA rated and the associated risk is low. With increasing competition in the banking industry, the BPLR lost its relevance as large chunk of bank lending to the commercial sector happened at sub BMPLR rates i.e. around 7.50% as against average BPLR of 12.5%. RBI report on BPLR reveals that more than two-thirds credit portfolio of the Banks (excluding small loans and export credit) belongs to sub BPLR category and majority of these loans pertains to Corporate Sector / Large Borrowers where as Retail and Small borrowers continued to pay higher interest rates. Lending to Corporate Sector / Large Borrowers at relatively low interest rates has a direct bearing on Yield on Advances and Net Interest Margin (NIM) of the banks.

Interest Rate war among banks has caused unhealthy competition and led to unwarranted low interest offerings to corporate/large borrowers, detrimental to the interest of banks and stake-holders. Contrarily, banks are reluctant to revise BPLR downwards in respect of retail loans despite reduction of key rates by RBI.

Base Rate:

In the above backdrop, RBI constituted a working group under the Chairmanship of Shri. Deepak Mohanty to examine the related issues of BPLR and suggest a transparent credit pricing mechanism with an objective to ensure effective transmission of the Monetary Policy signals from time to time. The working group suggested Base Rate in the place of existing BPLR, which is arrived, duly taking the following components:

Ø Cost of Deposits / Funds

Ø Negative carry in respect of CRR and SLR

Ø Unallocatable Overhead Costs

Ø Average Return on Net Worth

Based on the Working Group recommendations, RBI issued guidelines to all banks to announce Base Rate, duly taking the said criteria and directed the banks to price the loans accordingly w.e.f. 01.07.2010. Under this system, banks cannot lend below Base Rate except for certain categories such as Differential Rate of Interest (DRI) advances, Loans to bank’s own employees, Loans to bank’s depositors against their own deposits, Interest Subvention Schemes viz., Crop loans, Export credit and Restructured loans. The final lending rates include the Base Rate plus variable or product specific operating expenses, credit risk premium and tenor premium.

Banks are required to review the Base Rate at least once in a quarter with the approval of the Board or the Asset Liability Management Committee as per the bank's practice and inform the same to RBI.

On introduction of Base Rate, the Regulator has envisaged the following scenarios:

Impact on Public Sector Banks: Cost of deposit constitutes the important component of Base Rate and it crucially depends on the composition of low cost deposits of the Bank. The Cost of deposit of Banks (Group-wise) is as under:

(Percentage)

Category	2007-08	2008-09
Public Sector Banks	5.40	5.60
Old Private Sector Banks	5.70	6.20
New Private Sector Banks	5.90	6.40
Foreign Banks	3.80	4.30
Scheduled Commercial Banks	5.40	5.70

(Source: Report on Trend and Progress of Banking in India 2008-09)

PSBs will have an edge over Private Sector Banks in offering a more competitive rate as they have a larger deposit base which gives them access to low cost resources. Further, PSBs are better placed with regard to access to the government/treasury funds and thereby their Cost of funds works out to be lower than Private Sector Banks.

Impact on Corporate Borrowings: On implementation of Base Rate, borrowing funds from banks may cost more for some Corporate since the proposed rate might be slightly higher by 50 to 100 basis points over the existing interest rate (sub BPLR). This may warrant Corporate to look for alternate low-cost financing options such as Commercial Paper, Qualified Institutional Placement, External Commercial Borrowing etc., which could result in lower credit off-take of banks. However, PSBs with superior treasury operations can partially offset competitive pressures in the short-term lending segment by subscribing to the debt market issuances of Corporate.

Impact on Retail Segment: Reduction of interest rates by a minimum of 100 to 200 basis points for Retail borrowers since the Base Rate of the banks is estimated around 7.50% to 8.50% as against the average BPLR of 12.50%.

Impact on Macro Rates: The Base Rate of Banks should be in sync with macro rates and Banks to effect changes in their Base Rate as and when there is a change in CRR, SLR, Repo, Reverse Repo and Bank Rate.

In the above backdrop, a need was felt to introduce transparent and fair credit pricing mechanism to sustain Net Interest Margin besides providing credit to the needy borrowers at reasonable interest rates.

Base Rate - Post implementation scenario: The present Base Rate vis-à-vis erstwhile BMPLR of respective banks is furnished here under:

Name of the Bank	Base Rate	BPLR
SBI & Associates
State Bank of India	7.50	11.75
State Bank of Bikaner and Jaipur	7.75	12.25
State Bank of Hyderabad	7.75	12.25
State Bank of Mysore	7.75	12.25
State Bank of Patiala	7.75	12.25
State Bank of Travancore	7.75	12.25

Public Sector Banks	Base Rate	BMPLR
Allahabad Bank	8.00	12.00
Andhra Bank	8.25	12.00
Bank of Baroda	8.00	12.00
Bank of India	8.00	12.00
Bank of India	8.00	12.00
Bank of Maharashtra	8.25	11.25
Canara Bank	8.00	12.00
Central bank of India	8.00	12.00
Corporation Bank	7.75	12.00
Dena Bank	8.25	12.50
IDBI Bank	8.00	12.75
Indian Bank	8.00	12.00
Indian Overseas Bank	8.25	12.00
Oriental Bank of Commerse	8.00	12.00
Punjab & Sind Bank	8.20	13.50
Punjab National Bank	8.00	11.00
Syndicate Bank	8.25	12.00
UCO Bank	8.00	12.25
Union Bank of India	8.00	11.75
United Bank of India	8.00	12.00
Vijaya Bank	8.25	12.25

Private Sector Banks	Base Rate	BMPLR
Axis Bank	7.50	14.75
Bank of Rajasthan	8.00	15.25
DBS Bank	7.00
Development Credit Bank	7.75	16.75
Dhanlaxmi Bank	7.00	16.00
Federal Bank	7.75	14.25
HDFC Bank	7.25	15.75
ICICI Bank	7.50	14.75
IDBI Bank	8.00	12.75
Indusind Bank	7.00	16.75
Jammu & Kashmir Bank	8.25	12.75
Karnataka Bank	8.75	13.75
Karur Vysya Bank	8.50	13.50
Kotak Mahindra Bank	7.25	15.50
Lakshmi Vilas Bank	8.75	15.00
South Indian Bank	8.10
Yes Bank	7.00	16.50

Foreign banks	Base Rate	BMPLR
Citi Bank	7.25	15.00
Deutsche Bank	6.75
HSBC	7.00	13.75
Standard Chartered	7.25	14.25

An analysis of data reveals that the Base Rate arrived by the Banks is more herd in nature than adopting transparent and scientific approach. Some of the observations made on Base Rate are as under:

Ø Base Rates of the Banks are in the range of 6.75% to 8.75%.

Ø SBI set the Base rate at 7.50% and all its subsidiaries fixed the rate at 7.75%.

Ø Majority of Public Sector Banks (other than SBI & Associates), have fixed the Base Rate at 8%.

Ø SBI Base Rate is the lowest amongst PSBs on account of high composition of low cost deposits.

Ø The BPLR of Private Sector Banks was in the range of 13.50% to 16.75%, where as it was in the range of 11.25% to 12.75% with regard to PSBs. Contrary to the trend, Private Sector Banks announced their Base Rates much lower than the Base Rates announced by SBI / PSBs.

Re-engineering of Base Rate:

As per RBI guidelines, the cost of deposit/funds and unallocatable overhead costs plays an important and decisive role in fixation of Base Rate. In order to provide competitive loan pricing, some banks are conveniently manipulating the above components to suit their requireement. It is observed that some banks have taken six months card rate instead actual cost of deposits since the card rate is low compared to actual cost of deposits.

Though the cost of deposit of Private Sector Banks is high compared to Public Sector Banks, some Private Sector Banks have declared their Base Rate lower than SBI/PSBs. The reason is to offer finer interest rate to blue chip corporate clients to retain their accounts, besides garnering a market share in the corporate lending space.

Banks continued to lend at the erstwhile sub BPLR rate with slight marginal changes to most of the corporate clients even in the new system as they adjusted their Base Rate to suit the requirements of their Large/Corporate Borrowers. This aspect needs attention of the Regulator to have a relook on methodology adopted by the Banks in arriving the Base Rate.

The maximum spread that banks used to levy on borrowers was 3.50% during BPLR regime where as the present spread is in the range of 5% to 10% on most of the retail segment loans, which is too high and unjustifiable.

It is expected that Banks whose Base Rate is low, should price their loan products relatively low compared to banks having high Base Rate. Contrary to the expectations, all banks have adjusted Spread in such a way that interest rates remain the same as that of pre Base Rate interest rates. Further, it is observed that there is no transparency with regard to adoption of methodology by the banks in arriving Base Rate.

Though, Banks announced Base Rate as directed by RBI, the purpose for which it is introduced is not fulfilled since the interest rates on retail lending remains the same in the post Base Rate regime also.

It is high time that RBI should ensure that banks adopt transparent Base Rate methodologies especially with regard to calculation of Cost of deposits/funds and Unallocatable overhead costs. Further, there is an urgent need to have threshold limits on spread to ensure appropriate pricing of loans with special reference to Corporate/Large borrowers and also to enable the retail borrowers avail credit at reasonable interest rates.

***August, 2010***

*[Mr NSN Reddy, who is working as Chief Manager, in Andhra Bank has B,Com, CAIIB, PGDBM (NIBM) qualifications to his credit and has over 32 years of Banking experience]

Important Notice : [The articles written by authors contains only the academic view of the writer and purely for discussions and updation of the knowledge of the bankers. The views expressed in the articles may not at all be subscribed by the organisation where the author is working and / or AllBankingSolutions.com]