The Reserve Bank of India’s (RBI) decision to link all lending rates (except export credit and loans to small borrowers under the Differential Rate of Interest Scheme) to a new base rate is likely to raise the costs for blue-chip borrowers who have been accessing loans at rock-bottom rates so far.
Analysts say the base rate for even the best banks would be in the region of 9%. With the cost of deposits at around 6% and adding around 0.75% to compensate for the lower yields on statutory holdings of government bonds and zero yield on cash reserves, an additional 1.25% to unallocable overheads and an average of 1% return on assets, the base rate would add up in this illustrative case to 9%.
This would, of course, vary across banks, but on average, public sector banks with their lower cost of deposits will have lower base rates, as would private banks with a higher proportion of current and savings accounts. It’s also logical for export credit to be exempt, as that will depend on dollar rates of funding rather than local rates.
Graphic: Yogesh Kumar / Mint
While analysts say the net interest margins (NIMs) for banks may rise in the short term due to higher interest rates on blue-chip borrowers, in the long run banks will adjust their portfolios to maintain NIMs. In any case, it is impossible to gauge the impact on NIMs without knowing what proportion of advances at present fall below what will be the base rate.
These loans will have to be re-priced at the base rate since lending below that rate won’t be allowed. Moreover, the impact on NIMs will not be felt all at once, as borrowers’ loan rates will be linked to the base rate after 1 April as and when they become due for renewal. Analysts say it’s too early for them to revise their earnings estimates for banks.
Borrowers who will face higher interest rates are also likely to seek alternative financing from the market, through commercial paper or bonds.
Sujoy K. Das, head of fixed income at Bharti AXA Investment Managers, says that this could lead to an increase in disintermediation, with not only the supply of paper increasing but supply of funds too rising as banks, not finding takers for loans at higher rates, park their funds with mutual funds which, in turn, invest in commercial paper. This is especially true as bank base rates are likely to be sticky, while market conditions can change rapidly.
That brings us to the key problem in the base rate system: Surely what matters for banks in pricing loans is the marginal cost of funds, rather than the average cost?
In some cases, banks charge interest rates based on the rates at which they can raise money for the same tenor as the loan, and if the base rate has to be on a historical cost basis, these kinds of loans will no longer be possible.
There is also no clarity about the tenor for which the base rate applies and bankers say that since RBI has said the base rate will be the minimum rate and borrowers will be charged a tenor premium, that implies the base rate should be for the shortest possible maturity. In fact, some banks now lend at rates linked to the overnight Mibor, or Mumbai interbank offered rate.
These kinds of loans, too, will no longer be possible if the new regime comes into effect since they will have to be priced at some ludicrous average of deposit rates of all maturities.
Ideally, of course, the base rate should have been linked to market rates of interest, but the problem is that a term money market has not developed, largely because of the Reserve Bank’s requirements of statutory liquidity ratio (the portion of deposits banks need to invest in government bonds) and cash reserve ratio (the portion of deposits banks need to keep with the central bank). In the circumstances, allowing the banks to price their own products any way they see fit would have been the best option, while the needs of regulation would best be served by prudential norms.
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