Banks have been fixing their benchmark prime lending rate (BPLR) in an opaque manner to protect their earnings. Among those to suffer: retail borrowers who have gone in for floating-rate loans that linked to BPLR, which is the interest rate paid by borrowers with the highest creditworthiness. Are there any other benchmarks that banks can use to decide interest rates on floating-rate loans?
In its Report on Currency and Finance 2005-06, the Reserve Bank of India said: “The policy rate was revised downwards 10 times between 13 October 2000 and 25 October 2005. During this period, however, BPLR by one representative large bank was revised only six times and the lag varied between six to 13 months. However, on occasions when the policy rate was revised upwards, the bank was quick to respond with the time lag as low as 20 days.”
Doesn’t all this seem loaded against the customer? Consider a bank that gives a housing loan at a floating rate to a retail customer and at a fixed rate to another. The floating rate is based upon a spread over BPLR. So, for example, a customer could be charged BPLR-plus one percentage point.
But, BPLR as a stand-alone concept is flawed. It does not refer to a precise tenor, though interest rate is a measure of the time value of money. The only parameter that seems to be considered while changing BPLR is competitive forces in the market. Again, this factor is more pronounced for new loans rather than existing loans. As such there is no transparency on precisely how BPLR of a bank is computed.
Banks should use a transparent benchmark for their credit portfolios. Then the terms of a floating- rate loan will not be stacked against a borrower. For example, the treasury bill (T-bill) auction cut-offs may be used. The average of the three preceding T-bill auctions prior to the coupon date is already used to determine the benchmark for the government’s floating-rate bonds.
What happens when a transparent benchmark is not used? Let’s assume that competitive forces work in the market as they are supposed to. BPLR and new deposit rates would inadvertently be changed such that the earnings of the bank are protected—that is, the earnings of the bank are likely to be protected at the cost of floating-rate borrowers and new depositors.
Since all banks want to protect their earnings, they change their respective BPLRs in a manner that is non-disruptive to the earning of other banks. This is because fixed rates cannot be tinkered with during the tenor of the loan. So a floating-rate retail customer may end up finding that BPLR is sticky downwards. BPLR moves down much lesser and later than it should, in comparison with how much and how quickly it moves up. On the other hand, interest rates for new deposits (for most tenors) would be sticky upwards!
Besides, floating rates should be reset at predetermined regular intervals (say half-yearly or yearly) and not in an arbitrary manner. And, it would help if the benchmark was defined for the same tenor as the interval between resets (i.e., half-yearly or yearly). Auctions for the 182-day (approximately six months) and 364-day (approximately one year) T-bills are conducted every alternate week. We could consider the last three auctions immediately preceding a reset in the benchmark.
With transparent benchmarks in place, banks will be able to securitize their floating-rate portfolio, as the pricing would become more transparent from the investor’s perspective as well. In addition to securitization, other derivatives that use the same benchmark could be employed to manage risks better. Banking capital enables banks to bear risks. When banks transfer these risks (and associated returns) to the investors in securitized paper, bank capital gets freed up. The freed banking capital can be used to generate new loans (assets for the bank).
We know that competitive forces are not the only influencing factors in determining BPLR. Political interference is also a factor. Transparency through a new benchmark will help remove political interference and improve the transmission of interest rates. This will help the monetary authority to efficiently transmit policy changes in interest rates. The transmission would be calibrated, rather than an interest rate shock for borrowers generated by much larger jumps in BPLR. And, as discussed earlier, transparent benchmarks would enable better risk management by banks (by using securitization and other derivatives). Such a calibrated approach could mean that a fewer number of policy rate hikes would suffice.
Transparent benchmarks will also allow customers to compare the loan offered by various banks more easily. Everything else being the same, the bank charging the lowest spread over the benchmark rate is the best one for the customer. Currently, such a comparison is not possible. For the retail customers, the issue is one of fair play. Let such a new transparent benchmark system run concurrently with the current opaque BPLR system, and then let bank customers decide what is good for them.
A.M. Godbole is an executive assistant, A.V.Rajwade & Co. These are his personal views. Comment at firstname.lastname@example.org