The irrelevance of the base rate

Unlike many other banks, State Bank of India (SBI), the country’s largest lender, has not cut its base rate or minimum lending rate after the banking regulator cut its policy rate by half a percentage point, sending a strong signal to banks to cut their loan rates. Instead, SBI has cut rates for auto loans and money given to small and medium enterprises (SMEs). Its current base rate continues to be lower than many other banks’ that have cut their base rate but its decision to leave the base rate untouched and cut loan rates for certain business raises a pertinent question, that of the efficacy of base rate.

The base rate replaced the then prevailing benchmark prime lending rate, or BPLR, in July 2010. Ideally no bank should have lent at below BPLR but at least 70% of bank loans used to be disbursed at below BPLR, making a mockery of the benchmark rate. The base rate, below which banks cannot lend, is supposedly more transparent. The banks need to take into account their cost of funds, overheads, as well as other factors such as portion of deposits they keep with the Reserve Bank of India (RBI) and non-performing assets to arrive at the base rate. There is no cap on the spread between the base rate and the actual rate but the banks need to justify the spread. The tenure of the loan, risk profile of the customer and the industry that the customer represents can influence the spread. Nothing has happened in the past one week that could have changed the risk profile of SMEs and auto loan-seekers. SBI has simply pared the high spread that it was enjoying on such loans. By the same logic, a bank can keep the base rate unchanged and raise the spread for any segment if it wants to. And any such change in rates is applicable to only the new borrowers while the existing borrowers continue to pay the old rate. This goes against the grain of transparency.

In the US, the prime rate— higher that the Federal Reserve rate—is the benchmark rate for all consumer and retail loans, and the London interbank offered rate (Libor), is the reference point for all corporate loans. Similarly, in the UK, the Bank of England’s base rate is the benchmark rate for consumer and retail loans, while Libor is the benchmark for commercial loans. Libor’s Indian counterpart Mibor, or the Mumbai interbank offered rate, is an overnight rate and the efforts to develop one-month and three-month Mibor have not yet met with success. Two critical factors that can ensure a fair loan rate regime are a term money market and a vibrant bond market and we are far away from both.

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