If I were to write an epitaph on the tombstone of the benchmark prime lending rate (BPLR), which will be buried on 31 June by the Indian banking industry, it will probably read:
“To be fair to small and medium borrowers, it had to die;
A failure since birth, but can the bankers explain why?
The top-rated Indian companies will shed tears on the grave because they will no longer be able to raise money at below BPLR. Since it was introduced in 2003 as a benchmark rate below which no bank should lend money, the bulk of bank loans have been disbursed at lower than BPLR. Why did bankers do that? There is a structural problem here. Even though the industry is by and large deregulated, a few lending rates are still mandated and linked to banks’ BPLR. For example, loans to exporters are given at 2.5 percentage points below BPLR. Similarly, all loans to small farmers are priced cheaper than BPLR. This has prevented banks from paring their BPLR as the moment this benchmark rate is cut, automatically the loan rate for exporters and small farmers declines. So banks preferred to keep their BPLR at an artificially high level and charge most of their borrowers a rate much below the benchmark rate. This is the only way they could prevent loan rates for exporters and small farmers from declining to a level that does not even cover their cost of funds.
Also Read Tamal Bandyopadhyay’s earlier columns
On 1 July, the base rate will replace BPLR and banks are banned from lending at below the base rate. Small farmers and exporters will, however, continue to get cheap loans even though the rate at which which they will get money will not be linked to the base rate. The government gives a subsidy of 2 percentage points to banks on such loans. Apart from small-ticket borrowers (loans of up to Rs2 lakh) and exporters, two other categories of loans will not need to adhere to the base rate formula—loans to banks’ own employees and loans against deposits.
How will the banks calculate their base rate? They need to take into account their cost of funds, overheads such as the cost of running branches and employee wages. Then there are other critical factors to be considered. For instance, banks do not earn any interest on the cash reserve ratio (CRR), or the portion of deposits they keep with the regulator. Currently, the CRR is pegged at 6%. If it goes up, banks’ earning will go down and that will have an impact on the calculation of the base rate. Similarly, the level of non-performing assets (NPAs) will also influence the base rate. Banks do not earn any interest on their NPAs and, hence, the higher such assets the lower their income. The calculation for BPLR was no different. Despite that, most of the banks ended up having their BPLRs in the same range even though their cost of funds, overheads and level of non-performing assets were not alike. Typically, State Bank of India, the largest lender, takes the lead in setting the rate and others follow.
There is no cap on the spread between the base rate and the actual rate that a bank can charge its customers. This means that a bank can keep its base rate at 8% and still charge a customer 18%. But to do this, it has to justify the spread of 10 percentage points. The tenure of the loan, risk profile of the customer, the industry that the customer represents (real estate will carry higher risk than, say, a manufacturing unit) and even the geography (an individual borrower from the Dharavi slum in Mumbai will have a higher risk profile than one from Bandra) will influence the spread.
The biggest difference between the BPLR regime and the base rate regime will be transparency as the banks will be required to explain the rationale behind the actual loan rate—something they have not been doing. In a highly distorted financial world, efficient small and medium enterprises have been subsidizing top-rated companies, and this may end now. But still there are ways how a bank can offer loans to top firms at below its base rate, indirectly though, and no regulator can stop the practice. It’s fairly simply. A bank can offer loan to a top-rated firm at its base rate and pay 2 percentage points higher than the market rate on the deposit that the firm keeps with the bank.
To be sure, it’s not easy to arrive at an ideal loan rate in India as the policy rate here, unlike in the developed markets, does not have a direct bearing on banks’ loan rates. Also, there is no synergy between banks’ loan rates and government bond yields.
In the US, the prime rate—normally 3 percentage points higher that the Federal Reserve rate—is the benchmark rate for all consumer and retail loans, and the London interbank offered rate, or 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 is Mibor, or the Mumbai interbank offered rate—the rate at which banks can borrow funds from each other in the interbank market. But this 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 where the yields are not artificially suppressed to ensure the government’s huge annual borrowing programme goes through. We are nowhere close to either of them.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Email your comments to firstname.lastname@example.org