The discussion and deliberation on the base rate, within and outside banking circles, have been restricted to when and what base rate number to put out. This is surprising considering the fact that the base rate is not even an actual lending rate; it is at best an indicative reference rate.
The problem is that banks, in deciding on the base rate, seem to be taking a restrictive enterprise view and not an economy-wide perspective. Not surprisingly, like in the prisoner’s dilemma, the rate they will pronounce will benefit neither bank nor economy. It is more important to see it as a regime change in which the process of arriving at the base rate number is more important than the number itself.
There are three aspects to the base rate regime. First, structurally, it is to make the interest rate transmission mechanism effective across the financial system—be it to policy changes or deposit rates or for classes of borrowers. The macroeconomics of base rate is to ensure monetary policy signals are conveyed to the real side of the economy without much lag and distortion. This is more important now than ever before simply because the economy is far more open and monetary tools are the only policy instruments left to guide the economy.
Second, systemically, the base rate is meant to improve delivery and flow of credit at a reasonable price to small borrowers and prevent cross-subsidization of the corporate and organized sector borrowers by small borrowers.
Third, operationally, the base rate is a means to make pricing of bank loans more transparent, improve the nature of asset planning, and alter the method of asset-liability management.
To be sure, the base rate was born out of the regulator’s own failure to restrict sub-PLR (prime lending rate) lending, which had been emerging as a serious systemic risk. The bulk liabilities of banks were open to quick short and steep term repricing, and assets were not. Even the Indian Banks Association failed to get a consensus on this issue among banks. Many a sub-group was formed to deliberate this, but without any success.
Also, the Reserve Bank of India (RBI) was unable to get banks to change lending rates in line with policy rates, thereby reducing their policy effectiveness. It was in this context that the idea of a floor rate seems to have germinated.
The floor rate, as a concept, is not a bad one, considering there is hardly any product differentiation in “bank loans” that would engender and justify a wide variation in individual bank’s pricing of loan products. There cannot be a Bata and Bally pricing in bank loans. The only differentiators are operational efficiency and speed of sanctioning; borrowers are willing to pay premium for speed of sanction.
However, the manner in which the base rate was designed and introduced is flawed. For instance, the pricing discrepancy between loans offered to large corporate borrowers and small and medium enterprise (SME) borrowers, which triggered the move to a base rate, seems to have been exaggerated, if not misunderstood.
It is no secret that large companies have been getting very fine rates and the spreads between them and SME borrowers were wide and increasing. A triple-A corporate was able to contract debt at 6-7% at a time when the average PLR was 12.5% for a wide variety of reasons—be it for the liability-side relationship that it may have had with the bank or the size of its non-fund business. The point is that banks need not and do not look at earning money from an account only from its interest rate or advances yield; an account generates earnings in many ways. The possibility and practice of earning from an account is an important factor in pricing for banks.
The biggest problem with the base rate regime, apart from the obvious one of reducing operational flexibility of banks, is the possibility of banks going overweight on the investment side of their asset book, relative to credit. They may start behaving and eventually looking like non-banking financial companies.
This will have serious systemic implications—treasury incomes will contribute more to the bank’s earnings. This would mean that interest rate signals will get amplified and may add a lot of volatility to the bank’s bottom line, making the entire system very vulnerable to shocks.
At another level, the base rate regime will revive the practice of multiple banking and see the decline of consortium banking. This will, of course, create its own complications for banks. Not only will it reduce the semblance of homogeneity in the sector, but it will also add to transactional cost of banks.
At the end of the day, by the manner in which the base rate has been designed and the way banks have reacted to it as a mere calculation, it is unlikely that the base rate regime will make a difference. The base rate will be to banks what the bank rate is to RBI. Does anyone remember what the bank rate today is, and if it is 6% then why it is so?
Haseeb A. Drabu is the chairman and chief executive of Jammu and Kashmir Bank. He will write on monetary and macroeconomic matters from the perspective of policy and practice. The views are his own and don’t necessarily reflect the views of the organization he works for. Comment at email@example.com
To read Haseeb A. Drabu’s previous articles, go to www.livemint.com/haseeb.htm