The concept of a benchmark prime lending rate, or BPLR, the rate at which Indian banks are expected to lend to their best borrowers, is set to die. It was introduced six years ago, in November 2003, to enhance transparency in the pricing of loans, but the purpose has been defeated since its inception because a bulk of the loans, 70% or more, are priced below BPLR. The Reserve Bank of India (RBI) formed a committee in April to review the BPLR system and recently put up the panel’s report on its?website,?inviting public feedback.
The entire exercise reminds me of an apocryphal story of a king and a cobbler. I did narrate this in one of my earlier columns in a different context, but I am tempted to repeat the story. The king of this story loved walking on the streets, but did not like getting his feet dirty. So he announced an award for a person who could offer a solution to the problem. The first person appeared on the scene with millions of brooms, but his efforts to make the kingdom dust-free went in vain, even as the cloud of dust that enveloped his palace made the king sick. The second aspirant ended up killing millions of goats and sheep, but still could not cover even half of the roads with their skin. Finally, an old cobbler entered the royal court, carrying 2 sq. ft of hide in his tattered bag. After carefully measuring the king’s feet, he stitched a pair of sandals, and the problem was solved forever.
However complex the problem, the solution often lies in common sense. In this case, the common sense solution is delinking all mandated loans from BPLR, and not repositioning the benchmark rate. The root of the problem is not lack of transparency in loan pricing, but the fact that banks are giving loans to a majority of their customers at below BPLR.
Also Read Tamal Bandyopadhyay’s earlier columns
Why do banks offer loans to their top-rated customers at below BPLR? One reason behind this is plentiful liquidity. Barring for a few months after the collapse of Wall Street investment bank Lehman Brothers Holdings Inc. in September 2008 that rocked the global financial system and triggered an unprecedented credit crunch, there has always been enough money in the system. So the borrowers have been shopping for loans, leading to a rate war among banks. Faced with stiff competition, banks do lower their loan rates, but they are always reluctant to cut their BPLR. Since October 2008, RBI has cut its policy rate by 5.75 percentage points—from 9% to 3.25%—but banks have not reduced their BPLR even by half as much. Why has this been so? The official reason is banks’ inability to pare deposit rates aggressively. Banks compete with the government’s small savings schemes and the mutual funds industry for savers’ money, and both mutual funds and the small savings schemes offer tax benefits. This curbs banks’ ability to cut deposit rates sharply, and even if they choose to do that, the cost of deposits does not come down dramatically overnight as the new rates are applicable to fresh deposits and banks continue to pay old rates on existing deposits till they mature. But even this logic does not hold water because banks don’t pay high rates on their entire deposit base. The interest rate on savings accounts is 3.5% and on current accounts, maintained by companies, nil. Between them, savings and current accounts account for at least 30% of total deposits.
The real reason behind banks’ inability to pare their BPLR is something else. In a deregulated Indian banking industry, a few loan rates are still mandated by RBI and they are linked to banks’ BPLR. For instance, loans to exporters are given at 2.5 percentage points lower than BPLR. So a bank which has a BPLR of 11.5% now offers loans to exporters at 9%. If the BPLR is brought down to 9%, loans to exporters will be priced at 6.5%. Similarly, loans to all small farmers are priced cheaper than a bank’s BPLR. Overall, such concessional loans account for 30-35% of a bank’s loan portfolio. So, banks prefer to keep their BPLR at an artificially high level and charge the bulk of their borrowers a loan rate that is much below the prime rate.
The solution is delinking export loans and small farmers’ loans from BPLR. If the regulator insists on cheaper loans for exporters and farmers, the government can offer direct subsidy to the borrowers or even the banks, in the form of interest rate subvention, as has been suggested by the RBI panel. This alone will solve the problem, and it won’t matter whether a bank’s benchmark loan rate is called BPLR or “base rate”, as has been suggested by the panel. The base rate, according to the panel, should be arrived at considering the cost of one-year retail deposits, banks’ mandatory investments in government bonds and cash kept with the central bank besides “unallocatable overhead cost” and average return on net worth. Under current norms, banks are required to invest 25% of their deposits in government bonds (and the return from such investments is theoretically less than the return from loan assets) and keep 5% of deposits with RBI on which they do not earn any interest.
How a benchmark rate is arrived at should be left to the banks. Once the mandated rates are delinked from BPLR, the Indian central bank should ban the practice of giving loans below the prime rate. Market forces will take care of the rest.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Comment at firstname.lastname@example.org