The Reserve Bank of India (RBI) recently issued guidelines that would require banks to price loans using a base rate instead of the benchmark prime lending rate (BPLR). These guidelines are aimed at creating greater transparency in the way loans are priced.
Historically, banks charged interest rates on their floating rate loans based on their internally set BPLR. BPLRs are set and changed by each bank’s asset liability committees or board based on factors, such as cost of funds, asset strategy and market forces. Given the multiplicity of these factors, banks refrained from making changes to the BPLR as often as the underlying factors changed, resulting in much of the lending at sub-BPLR rates. BPLR was, thus, fast losing its relevance while creating a perception of lack of transparency among borrowers and the regulator.
Consequently, a large base of customer, especially retail borrowers comprising about 21% of the net bank credit felt that banks were quick in increasing rates in a rising rate cycle and slow to drop rates in a falling rate cycle. The draft base rate guidelines have proposed to link floating rate loans to actual costs of funds of the banks, thereby creating a higher degree of transparency.
Under the new base rate guidelines, effective from 1 April 2010, banks may determine their actual lending rates on loans and advances with reference to the base rate.
Base rate shall include all those elements of lending rates that are common across all categories of borrowers, This would include cost of deposits; adjustment for the negative carry in respect of cash reserve ratio and statutory liquidity ratio; overhead costs for the bank that cannot be allocated, such as aggregate employee compensation relating to administrative functions in the corporate office, directors’ and auditors’ fees, legal and premises expenses, depreciation, cost of printing and stationery, expenses incurred on communication and advertising, IT spending, and cost incurred towards deposit insurance; and profit margin.
Illustration: Shyamal Banerjee/Mint
Banks will be required to disclose information on base rates at all branches and on their website. Further, the basis of computation will be auditable by RBI, leading to a higher degree of transparency in movement of floating rates of consumer loans.
The base rate will be the minimum rate for pricing commercial loans. This means that the bank cannot, under any circumstances, price a loan at levels below the base rate even to high-quality AAA customers, who hitherto have access to highly competitive, low priced domestic markets.
While this creates a level playing field between savvy corporate borrowers and retail customers, it also means that many banks may not be able to lend to top-end borrowers since their cost of funds will be higher than the rates in international markets. Most banks seldom make profits on lending to top-end customers, but make their returns largely on fee-based businesses, such as foreign exchange and trade cash management. The regulation does not allow banks to look at their relationship as a whole but purely on a stand-alone lending basis.
Further, the base rate guidelines expect banks to price a minimum rate of profit into the base rate. This will make it even more difficult for banks to lend to the top end of the market. In fact, one would argue that since the base rate is the minimum rate charged by banks to its customers, no profit element should be included in the rate and only marginal cost (the cost of funds) should be priced into the base rate.
Cost of borrowing
The base rate may also increase the cost of borrowing for agricultural and other priority sectors. Traditionally, due to RBI’s lending guidelines, banks are required to lend 40% of their advances to priority sectors of the economy, including agriculture. The lending norms ensure that credit to areas such as agriculture was made available at subsidized rates. Given low capital investment in agriculture, there is a need to increase low-cost lending to this sector to increase national food output.
A recent poll among banks showed that base rates would be in the 6-9% range, given the current cost structure of banks. This means that the cost of funds to agriculture and other priority sectors could increase, putting further strain on these sectors. RBI may want to consider permitting banks an exception to lend to priority sectors at rates below the cost of funds.
Despite a few shortcomings the base rate regulation will enable banks to price loans based on the actual cost, creating greater level of transparency and a level playing field for the customer.
Rana Kapoor is founder, managing director & CEO, Yes Bank. Your comments, questions and reactions to this column are welcome at firstname.lastname@example.org