An overhaul of the loan pricing regime in India was long overdue and hence the move by the Reserve Bank of India (RBI) to replace the benchmark prime lending rate (BPLR) with a new base rate is welcome.

The BPLR was supposed to be the benchmark rate in the credit market but as much as three-fourths of bank lending is done below BPLR, with many implications. One, it is hard to figure out how lending rates in India are moving and whether they are correlated to changes in policy rates. Two, large companies with bargaining power can force banks to lend to them at very low rates as a result of which small companies are forced by banks to pay higher rates to protect bank profit margins. Three, the limitations of the BPLR system meant that the money markets do not have a risk-free reference rate to price credit and (in the future) credit derivatives.

Illustration: Jayachandran / Mint

The fear is that India has moved into a new regime of administered interest rates, with the base rate acting as an artificial floor linked to the cost of funds of banks. This is a cost-plus approach to pricing loans, which will help public sector incumbents with a nationwide branch network and a huge low-cost deposit base. Newer players who necessarily depend on high-cost deposits in their early years may find themselves shut out of many deals. This is an issue RBI should consider.

True, there are many countries such as Japan, Singapore and Taiwan that use a cost-plus method to determine the benchmark or base lending rate. But India needs to develop a robust term money market which ensures that participants decide on a benchmark credit rate through price discovery. Banks can then price loans at or above this benchmark, depending on their risk assessment of the customer and loan tenure.

There is little doubt that the new base rate is better than the BPLR it replaces, but the monetary authorities should see this as a necessary stop on the long road to an active term money market, rather than as an end in itself.

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