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Base rate and beyond

Base rate and beyond

Indian banking will enter a new era on 1 July when an improved method of pricing loans is finally activated. This newspaper welcomes the move to a transparent base rate that will act as a benchmark for the pricing of all loans dished out by banks. However, we also believe that the base rate should not be considered a final destination, but only a necessary stop on the long road to the development of a vibrant term money market in India.

The base rate replaces the benchmark prime lending rate, or BPLR. This reference rate was introduced in 2003 and its limitations are now well known. The easy liquidity situation in recent years encouraged banks to enter a price war to attract large companies who were otherwise quite happy to borrow from global bond investors. The BPLR floor was breached for these large companies, which got cheap loans at the cost of smaller companies which in turn, had to bear the subsidy burden.

There were problems on other fronts as well. The Reserve Bank of India saw its monetary policy lose teeth, as banks did not adjust lending rates in response to monetary policy, thus clogging an important transmission channel through which central bank actions effect the real economy of output, consumption and jobs. Any amount of fretting and fuming by the central bank could not change the behaviour of banks on this front. The base rate should ensure that floating rate loans get repriced in tandem with changes in policy interest rates such as the repo and reverse repo.

The base rate is far better than the BPLR it will replace, but there is no way to ensure that banks will not learn to beat the system a few years down the line. The base rate is by no stretch of imagination the end game as far as reforms in bank lending goes.

Developed financial markets have vibrant term money markets that can help lenders price loans depending on the tenure of these loans and the risk profile of the borrower. These spot markets need to be complemented with active markets for interest rate options and swaps. The loan pricing in such a market will be truly transparent and dynamic. It is worth noting that the new base rates that banks will announce are unrelated to loan tenures, which is surely a flaw in the system.

The base rate does, for now, offer hope of becoming a benchmark interest rate in India. But the finance ministry and financial sector regulators need to move ahead to create the conditions where India gets a robust money market where interest rates across tenures are decided by price discovery.

BPLR: The first step in a longer journey? Tell us at views@livemint.com

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