The problem at its base

The problem at its base

For four years, Indian banks have been disobeying the central bank’s instructions, presented in its master circulars on interest rates on advances—2006-09, to use an external transparent benchmark to set interest rates for floating rate loans. Besides providing transparency to borrowers, such a benchmark may help the central bank to implement its interest rate policy. But banks’ most common excuse has been that there is no suitable floating rate benchmark.

In its most recent attempt, the Reserve Bank of India (RBI) requires all banks to price most loans (including floating rate loans) by using its recommended base rate formula, the bank’s own defined transparent base rate formula or any other transparent benchmark. RBI publicized specific guidelines last week, expecting banks to start the new system on 1 July.

Unlike its earlier attempts, by recommending a formula this time, RBI can ensure that banks do not fail to comply with one of its three options. However, unlike external transparent benchmarks, the recommended base rate, though transparent, has a few problems.

First, it is not forward-looking: It is computed using the cost of existing deposits, including deposits which may have been taken a long time ago and which may mature tomorrow. Second, there is no tenor—the time period for a loan—intrinsically associated with the formula. That means no logical reset period, for banks to change rates, exists: RBI’s requirement for a review of the base rate at least once a quarter is well intentioned and convenient, but not natural. Third, it is not easy for the borrowers to compare base rates of different banks. Fourth, banks can’t use the base rate as a benchmark for floating rate deposits—as the base rate itself depends upon the cost of the deposits.

Banks then have a reason to devise a better method than the base rate. In an effort to devise a transparent market benchmark for, say, a three-month tenor, banks could start an active-term money market—an interbank market for borrowing and lending for tenors ranging from 15 days to one year.

The most liquid overnight interbank market currently is the collateralized borrowing and lending obligation market in which entities lend to or borrow from one another through a central counterparty. Here, the borrower posts a government security as collateral—except that this market is currently liquid for only the one-day tenor. It’s based on the interest rates in this market that an overnight collateralized benchmark offer rate (CCBOR) is published daily. Similar borrowing and lending is permitted for a three-month period. However, the volume for the three-month tenor is insignificant. The overnight benchmark is not very suitable since it effectively requires a daily reset.

Getting a good benchmark is necessary. Banks typically have short-term deposits that fund longer-term loans. Thus, long-term fixed-rate loans are often risky for banks. With a transparent market benchmark such as a three-month CCBOR, the interest rate swap market could attract renewed interest from all banks. It’s only with a liquid interest rate swap market based on a transparent market benchmark that banks will be able to offer their borrowers true fixed interest rates—a swap can convert fixed rate to floating rate and vice-versa.

Without a transparent external benchmark, banks cannot price, and hence competitively offer, interest rate options either—derivatives that, for a price, can put either a ceiling for a floating rate borrower or a floor for a depositor. RBI doesn’t allow them currently, but even if it did, banks wouldn’t be able to get it right.

If our banks take the easy route of either using RBI’s formula or their own, rather than an external transparent benchmark, then they will have only themselves to blame for their inability to offer true fixed rates, as well as for a stunted derivatives market. Perhaps RBI could consider some incentives too: It could grant more urban branch licences for banks that adopt a transparent market benchmark.

A.M. Godbole is an adviser with AV Rajwade & Co. Pvt. Ltd, a risk management consulting firm. These are his personal views. Comment at