(My heartfelt thanks to Mr. G. C. Nath, Senior V.P., CCIL for his invaluable insights on this topic)
There hardly is an adult nowadays who hasn't felt the need or has gone ahead to avail a loan. You can blame it on the increasing consumerism or the inflationary forces. Anyways, I am not going to discuss the rate of inflation or conspicuous consumption rather I will focus on the rate of interest on these loans. These rates were affected by a major change that took place on the 1st of July, 2010. This happening was; "coming into effect of Base Rate System".This blog is on Base Rate System and its likely impacts.
So, the first question that would come to our minds would be , why was a new system needed? To answer this, I will first explain the old regime. The rate that took the centerstage in the previous era was Base Prime Lending Rate(BPLR). BPLR indicated the rate of interest at which banks lent to favored customers, i.e., those with high credibility. So, one might be tempted to say that it was the best available rate of interest. BPLR of SBI was 11.75% in Jun'10. But unfortunately almost 70% of the loans carried an interest rate below BPLR. So what was so unfortunate about it? The disturbing aspect was cross-subsidization. The blue chip companies walked away with lowest of rates whereas the SME compensated for them by paying a higher rate. This was because there was no transparency involved in the process of arriving at BPLR and the large firms could arm-twist their way to lower rates.
So let me now define Base Rate System(BRS) in a little detail. BRS is a system to fix interest rates for borrowers which will serve as the minimum rate for all loans i.e. a bank can't lend below the base rate. As was the case with BPLR, each bank can have its own Base Rate. Its basis of calculation will mainly include cost of deposits, profit margin etc. (RBI guidelines and illustration for computing it). It has to be revised every quarter. Though so far an option is available to the existing borrowers to move to the BRS price from the BPLR one, but in near future a sunset clause from RBI might make the transfer mandatory. Most of the PSB (public sector banks) have announced their base rate as 8% whereas SBI has declared 7.5% as its rate. On the other hand private banks like ICICI has pegged it at 7.5% and HDFC has fixed it at 7.25%.
So, let's point out some of the advantages of this new system:
- An effort has been made towards transparency in the interest rate calculation for the loans.
- Cross-subsidization has caught the attention of the policy makers.
- It could lead to a "rate war" thus lowered cost of borrowings esp. for SME can't be ruled out.
- A transparent regime will result in credit worthy customers availing loan at suitable rate who may have been refused loan in the past regime.
- BPLR as the ceiling rate for loans up to Rs. 2 lakh has been withdrawn which reinforces the third point.
- It could prove to be a blessing in disguise for alternative short term debt instruments like Commercial Papers (CP) or non-convertible debentures (NCD) or Certificate of deposit (CD).
But even BRS has its share of concerns:
- The Indian method of setting interest rates is far from scientific.
- The banks can still provide benefits to the large borrowers by say paying higher interest rates on their deposits
- Why quarterly revision, why not daily even when computerization (of above 85%) is the norm at the Indian banks.
- It could lead to banks shying away from lending (with low interest rates) rather they might prefer investing in CP or CDs.
- The announced base rates expose the cartelization of banks else how come most banks have the exactly same base rates? (reinforces the first point)
So whether BRS will be the dawn of a new era or will it prove to be an exercise in futility? My answer: Only time will tell.
(Pls don't miss the comments of Mr. G.C.Nath in the comments section.)
gud work n thanks 4 givin this piece of information.......
ReplyDeletebt if government fixes the minimum rate of interest i think it could harm our economy.....
why market forces alon cant decide d same?
Hi Avi,
ReplyDeleteThanks for your appreciation.
The main motive behind the BRS is to know the minimum possible rate at which loan can be provided. The banks can still charge a higher rate (depending upon the customer risk profile) than base rate but it will have to explain the rationale behind it. Add to that, this rate is to be fixed by the banks, not by the RBI. So banks are free to fix their rates depending on their cost, margin or customer (pls go through the rbi guidelines and illustration links that i have provided.It might help.)
I believe that BRS is a step in write direction. The question is if it will be implemented in right spirit. BRS is much better than BPLR it replaced but is there any way to ensure that banks do not learn the circumvent this system in future?
ReplyDeleteAlso, with cost of borrowing going up, the corporations may use alternative ways of funding like issuing bonds and papers. And if banks find it difficult to lend, i see more of them parking their funds in mutual funds which in turn invest in corporate bonds.
BRS does not factor the tenure of loan. If the loan duration will be factored in the premium charged above the base rate then it implies that BR is a loan rate for shortest possible maturity which is usually a day for inter bank over-night loans to maintain necessary ratios. Does this mean that BR will be Indian LIBOR? If yes, then is this right way to calculate Indian Bench mark rate?
IMO, dynamic interest rate options and futures market is needed in India to better establish the benchmark rates.
@Amit... Thanks for a great analysis.
ReplyDeleteMr. G.C.Nath has addressed most of the concerns that were raised by me as well as some of them that have been raised by you e.g. The use of 5Yr tenure bond yield to calculate the Base rate will make it scientific. Even the CPs and other such instruments will get progressively costlier as their demand increases so banks will still rely on the loan market .
As far as the premium for duration is concerned, it will be a consideration apart from the customer profile.
As the review period is of one quarter so I expect rates to be sticky in the short run so it may not be suitable to compare it with over-night loan rates which may be more volatile and liquid. Also the dynamism of a fixed income market will be slightly different from the loan market which is affected by the Base rate as players are more diverse here.
And I wholeheartedly agree that a dynamic set up will indeed help whether in rate discovery or in bringing about changes.
I am including the comments (between inverted commas) of Mr. G.C.Nath, Senior V.P., CCIL. This helped me gain great insight into the BRS. I am sure they will add value to the readers as well.
ReplyDelete* The Indian method of setting interest rates is far from scientific. -
"A base rate (below which the loan can not be sanctioned except few subsidied loans which Govt funds) should be either a fully covered cost plus rate or a benchmark rate like 5YR soverign Bond Rate plus. Both will be dynamic as the rates would be monthlyresents and it will take into account all possible costs a Bank can incur for running business. BPLR did nothing of the sort and the method was also not known to public. Hence new system of base rate is scinetific. However, excluding agri loans from the purview is a dampener."
* The banks can still provide benefits to the large borrowers by say paying higher interest rates on their deposits.
"This is not true as Banks can not provide higher interest rate to large deposits. They could provide the same to buld deposits but today banks have been advised not to go for bulk deposits. Large borrowers would normally not keep high deposits as loan interest rate will always be higher than deposit rates. It does not make economic sense."
* Why quarterly revision, why not daily even when computerization (of above 85%) is the norm at the Indian banks.
"Daily not is advised because the regulatory cost will drastically increase by doing the same. And you do not get much benefit as we do not expect banks to increase their deposit rates on daily basis - neither other cost increase on daily basis. So quarterly reset is okay as it maps with the policy announcements."
* It could lead to banks shying away from lending (with low interest rates) rather they might prefer investing in CP or CDs. -
"CPs and CDs will always give far lower rate that a loan rate. Then you have not factored into the roll over cost. Average CP/CD life cycle is 3 months and hence the cost of roll over will be immense. Banker has to find a loan customer if it wants to survive competition."
* The announced base rates expose the cartelization of banks else how come most banks have the exactly same base rates? (reinforces the first point).
"Banking is an oligopolstic structure and their business deal in homogeneous products. Most banks offer the same kind of rates for deposits - a few bps here and there. Due to competition, banks also try to keep the customers with them. Customers compare rates across banks and then bargain with banks for the best rate. Yes, banks form groups like PSU banks, Foreign banks, Private banks, co-op banks, etc. and develop some kind of informal structure to deal with various issues."