(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.)