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The Macrolevel Implications In A New Base Rate Regime Finance Essay

Before the Base rate system, RBI had introduced the system of BPLR in November 2003 for pricing of loans by commercial banks with the objective of enhancing transparency in the pricing of their loan products. However, the BPLR, supposed to be the best rate for prime borrowers, remained only on paper, as in the last few years they have begun lending to customers at way below the prime rates.

In contrast, under the erstwhile Benchmark Prime Lending Rate (BPLR) regime the BPLRs for Public Sector Banks ranged from 11% to 13.5% while Private Sector Banks had BPLRs ranging from 12.50% to as high as 16.75%. The BPLR system was introduced with a view to enhance transparency in the pricing of bank loans. However, over time the system of BPLR lost its relevance as a meaningful reference rate as the bulk of loans were advanced below BPLR. This not only made the loan pricing system non-transparent and impeded the smooth transmission of monetary signals but also led to cross-subsidization of large corporates.

BPLR: Insensitivity to policy rate changes

Source: RBI

As seen from the above graph, the banks did not change their BPLR despite the RBI changing the policy rates in form of Repo and reverse repo rate. The BPLR for Q4 2008-09 was 11.50% to 14% for Public sector banks, 12.75% to 16.75% for Private Banks and 10% to 17% for Foreign Banks. The BPLR stayed constant for rest of the quarters at 11% to 13.50% for Public sector Banks, 12.50% to 16.75% for Private Banks and 10.50% to 16% for Foreign Banks as of June 2010. Further the quantum of movement in BPLR did not mirror the changes in policy rates leading to poor transmission of policy rates.

Source: RBI

The graph shows the average deposit rates across public sector, private and foreign banks for less than 1 year maturity period. As it is evident from the above graph, the deposit rates are more sensitive to the changes in the repo rates made by the RBI. The private banks deposit rates are the most sensitive to repo rates. Over the period of March 2009 till June 2010, private banks had reduced their average deposit rates by 163 basis points with lowest change of 12 basis points to maximum of 263 basis points; public banks reduced their deposit rates by 188 basis points and foreign banks by 138 basis points. However repo rates were reduced from 5% in March 2009 to the lowest of 4.75% in April 2009 till February 2010 and then increased it to 5.25% in June 2010.

Hence banks were transmitting the changes in policy rates on to deposit rates but were reluctant to pass on the same quantum of change on to the borrowers. Hence in BPLR regime, both depositors and borrowers were at disadvantage due to lack of transparency and transmission of policy changes.

Base rate system – A way forward to make banking system more transparent

Banks in India have now moved to Base rate system from BPLR system that existed earlier. RBI has made it mandatory for banks to update their base rate every quarter. Let’s understand Base Rate by answering these few questions.

What is base rate?

When was it introduced?

Why was it introduced?

What are the components of base rate or how is it calculated?

Where is it applicable?

What is base rate?

Base rate is the minimum rate of interest that the bank will charge to its prime customer or borrower. Changes in the Base Rate shall be applicable in respect of all existing loans linked to the Base Rate, in a transparent and non-discriminatory manner.

When was it introduced?

RBI introduced base rate system on July 1 2010. In order to give banks some time to stabilize the system of Base Rate calculation, banks are permitted to change the benchmark and methodology any time during the initial six month period i.e. end-December 2010.

Why was it introduced?

The Base Rate system is aimed at enhancing transparency in lending rates of banks and enabling better assessment of transmission of monetary policy which BPLR failed to fulfill.

What are the components of base rate or how is it calculated?

1) Cost of Deposits/ Funds

The cost of deposit would consist of the Interest rates at which the interests are paid out to the depositors. The deposits under consideration for the calculation of this are Time deposits, Current Deposits & Saving Deposits. Based on the weights of every component of deposits as mentioned the cost of deposits varies.

2) Negative carry on CRR ad SLR

Basically CRR and SLR form an integral part in the calculation of base rate. Since they fetch a return, the rates will be deducted to arrive at the final base rate. Why consider them in the first place if they do not form a part of the cost? Since they are mandatory regulatory requirements and they affect the base rate to a large extent, their impact on the base rate cannot be ignored.

Negative carry on CRR and SLR is arrived at in three steps. In the first step, return on SLR investment was calculated using 364-day Treasury Bills. In the second step, effective cost was calculated by taking the ratio (expressed as a percentage) of cost of deposits (adjusted for return on SLR investment) and deployable deposits (total deposits less the deposits locked as CRR and SLR balances). In the third step, negative carry cost on SLR and CRR was arrived at by taking the difference between the effective cost and the cost of deposits.

3) Unallocatable Overheads cost

Unallocatable Overhead Cost is calculated by taking the ratio (expressed as a percentage) of unallocated overhead cost and deployable deposits.

4] Returns on Net worth

Average Return on Net Worth is computed as the product of net profit to net worth ratio and net worth to deployable deposits ratio expressed as a percentage.

However, final lending rate for customers will be the base rate, plus the risk-cost attached to the credit rating perception of the borrower by the bank.

Where is it applicable?

All categories of loans are to be priced only with reference to the Base Rate. However, the following categories of loans could be priced without reference to the Base Rate: (a) DRI advances (b) loans to banks’ own employees (c) loans to banks’ depositors against their own deposits.

The Base Rate could serve as the reference benchmark rate for floating rate loans besides external market benchmark rates. The floating interest rate based on external benchmarks should, however, be equal to or above the Base Rate at the time of sanction or renewal

Effect analysis of Base rate system

Introducing base rate system will not only answer to the problem of transparency in the loan pricing mechanism but will also bring about effects at macro level. Here are some likely effects that we think will be brought about by introducing base rate regime in Indian banking system

Transparency in loan pricing: Banks will now arrive at the lending rates on loans and deposits with reference to base rate and by including the customer specific charges based on their credit profile. Banks are required to publish their base rates at all branches as well as on their website. Changes in base rates need to be published to general public through appropriate channels. Banks are also required to update their base rates at least every quarter. Hence these disclosure requirements of base rate system will bring about great amount of transparency as compared to BPLR system.

Effective transmission of policy rates: Banks were not effective in transmitting changes in policy rates during BPLR regime. Banks were quick to pass on policy rate hikes to borrowers while there was a lag in bringing the changes on to the deposit rates. Now with base rate, banks will reflect similar changes in interest rates on loans and advances as well as deposits, since most banks use cost of deposits in arriving at the base rate calculation. Thus there will be effective transmission of policy rates onto the banking system.

Increase in short term borrowing cost of corporate: During BPLR regime, banks used to give loans to the large, highly rated corporates at rates as low as 5% to 6%, way below BPLR. Now that the base rate has been introduced, the banks cannot lend to any borrower below its base rate which in most cases is above the rate that banks used to offer earlier to large corporates. Hence the cost of borrowing for corporates is set to go up marginally. However corporates can switch to funding their short term finances through commercial paper (CP) where the average quarterly rates have ranged from 6.35% as of June 2010 to 7.36% as of September 2010. We expect foreign banks to attract more corporate customers since they have relatively lower base rates.

Floating rate loan borrowers will benefit: Banks are required to price their loans at or above base rate and since one of the major component of calculating base rate is cost of deposits, any change in deposits rate will bring about change in the ultimate lending rates. Hence the floating rate loan borrowers will get fair share of reduction in the interest rates announced in the policy by RBI. However in case of increase in the policy rates, floating rate loans will be the first ones to be panelized. But this was the case even earlier during BPLR system of pricing loans.

Reliance on ECBs: The demand for external commercial borrowing is expected to rise since the interest changed on such borrowings is lower than base rates of most of the banks.

Rupee exchange rate: As the demand for ECBs are expected to rise, this will have a triggering effect on the rupee depreciating in the currency exchange market against US dollar. Although not to a large extent but ECBs will be one of the contributing factors in rupee depreciation. Rupee depreciation will help to improve exports to some extent and thus narrowing down the current account deficit.

Conclusion

One of the main reasons of introducing Base rate system by RBI was to effectively transmit the changes in policy rates on to the end customers of the banks. Banks were clinical in passing the rate changes announced by the RBI on to the deposit holders but there was always a time lag in implementing same change on to the borrowings, especially during the rates hike. Therefore with new base rate regime, we expect better transmission of policy rates and a fair pricing of loan products will be made.

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