Base Rate System

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”.

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 centre stage in the previous era was Base Prime Lending Rate (BPLR). BPLR indicated the rate of interest at which banks lent to favoured 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.

This is the illustrative methodology released by RBI for computation of Base Rate:

Negative carry on CRR and SLR balances arises because the return on CRR balances is nil, while the return on SLR balances (proxied using the 364-day Treasury bill rate) is lower than the cost of deposits.

Unallocatable overhead cost for banks could include aggregate employee compensation relating to administrative functions in corporate office, directors’ and auditors’ fees, legal and premises expenses, depreciation, cost of printing and stationery, expenses incurred on communication and advertising, IT spending and cost incurred towards deposit insurance.

The Base Rate 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 have 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:

• This could usher into a era of interest rates that are set by scientific methods which was not the case with BPLR
• An effort has been made towards transparency in the interest rate calculation for the loans i.e. the credit spread above the Base Rate which could be different for different types of customers will have to be calculated in a transparent manner.
• Cross-subsidization as evidenced from the SMEs paying higher interest rates to compensate for the low rates of blue chip firms has finally 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).
• This system can also lead to innovation in the fixed income markets with products being designed to suit the needs of the lenders and borrowers

But even BRS has its share of doubts and concerns:

• The banks can still provide benefits to the large borrowers by say paying higher interest rates on their deposits though large borrowers would normally not keep high deposits as loan interest rate will always be higher than deposit rates.
• 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.
• Segments which are perceived as more risky may see their effective lending rates going up.
• Excluding the agri-loans, loans to banks’ own employees, loans against deposits from the purview of BRS is a dampener
• The announced base rates expose the cartelization of banks else how come most banks have the exactly same base rates or the difference being in multiples of 25 basis points?

So, the road ahead for the Base Rate would be to link it apart from the fully covered cost plus rate, to a benchmark rate like 5YR sovereign Bond Rate. Now, both will be dynamic as the rates would be monthly reset and it would take into account all possible costs a Bank can incur for running its business. This would be a big improvement from the past regime as BPLR did nothing of the sort and the method was also not known to public. This would make the system scientific. As macroeconomic indicators could have a more pronounced and immediate impacts on the lending rates now so dynamic regulations would be the need of the hour.

As Mr. G.C. Nath, Sr. V.P., CCIL (Clearing Corporation of India) while sharing his insights on BRS says, “Daily revision of Base rates is not 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 fine as it maps with the policy announcements.” So we may continue with quarterly revision of Base Rates in near future as well. Though the trade-off remains as a one-year cost might not have reflected the current cost while a three-month cost may not reflect the historic cost.

Mr. Nath adds that roll over (reinvesting funds from a mature security into a new issue of the same or a similar security) cost of average CP/CD could be very high as they have a life cycle of 3 months. So, a banker has to find a loan customer if it wants to survive competition.”

With banking having an oligopolistic structure and their business dealing in homogeneous products, most banks offer the same kind of rates for deposits – a few bps here and there. Also due to competition, banks also try to keep the customers with them. The customers compare rates across banks and then bargain with banks for the best rate. So, cartelizations of banks say they forming groups like PSU banks, foreign banks, private banks, co-op banks, etc. and developing some kind of informal structure to deal with various issues could still be the norm.

So whether BRS will be the dawn of a new era or will it prove to be an exercise in futility? For now it would be safe to say that “Only time will tell.

- Saket Saurabh

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