Lassoing the lenders

On April 1, the All Fools Day, country’s central bank — the Reserve Bank of India (RBI) — will start a new interest rate system for commercial banks that will make borrowers wiser and also happier.

The RBI has issued a draft guideline, which will take effect from April 1, 2010, paving the way for ‘base interest rate’ replacing the present system of benchmark prime lending rate (BPLR), which forms the basis of fixing interest rate now.

The base rate for lending will be worked out after accounting for the cost of deposits — savings as well as term deposits, cost of money kept with RBI as CRR (cash reserve ratio), cost of money set aside for SLR (statutory liquidity ratio), the administrative and manpower cost and profit margin.  In short, the base rate will be inclusive of all cost plus a reasonable profit. As per the new system banks will have to make it public the base rate and the calculation of it. It is expected that the base rate for banks may vary between 8 to 10 per cent.

Why change?

The new method certainly is more scientific and transparent compared to the present system of BPLR which gets fixed arbitrarily by banks depending on the supply-demand conditions of funds. The change also became necessary because BPLR has become meaningless as bulk of bank loans, as much as 60 per cent according to estimates, is below the BPLR which varies between 11 and 15 per cent.

To keep the credit risk at minimum, banks prefer to lend money to good corporates having high credit rating. They also fund new projects promoted by well known names. Since such companies or projects enjoy low risk, they always command discounts on prime lending rates. In fact, some companies get money below the cost price at BPLR minus 500 points or at around 8 per cent when the BPLR is 13 per cent.

While not-so-lucky borrowers, mostly midsize companies not aided by a strong balance sheet are charged at rates much higher than the BPLR. So the underlying loan pricing mechanism is — higher the risk, higher the rate and vice versa. Another interesting implication of the present system is that weaker companies, small businesses, farmers are subsidising for the low interest cost of large corporates.

Back to basics

 Yet another reason for the change is that the present BPLR system does not respond quickly and adequately to the changes in the policy rates initiated by the central bank. When RBI changes bank rate, banks take long time to adjust their lending rates, making RBI’s monetary policy less effective.  Will the new base rate system be a panacea for all ills? It is rather too early though to be affirmative. The general consensus  is that it will bring in a great deal of transparency as also certain amount of discipline in competitive loan pricing.

First of all, the new system, hopefully, will address the fundamental issue of economic pricing where cost plus a reasonable profit should be the basis. Will banks be able to load fictitious costs to claim higher base rate? It is highly unlikely because all banks produce and submit audited financial figures quarterly and annually to RBI and Sebi & stock exchanges (if listed) and any divergence from the published figure can be easily detected.

Changing over to a base rate system will affect different class of borrowers in a dissimilar way. Important factors influencing the effective rates will depend on the risk profile, tenor of loan and the end use.

Home and auto loans: It is unlikely that the home and car loan rates will be cheaper under the new system. Under the present system banks have different BPLR for home and auto loans and the same may continue in future. Since such retail loans are given to individuals based on their credit worthiness, banks will factor in credit risk and charge a rate above the base rate. How much more is yet to be announced.

Big borrowers: Under the present system big and high credit worthy borrowers are kings. Chased by banks, not the other way, such borrowers bargain hard to extract maximum possible discount on BPLR from banks. Now the banks’ freedom to offer discounts will be considerably reduced because minimum they will have to charge is the base rate. But it is yet to be seen if banks will find some way to palm off indirect concessions.

Small borrowers: Companies with lower credit ratings and small and medium businesses will benefit under the new system. At present they are generally fleeced by banks by way of higher interest rates in the garb of high credit risk.  Under the new system also banks will charge risk premium to the relatively weaker borrowers, but if the interest rate is too high from the base rate they will find it hard to justify. Transparency in calculation may arm weaker borrowers to contest unrealistic high rates.

Question marks

The RBI’s draft regulation is now open to discussion and also needs clarifications on some points. Banks and borrowers must know how frequently the base rate will and can be changed. How will the change get reflected in long term borrowing?

Will the base rate be allowed to reflect the liquidity situation in the money market? If the demand for money exceeds supply creating tight liquidity, will banks be allowed to reset base rate higher? Similarly, for short term loans, say for loans less than one year, banks should be allowed to offer discounts on base rate because in such cases risk premium is extremely low. Hopefully, all these doubts will be cleared once the new system starts.