Monetrix The Finance and Economics Club of MDI

Gyaan@ Finstreet Base Rate

Monetrix The Finance and Economics Club of MDI

Base Rate

List of Contents: Snapshot Base Rate History (BPLR) Reasons for change to Base Rate Effect on banks lending rate Effect on Home loan & retail borrowers Effect on Big Corporates Effect on small borrowers Effect on profitability of banks Effect on NBFCs Some Contentious Issues

Snapshot - RBI stipulates that banks cannot charge below the base rate for loans effective 1st July, 2010, replacing the benchmark prime lending rate regime. This shift is primarily to increase the transparency in banks lending rates and to have an effective transmission of monetary policies which were ineffective earlier because of the subBPLR lending of banks to big corporates. The shift to base rate regime will see fairer interest rates charged for the high volume, short term loan seekers and will give better bargaining powers for the small borrowers like SMEs. Floating home loan borrowers will have an immediate effect with changing base rates. All new loans will be based on the base rate while an earlier customer has an option to shift to base rate from the BPLR. This change is going to affect the Non-Banking Financial Companies (NBFCs) by increasing their borrowing rates.

Monetrix The Finance and Economics Club of MDI BASE RATE The Reserve Bank of India (RBI) announced that banks will have to determine their lending rates with reference to the base rate effective 1 July 2010. RBI has stipulated that banks cannot charge below the base rate for most loans (there are a few exceptions like agricultural loans, export credit and loans to employees). Additionally, the base rate will have to be reviewed at least once every quarter with the approval of the board or the asset liability management committees (Alcos), as per the banks practice. The central bank has given banks freedom to use any methodology to compute the base rate, or the minimum below which they will not be permitted to lend money, provided it is consistent and is available for supervisory review or scrutiny, when required. The new reference rate for country's largest bank SBI is 7.5 per cent. Most of the other public sector banks have the base rate at 8 per cent. These include, IDBI Bank, Indian Bank, Bank of Baroda, Allahabad Bank and Punjab National bank. HDFC Bank has set the rate at 7.25 per cent. ICICI and Axis bank have set their base rate at 7.5 per cent, same as that of SBI. HISTORY: The so-called base rate is a new concept that will replace the current benchmark prime lending rate (BPLR) in an attempt to improve transparency in banks lending rates and to enable better assessment of transmission of monetary policy. Though BPLR is meant for banks most creditworthy customers, typically 70% of loans are given below that rate. Banks kept BPLR artificially high because both small loans to farmers and small industries as well as export loans were linked to it. When the prime rate goes down, the rates on these loans also decline, which would dent banks earnings more than if loans were at BPLR. The central bank has also withdrawn the current stipulation of BPLR as the ceiling rate for loans up to Rs2 lakh. Since banks will now not be able to lend below their respective base rates, the move will end the proliferation of lending below the benchmark prime lending rates (BPLR), which accounts for 70 per cent of bank loans. REASONS FOR CHANGE TO BASE RATE Transparency: Unlike the BPLR that was set somewhat arbitrarily by banks, the base rate will follow an explicit formula that factors in a bank's cost of deposits, operating costs (expenses of running its branches, for instance), the cost of statutory drafts on bank funds imposed by the Reserve Bank of India (the Cash Reserve Ratio and Statutory Liquidity Ratio) and the profit margin. The base rate will help borrowers to compare interest rates offered by various banks and make the process of how banks arrive at interest rates for loans more transparent.

Monetrix The Finance and Economics Club of MDI Assessment of transmission of monetary policies: From a monetary policy perspective, a transparent basis for credit pricing should make the transmission of policy impulses to actual lending rates more efficient. It would at least provide a better gauge of whether monetary policy changes are making a difference to borrowing and lending rates on the ground. Avoid heavy subsidies: Some would argue that banks subsidised the low-cost loans to their prime borrowers by charging hefty rates from smaller, riskier borrowers small and medium enterprises and households, for example. Those who argue this claim that once banks are forced to price loans in line with their costs, these subsidies are likely to disappear and the segments that arguably need the money the most are likely to get fairer rates. Prevent Predation: The other thing that the base rate could prevent to a degree is what regulators term predation the phenomenon of large banks dropping loan rates way below costs to grab market share. There have been recent instances of predation in retail credit markets breeding the risk of credit bubbles building up on the back of these exceptionally cheap loans. EFFECT ON BANK LENDING RATE: According to an IBA (Indian Bankers Association) official, 60 per cent member banks reported no change in effective rates pre and post base rate regime. IBA has 159 members. For example, if the effective lending rate was 10 per cent for a BPLR of 12 per cent, it will be base plus two per cent if the base rate is eight per cent. The categories which saw a change in the lending rates are the SME category and the short term lending rates to big corporates. Some banks effective rates for small and medium enterprises were lower in the base rate regime. The short term lending rates for the highly rated companies has gone up. EFFECT ON HOME LOAN & RETAIL BORROWERS The introduction of base rate will ensure that Floating rate home loan borrowers struck on higher base rates, will see automatic rise and fall in their existing rates. Another good news is that the Reserve Bank of India has asked banks not to charge any fee for shifting from prime lending rate to base rate. Importantly, even though banks are going to charge a fee - in excess of 1.5 per cent in most cases - for renegotiating the loan, it could still make sense in doing so. Once you have shifted to the latest rate, this along with the linkage with base rate will ensure that future costs are saved.

Monetrix The Finance and Economics Club of MDI But not all home loan customers would benefit linking their loans to the new benchmarking system. For an existing borrower, there are some situations in which they will benefit by shifting. In other cases, it may not make much difference. It is important to analyse the rates at which the loan was taken and the remaining period of repayment. For example, if you have taken a teaser loan just few months back, it would still make sense to stick to it. The borrowers need to do their math and compare the advantages of BPLR vis a vis base rate. If they have more than three years to repay the loan and they are still saving money on the EMI (through tax savings), then it makes sense to go for the base rate. However, only home loan rates will be impacted by the shift to base rate regime. All other retail loans, like auto and personal, are given at fixed interest rate. Bottom line: Shift to base rate anyway. Because it will ensure that you get the advantage of loan rate fluctuations. As far as renegotiations go, it would be a decision based on the tenure that is remaining, and your finances. EFFECT ON BIG CORPORATES In fact, banks' blue-chip corporate borrowers could see some increase in their cost of borrowing. The reason is somewhat simple. RBI allowed banks to lend below their prime lending rates and the majority of banks did the bulk of their corporate lending at 'subPLR rates'. The best 'credits' for a bank could drive the hardest bargains. This led to peculiar situations in which a bank whose official BPLR was in the range of 14-16 per cent was found lending to its best customers way below its costs at 5-6 per cent. (Source: Business Standard). The incentive for this 'irrational' pricing was to keep the ratio of non-performing assets low, particularly in the wake of the global financial crisis when banks' risk appetite waned and safety got precedence over margins. The base rate regime does away with this. EFFECT ON SMALL BORROWERS: Since the new system would be transparent and the base rate would be publicly available, SMEs with healthy credit profiles would be able to negotiate for better rates with banks. The final interest rate charged to borrowers, under the base rate regime, would be a function of the base rate plus borrower-specific charges, which would include product specific operating costs, credit risk and loan tenure.

Monetrix The Finance and Economics Club of MDI The new regime would see an increased credit flow to small borrowers also because of the fact that the earlier stipulation of BPLR as the ceiling rate for loans up to Rs 2 lakh would be withdrawn. The greater transparency and increased competition would result in average yield on banks advances declining by 10-15 basis points (bps) over the next two years (for SME sector). EFFECT ON PROFITABILITY OF BANKS: The base rate regime will spur competition among banks but is unlikely to impact their overall profitability, according to ratings agency Crisil. Banks with competitive base rates and efficient treasury operations are well placed to benefit from the new scenario. However, competitive pressures were unlikely to impact the overall profitability of the banking system materially, Crisil said. Banks have the flexibility to control other loan-pricing elements, including tenor and credit risk premiums, and product-specific operating costs. This will provide them some cushion to protect interest spreads. Highly-rated companies availing of short-term loans (estimated at 7 to 10 per cent of total corporate loans) will have to shell out more and look to transit to the more attractive debt capital markets (through short-term instruments) and choose banks with lower base rates. Crisil Ratings believes that large private sector banks with more competitive base rates are, therefore, now relatively better placed to garner market share in the short-term corporate lending space. However, public sector banks with superior treasury operations could partially offset competitive pressures in the short-term lending segment by subscribing to the debt market issuances of corporates. Bill discounting activity, in which a bank buys the bill before it is due and credits the value of the bill after a discount charge to the customer's account, is shifting to private banks. This is because the discount rate is lower than the base rate of most public sector banks. Public sector banks, led by State Bank of India, have requested the Reserve Bank of India to keep bill discounting outside the base rate regime. The regulator, however, sees no merit in the request.

EFFECT ON NBFCS (Non-Banking Financial Companies) With most public sector banks setting their base rate at 8 per cent, non-banking finance companies (NBFCs) say their borrowing costs are likely to rise by up to 100 basis points (bps).

Monetrix The Finance and Economics Club of MDI However, NBFCs, which compete with banks in certain sectors but rely on term loans from banks for a bulk of their funding needs, say they will look at alternative sources of funds such as CPs (commercial papers) before taking a call on raising lending rates. Most public sector banks have set their rate at 8 per cent. At present, the NBFCs are on term loans of around 7 per cent with an annual reset. Hence, when these loans come up for reset, the dependence on CPs is going to increase which in turn would harden the rates of CPs and borrowing cost anyways is likely to go up. Difference between NBFCs & Banks NBFCs perform functions similar to that of banks; however there are a few differences: (i) an NBFC cannot accept demand deposits; (ii) an NBFC is not a part of the payment and settlement system and as such an NBFC cannot issue cheque drawn on itself; and (iii) deposit insurance facility of Deposit Insurance and Credit Guarantee Corporation is not available for NBFC depositors unlike in case of banks. SOME CONTENTIOUS ISSUES: BPLR is here to stay: Banks may have to pursue a dual-rate system for many more years because the regulator is not inclined to accept their demand to set a deadline for the conversion of loans linked to the benchmark prime lending rate (BPLR) to the new base rate regime. The original plan was to continue with BPLR for existing borrowers for one year and then have them migrate to the base rate with a sunset clause. In public policy, a sunset clause is a provision that terminates or repeals all or portions of an existing arrangement after a specific date. However, because all loans are contracts between banks and their customers, the Reserve Bank of India (RBI) cannot enforce such a clause for BPLR-linked loans. Most long-maturity loans such as mortgages and infrastructure loans are linked to BPLR. If these borrowers do not voluntarily migrate to the base rate system, banks will have to continue to keep the BPLR regime. About 80-90% of loans are linked to BPLR. This is a huge operational issue. The continuation of BPLR may not have a significant impact on the cost of funds for borrowers because there is not much of a difference between the effective interest rate under both BPLR and the base rate regimes. But banks will be burdened with additional work to administer a dual-rate system. According to RBI guidelines, existing BPLR loans can be shifted to the base rate when a loan reaches the reset or maturity date or if the customer opts for it. All new loans will have to follow the base rate system.

Monetrix The Finance and Economics Club of MDI Bankers pitch for allowing sub-base rate lending: Banks led by State Bank of India (SBI) have made a pitch to the Reserve Bank of India (RBI) to permit them to lend below the base rate, at least for short-term loans with duration of a few days. Earlier, a large AAA-rated company was availing loan for 4.5-5 per cent for tenure as short as seven days. Now, they are not ready to pay 7.5-8 per cent for the same product. The banks feel that lending to a borrower even for a few days is better than parking surplus funds with the central bank through the reverse repo route. RBI on its part does not appear keen to provide further relaxations to the scheme at the moment. Other grey areas: It is unclear how loans given at concessional rates to industries that are being restructured or rehabilitated would be treated. The base rate mechanism leaves out government borrowings, which plays a crucial role in determining interest rates. According to the industry chamber Assocham, the base rate mechanism should also cover non-banking finance companies (NBFCs), cooperative banks and regional rural banks (RRBs).