Higher levels of transparency can be achieved by disclosing important information on loan pricing and possible fees to the borrower before he or she signs an agreement.

“Transparency” was the key word when the Reserve Bank of India (RBI) freed the interest rates from a regulated regime from April 2010. The newly introduced Base Rate is expected to be significantly lower than the prevailing Benchmark Prime Lending Rate (BPLR) and thus the beneficiary would be individual borrowers.

In a notification to all scheduled commercial banks, the RBI stated that the Base Rate system will replace the BPLR system with effect from April 1, 2010. Banks may determine their actual lending rates on loans and advances with reference to the Base Rate.

Deregulation

“It is expected that deregulation of lending rates will increase the credit flow to small borrowers at reasonable rate. Thus, direct bank finance will provide effective competition to other forms of high-cost credit,” RBI noted in its guideline to all banks.

Base Rate would include all those elements of the lending rates that are common across all categories of borrowers. While each bank may decide its own Base Rate, some of the criteria that could go into the determination of the Base Rate are: (i) cost of deposits; (ii) adjustment for the negative carry in respect of CRR and SLR; (iii) unallocatable overhead cost for banks such as 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; and (iv) profit margin.

The actual lending rates charged would be the Base Rate plus borrower-specific charges, which would include product-specific operating costs, credit risk premium and tenor premium.

“All categories of loans should henceforth be priced only with reference to the Base Rate,” the RBI noted. The Base Rate could also serve as the reference benchmark rate for floating rate loan products apart from other 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.

Since the Base Rate will be the minimum rate for all commercial loans, banks are not permitted to resort to any lending below the Base Rate. Accordingly, the current stipulation of BPLR as the ceiling rate for loans up to Rs. 2 lakh stands withdrawn.

Interest rates on loans under the Differential Rate of Interest (DRI) scheme will continue to be fixed without reference to the Base Rate. The Reserve Bank will separately announce the stipulation for export credit. Under the DRI scheme, weaker sections of society are provided small loans at an interest rate of 4 per cent annually.

Since transparency in the pricing of lending products has been a key objective, banks are required to exhibit the information on their Base Rate at all branches and also on their websites. Changes in the Base Rate should also be conveyed to the general public from time to time through appropriate channels. Banks are required to provide information on the actual minimum and maximum lending rates charged to major categories of borrowers to the Reserve Bank on a quarterly basis. Apart from transparency, banks were asked to ensure that interest rates charged to customers in this new arrangement are non-discriminatory in nature.

The Base Rate system would be applicable for all new loans and for those old loans that come up for renewal. However, if the existing borrowers want to switch to the new system before the expiry of the existing contracts, the new/revised rate structure should be mutually agreed upon by the bank and the borrower. Interestingly, few days back, the RBI sought clarification from the Indian Banks Association (IBA) whether the existing borrowers were getting the benefit of reduced home loan rates. At present, the reduced interest rates did not apply for existing borrowers. An empirical exercise carried out to ascertain the responsiveness of BPLR to the changes in the Reserve Bank’s policy rates (repo rate) between the first quarter of 2004 and the first quarter of 2009 suggests a mixed picture across the bank groups and interest rate cycles. An increase in the repo rate was observed to bring about a contemporaneous change in BPRLs of private sector banks and major foreign banks and a lagged response in the case of public sector banks. A reduction in the repo rate had a significant contemporaneous impact only in the case of public sector banks.

“This asymmetric response shows that while public sector banks were slow to respond to an increase in policy rate, they were quick on the reverse. This could be attributed to the ownership structure of public sector banks which makes them more amenable to moral suasion by the authorities,” stated the report of the working group on BPLR.

Another issue that is often raised is the asymmetric downward stickiness of the BPLRs. This not only raises an issue of equity but also results in poor transmission of monetary policy in credit markets.

For instance, during the monetary policy tightening phase (March 2004 to September 2008), it has been observed that while banks were often quick in raising lending rates during an upturn in the interest rate cycle, they were slow to bring down the interest rate in the downturn of the interest rate cycle.

Representations

The Reserve Bank has received several representations on the arbitrariness of resetting the lending rates on loans and the benchmark rates used for pricing floating rate products. Many banks charge lending rates with reference to benchmarks which are internal and non-transparent.

In addition, provisions on conditional resetting interest rates are placed as ‘force majeure’ in loan covenants, thereby making the terms of contract non-transparent for the borrower. This practice has added further opaqueness in the setting of lending rates since the re-pricing is generally arbitrary and not with reference to transparent publicly known benchmarks.

Given the large proportion of sub-BPLR lending by the banking system, concerns have been raised on the transparency aspect of computation of BPLRs. Competition had forced the pricing of a significant proportion of loans far out of alignment with BPLRs and in a non-transparent manner. As a consequence, this had undermined the role of the BPLR as a reference rate.

Sub-BPLR lending on a large scale has created a perception that large borrowers are being cross-subsidised by retail and small borrowers. Furthermore, there was a public perception that there was under-pricing of credit for corporates while there could be overpricing of lending to agriculture and small and medium enterprises. The latest available information as at end-March 2008 (based on the BSR data) suggests that loans to individual borrowers are generally — other than for housing purposes — in the high interest rate range at 14 per cent and above.

Transparency in bank lending is understood as bank lending practices with appropriate information disclosures that ensure that the borrowers clearly understand the terms and conditions.

Higher levels of transparency can be achieved by disclosing important information on loan pricing and possible fees to the borrower before he or she signs an agreement.

Transparency also implies that banks must not indulge in irresponsible lending by having hidden additional costs and unexpected rate increases, the possibility of which is not made known upfront to the borrower. It should be ensured that all charges and possibility of increases are made clear to the borrower at the beginning of the agreement.

The existence of a benchmark rate, to which various loans are tied to, is a crucial component in attaining transparency in loan pricing.

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