The introduction of a base rate mechanism that will set the floor for lending rates is hardly the seminal event it has been made out to be. Nor does the cluster of announcements by leading banks of their base rates give an indication of what the general level of lending rates will be after the new system settles down. The base rate mechanism is the same as the Prime Lending Rate (PLR) system that was in vogue in the early 1990s. The PLR mechanism was diluted over time, with too many categories of borrowers exempted from its purview. By 2001, it had become a mere reference rate, a far cry from what it was intended to be. There is a danger that the new system will meet a similar fate. For now, however, the Reserve Bank of India's directive to banks seeks to ensure transparency and uniformity in the methodology of calculating the base rate. Only a small number of borrowers — staff members, those availing of loans under the differential interest rate schemes, and a few other categories — will be charged rates that will be lower than the ones arrived at through the base rate method. The base rate will be calculated by each bank taking into account the cost of funds, possible loss incurred due to the reserve requirements, administrative costs, and the profit element. The actual rate to a borrower will be the base rate plus borrower-specific charges, product-specific operating costs, and premia on account of credit risks and tenure.
The point is that even though the base rates announced recently are in the region of just 7.5 to 8.25 per cent, they will not necessarily translate into lower borrowing costs. The chief merit of the new system is that it will make it difficult for top-rated customers to arm-twist banks to lend to them at rates well below the benchmark. That widely prevalent practice was regressive: small and medium borrowers were charged higher interest rates, thus subsidising the larger ones. The old system stood in the way of an orderly transmission of monetary policy signals. There is no guarantee that the new base rate system will not be circumvented by banks and their borrowers. However well laid down, it will be impossible to do away with subjectivity while calculating the final lending rates. Banks can be persuaded by their borrowers to subscribe to their commercial paper issue and thereby get funds at lower costs. As disintermediation gathers pace in the financial sector, banks will be facing greater competition from other intermediaries who may not be bound by central bank rules.