The transition from non-transparent Benchmark Prime Lending Rate (BPLR) to a transparent base rate of banks from July 1, 2010, would herald a new era in the lending space.
Borrowers had always looked at the BPLR to know their interest payments though it revealed very little to the borrowers about the actual rate. But over a period its importance had vanished as there was a complete confusion on how it was calculated.
While a major public sector bank, State Bank of India, and private sector bank, ICICI Bank, fixed their base rates at 7.5 per cent, other banks fixed it around 8 per cent. The clarity in the interest scenario had always been a concern for the central bank. It always found that the banks failed to adapt the signals on rates given by the central bank from time to time.
The monetary transmission mechanism in India has been improving but is yet to fully mature, said D. Subbarao, Governor, Reserve Bank of India, while speaking on ‘India and the global financial crisis: transcending from recovery to growth' at an event held at the Peterson Institute for International Economics, Washington DC, last April.
Transmission process
While explaining various factors inhibiting the transmission process, Dr. Subbarao said “It should be recognised that the clogs in monetary transmission in India are possibly exaggerated because of the current system of loan pricing. Banks are required to declare a benchmark prime lending rate (BPLR) but they enjoy the freedom to lend at rates below their BPLR. Over time, sub-BPLR lending has become a rule rather than an exception. Currently, about two-thirds of bank lending takes place at rates below the BPLR. As many interest rates are indexed to the BPLR, banks have been reluctant to adjust their BPLRs in response to policy rate changes as changes erode their discretionary flexibility in pricing the loans. The BPLR system has, therefore, become an inadequate tool to evaluate monetary transmission.”
Improving monetary transmission is important if the RBI's efforts at promoting growth with price stability are to be effective.
According to Dr. Subbarao, an important reform initiative post-crisis has been the replacement of the BPLR system by a new base rate (BR) system, which came into effect on July 1.
The BR will set the floor for all lending rates. Concurrently, interest rate ceiling on export credit and small loans up to Rs. 2 lakh has been withdrawn making deregulation of lending rates complete.
“The new system is expected to be transparent, fair, and contestable and will help in improving monetary transmission to credit markets.”
In April 2004, the then RBI Governor Y. V. Reddy had asked industry body Indian Banks' Association (IBA) to come up with a transparent calculation of the BPLR. Giving a policy update at a book release function in New Delhi, Dr. Reddy had said: “We have also encouraged banks to be more transparent on their interest rates.”
In October 2005, the RBI again stated that the BPLR system might be reviewed and transparent guidelines issued for appropriate pricing of credit. “There is a public perception that there is under-pricing of credit for corporates, while there could be over-pricing of lending to agriculture and SMEs.”
Till the late 1980s, the interest rate structure in India was largely administered in nature and was characterised by numerous rate prescriptions for different activities, and borrowers were charged different rates for the same loan amount, thereby distorting the structure of lending rates.
On account of the complexities under the administered rate structure, efforts since 1990 have been made to rationalise the interest rate structure so as to ensure price discovery and transparency in the loan pricing system. The process of rationalisation culminated in almost complete deregulation of lending rates in October 1994. The freeing up of lending rates of scheduled commercial banks for credit limits of over Rs. 2 lakh along with the introduction of PLR system in 1994 was a major step in this direction aimed at ensuring competitive loan pricing.
Public perception
The system of BPLR introduced in 2003 was expected to serve as a benchmark rate for banks' pricing of their loan products so as to ensure that it truly reflected the actual cost. However, the BPLR system has fallen short of its original objective of bringing transparency to lending rates.
Competition has forced the pricing of a significant proportion of loans far out of alignment with BPLRs and in a non-transparent manner, undermining the role of the BPLR as a reference rate.
There was also widespread public perception that the BPLR system had led to cross-subsidisation in terms of underpricing of credit for corporates and overpricing of loans to agriculture and small and medium enterprises.
The annual policy statement 2009-10 noted that since bulk of the bank loans were lent at sub-BPLR rates, the system of BPLR evolved in such a manner that it had lost its relevance as a meaningful reference rate. Lack of transparency in the BPLR system also caused impediment to the effective transmission of monetary policy signals.
In view of the concerns pertaining to the shortcomings in the BPLR system raised by the public and those recognised by the Reserve Bank, the annual policy statement of 2009-10 announced the constitution of a working group on BPLR to review the BPLR system and suggest changes to make credit pricing more transparent.
While discussing the need to replace the present BPLR system with the base rate system, the group, under the Chairmanship of Deepak Mohanty, Executive Director, RBI, stated that, “after carefully examining the views expressed by trade and industry associations and others and international best practices, the group is of the view that there is merit in introducing a system of base Rate. The proposed base rate will include all those cost elements which could clearly be identified and are common across borrowers.”
In order to make the lending rates responsive to the Reserve Bank's policy rates, the group recommends that banks may review and announce their base rates at least once in a calendar quarter with the approval of their boards. The base rates alongside actual minimum and maximum lending rates may be placed in public domain.
It is possible that some banks charge unduly high product-specific operating expenditure, credit risk and term premia from some borrowers. In order to avoid such unhealthy practices, banks should continue to provide information on lending rates to the Reserve Bank and disseminate information on the base rate. In addition, banks should provide information on the actual minimum and maximum interest rates charged to borrowers.
Debt market
Market participants believe that introduction of the base rate mechanism will enhance competition in the short-term lending space. Issuance volumes in the debt capital markets are also likely to increase as highly rated corporates begin to shift towards these markets. Banks with competitive base rates and efficient treasury operations are well placed to benefit from the new scenario. However, competitive pressures are unlikely to impact the overall profitability of the banking system materially.
“We believe that the highly rated corporates availing short-term loans (estimated at 7-10 per cent of total corporate loans) will look to transit to the more attractive debt capital markets (through short-term instruments) and choose banks with lower base rates.” said Pawan Agrawal, Director, Crisil Ratings.
In the long-term lending space, however, a material shift in market share is unlikely: According to Crisil Ratings, banks will set lending rates that are near the current levels. However, corporates with strong credit risk profiles and high ratings will be better placed than others to negotiate rates with the banks. “Ratings may become strong differentiators for corporates over the near to medium term”, adds Mr. Agrawal.
Despite the expected increase in competition in the short-term lending space, implementation of the base rate system is unlikely to have a significant impact on banks' interest spreads. “Banks have flexibility to control other loan-pricing elements, including tenor and credit risk premiums, and product-specific operating costs. This will provide banks with some cushion to protect their interest spreads.” said Suman Chowdhury, Head, Crisil Ratings. According to a recently published report from Crisil Research, the average yield on bank advances is expected to decline by 10-15 basis points over the next two years.
