Jun 29, 2010|
The why and how of 'base rate' in Indian banking
The verdict is out. The country's largest bank SBI has decided to not lend below 7.5% interest rate going forward. In other words, the much awaited 'base rate' for the banking system will have to take off from here.
For investors to understand why this new rate needs to exist and how can it affect them, here we have some explanations. The base rate was proposed to take care of three necessities.
- Ensure that monetary policy signals are conveyed to the real side of the economy without much lag and distortion.
- Ensure improved flow of credit at a reasonable price to small borrowers, instead of them subsidising large corporate borrowers.
- Make pricing of bank loans more transparent.
To make it even simpler, the base rate was born out of the RBI's own failure to restrict sub-PLR (prime lending rate) lending. This had been emerging as a serious systemic risk. While banks were lending to small borrowers above the PLR rate - say 10%, the large companies got away with much cheaper loans. This was due to their bargaining power with the banks. Try as it might, the RBI did not see higher interest rates flowing down to the AAA rated companies.
In some cases these companies fetched loans at nearly 3% below PLR almost eroding the spread that the bank was expected to earn in the transaction. Only the less fortunate borrowers bore the brunt, thus impacting consumption and credit demand. Further, every bank had a different mix of above PLR and sub-PLR lending. Hence it was difficult for the regulator to figure out which bank was taking how much undue risk. The 'base rate' is expected to address all these issues.
Now coming to how the base rate is arrived at. The RBI has asked banks to fix the base rate, below which they will not be allowed to lend taking into account three factors. These are the bank's minimal spread, transaction cost and risk involved. However apart from this, banks are also likely to devise the rate keeping in mind the necessity to keep their large borrowers happy. After all most of them would not want to pay a substantially higher interest rate. Thus, in all chances, the base rate might only replace the PLR.
Further, the base rate will have its own set of problems. The most obvious one is that it will steal the banks' operational flexibility from them. Banks will thus be unable to tweak their pricing power depending upon market conditions. More so when interest rates are headed lower.
Also, if the credit demand from large companies were to dry up, banks will have to depend on treasury income for a large portion of their revenues. This may again subject them to the vulnerability of short term movement in interest rates. And the tendency to carry higher risk will also be acute to make up for the loss of revenue.
Thus the base rate is just the beginning and not the end to anomalies in risk pricing. While the SBI's rate may serve as guidance to the smaller entities, we doubt if there would be many toeing on its line. Also, the base rate may after all end up one of the many rates that banking players are already saddled with. Bank rate, repo rate, reverse repo rate, CRR, SLR are just few of them.
More Views on News
Aug 10, 2017
IDFC Bank is taking steps to address contracting NIMs and successfully transition in to a retail bank.
Aug 10, 2017
Asset quality will be the key thing to watch out for going forward.
Jul 31, 2017
Almost 74% of the watchlist as provided by the bank of Rs 226 billion in FY16 has turned into non-performing assets.
Jul 6, 2017
Does the stock score on the value versus price equation?
Jun 27, 2017
Should one subscribe to the IPO of AU Small Finance Bank Ltd?
More Views on News
Aug 7, 2017
The data tells us quite a different story from the one the government is trying to project.
Aug 10, 2017
Don't miss these proxy bets on growing companies or in a few years you will be looking back with regret.
Aug 8, 2017
Bharat-22 is one of the most diverse ETFs offered so far by the Government. Know here if you should invest...
Aug 12, 2017
The India VIX is up 36% in the last week. Fear has gone up but is still low by historical standards.
Aug 7, 2017
Raksha Bandhan signifies the brother-sister bond. Here are 7 thoughtful financial gifts for sisters...
Copyright © Equitymaster Agora Research Private Limited. All rights reserved.
Any act of copying, reproducing or distributing this newsletter whether wholly or in part, for any purpose without the permission of Equitymaster is strictly prohibited and shall be deemed to be copyright infringement. LEGAL DISCLAIMER:
Equitymaster Agora Research Private Limited (hereinafter referred as 'Equitymaster') is an independent equity research Company. Equitymaster is not an Investment Adviser. Information herein should be regarded as a resource only and should be used at one's own risk. This is not an offer to sell or solicitation to buy any securities and Equitymaster will not be liable for any losses incurred or investment(s) made or decisions taken/or not taken based on the information provided herein. Information contained herein does not constitute investment advice or a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual subscribers. Before acting on any recommendation, subscribers should consider whether it is suitable for their particular circumstances and, if necessary, seek an independent professional advice. This is not directed for access or use by anyone in a country, especially, USA or Canada, where such use or access is unlawful or which may subject Equitymaster or its affiliates to any registration or licensing requirement. All content and information is provided on an 'As Is' basis by Equitymaster. Information herein is believed to be reliable but Equitymaster does not warrant its completeness or accuracy and expressly disclaims all warranties and conditions of any kind, whether express or implied. Equitymaster may hold shares in the company/ies discussed herein. As a condition to accessing Equitymaster content and website, you agree to our Terms and Conditions of Use, available here
. The performance data quoted represents past performance and does not guarantee future results.SEBI (Research Analysts) Regulations 2014, Registration No. INH000000537.
Equitymaster Agora Research Private Limited. 103, Regent Chambers, Above Status Restaurant, Nariman Point, Mumbai - 400 021. India.
Telephone: +91-22-61434055. Fax: +91-22-22028550. Email: email@example.com. Website: www.equitymaster.com. CIN:U74999MH2007PTC175407