The why and how of 'base rate' in Indian banking - Views on News from Equitymaster

Helping You Build Wealth With Honest Research
Since 1996. Try Now

  • MyStocks


Login Failure
(Please do not use this option on a public machine)
  Sign Up | Forgot Password?  

The why and how of 'base rate' in Indian banking

Jun 29, 2010

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.

Equitymaster requests your view! Post a comment on "The why and how of 'base rate' in Indian banking". Click here!


More Views on News

5 Indian Banks with the Lowest NPAs. Here's How they Did It... (Views On News)

Sep 27, 2021

These banks have managed to maintain their asset quality even in the middle of a pandemic.

PNB Reports an Over Three-Fold Jump in Net Profit as Provisions Fall (Views On News)

Aug 3, 2021

The reduction in provisions for bad loans and asset quality stability may have aided the lender's earnings.

Here's Why IndusInd Bank's Net Profit Doubled in the June Quarter (Views On News)

Jul 28, 2021

All you need to know about the latest quarterly results of IndusInd Bank.

Axis Bank's Stock Falls as Results Disappoint on Asset Quality (Views On News)

Jul 27, 2021

Axis Bank's net profit more than doubles on a spike in other income and lower provisioning.

ICICI Bank's Quarterly Results Sends Stock to 52-Week High (Views On News)

Jul 26, 2021

ICICI Bank expects to maintain margins at the same level in coming quarter.

More Views on News

Most Popular

Infosys vs TCS: Which is Better? (Views On News)

Nov 26, 2021

In the post pandemic era, the top two IT companies in India are fighting to capture the growing demand for IT.

This Multibagger Stock Zooms 20% After Dolly Khanna Buys Stake (Views On News)

Nov 24, 2021

Shares of this edible oil company zoomed over 50% in three days after ace investor bought around 1% stake.

Don't Sell these Stocks if the Market Falls (Profit Hunter)

Nov 17, 2021

These are the 3 types of stocks that you should not sell in a market crash.

How to Find Your Next 10-Bagger in this Market (Profit Hunter)

Nov 19, 2021

The #1 make or break factor in your portfolio you shouldn't ignore.

6 Popular Stocks that Turned into Penny Stocks (Views On News)

Nov 27, 2021

A look at popular stocks that crashed big time and never recovered, i.e. which went from 'Multibaggers to Multibeggers'.


Become A Smarter Investor
In Just 5 Minutes

Multibagger Stock Guide 2022
Get our special report Multibagger Stocks Guide (2022 Edition) Now!
We will never sell or rent your email id.
Please read our Terms


Nov 30, 2021 (Close)