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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.

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