In order to make bank lending rates more responsive to the policy rate changes, the Reserve Bank of India (RBI) has once again initiated the process of revising the manner in which banks calculate their lending rates.
This time it seeks to change the way banks calculate the base rate and the minimum interest rate below which banks cannot lend to their customers irrespective of the loan size.
The central bank has said that the banks should use the marginal cost of funds, or the average interest it pays on new loans, to arrive at the base rate instead of the weighted average cost of funds or blended cost of fund.
The old guard
Much before the base rate system came to effect, the lending rates were calculated by the Benchmark Prime Lending Rates (BPLR) — the rate at which the bank was supposed to lend to their most credit worthy customers. However, the BPLR system suffered from an inherent problem. Under the system, the banks could lend to large corporates with big ticket sizes below the BPLR rate. This necessarily meant that corporate and big businesses were subsidizedat the cost of retail lenders. Almost 70 per cent of a bank’s loan book at that time comprised corporate loans. The BPLR also led to poor transmission of changes in policy rates.
The existing system
At present, banks can choose any of the three options — marginal cost of funds, weighted average cost of funds, or blended cost of funds — to calculate base rate. Nevertheless, RBI says that the marginal cost method is more responsive to the changes in the policy rates.
The current base rate regime was adopted in July 2010 after seven years of the BPLR system that came into existence in 2003. The pitfall of the existing system in determining the base rate is that it is very slow to reflect policy rate chan-ges in the bank lending rate. This deprives the borrowers of the immediate benefits of any change in policy rates.
Banks are typically slow to cut interest rates responding to a policy rate cut, while they quickly increase bank rate in case of a hike in the repo rate.
Since the start of 2015, RBI has cut the policy rates by 75 basis points. However, the bank lending rates have not fallen more than 50 basis points. After the latest round of repo rate cut of 0.5 per cent in September, some banks have slashed their base rates and passed on some of the rate cut benefit to their customers.
Nevertheless, the transmission has been slow, and has happened after much nudging from RBI.
Banks, on the other hand, have held firm that it takes time for their cost of funds to come down after the policy rate changes, and hence they cannot pass the benefit of reduced rates to customers immediately. The other reason often quoted is that deposit rates of government-run schemes like the PPF have not dropped much, hence it would be difficult for banks to cut their rates.
The new order
The marginal cost of funds under the new base rate regime as suggested by RBI can be arrived at by taking the weighted average of the latest rates of all deposits and the average one-month cost of borrowings from RBI, other banks, and institutions and bonds.
This marginal cost thus arrived at should then be added to the negative carry or the negative yield on cash reserve ratio (CRR) and statutory liquidity ratio (SLR), the overhead cost of the bank, and the average return on net worth. The return from CRR — the mandatory proportion of deposits banks have to keep with RBI in the form of cash or deposits with the central bank — is zero. The yield on SLR — the minimum percentage of total deposits banks have to maintain in government securities — can be negative. So, base rate would ha-ve four components — marginal cost of funds, negative carry on CRR and SLR, overhead costs, and average return on net worth.
RBI seeks to remove the arbitrariness in deciding the spread — the additional cost over the base rate — to arrive at the lending rate. Usually, the decision on the spread lies entirely with the bank’s treasury board. RBI now maintains that the broad components of spread should be finalised by the Indian Banks Association (IBA).
The aim is to reflect the changes in policy rates more frequently in the lending rates. Banking experts believe that the new system would be good for borrowers when the policy rates are falling, as loan rates would adjust accordingly to the new rates. However, they say that when rates would start rising, there could be sharp jump in the lending rates.
These changes are still in the planning stage and the RBI is seeking views from public on the changes suggested. However, once impl-emented, borrowers would have to gear up for more responsive lending rates, which could trend in either direction based on macroeconomic developments.
(The writer is the CEO of BankBazaar.com)
