Don’t break the base rate regime, fix it

The Reserve Bank of India’s second rate cut outside the policy review cycle has now prepped the pitch for lower lending rates. But will this nudge banks to pass on the benefit to customers and cut rates? The short answer to that is anything but simple. Only three public sector banks have lowered their base rates so far and others don’t seem in a rush to follow suit.

Since each bank decides its base rates — against which lending rates are benchmarked — based on its costs and profitability, rate action cannot follow a harmonised pattern, much like peas in a pod. With policy rates in effect having a negligible impact on banks’ base rate, the issue of transmission is lot more tricky.

Does that mean the existing base rate mechanism needs a total makeover? Hardly. The issue of transmission and the lack of transparency in lending rates have been prevalent for decades now — right from the pre-PLR (prime lending rate) era.

In an attempt to fix these issues, the regulator has been revamping the interest rate structure in India for many years now. Overhauling the existing base rate system is unlikely to have a meaningful impact. The key lies in removing the hurdles in transmission rather than starting afresh with yet another rate structure for banks.

The recent tardiness by banks in cutting lending rates has once again sparked the debate on the effectiveness of the base rate system. But banks have almost always been unable to pass on the RBI’s rate action in its entirety. Till the late 1980s the interest rate structure in India was administered and regulated by the RBI. With a view to ensure transparency in the loan pricing system, lending rates were deregulated for credit limits of over ₹2 lakh along with the introduction of PLR system in 1994.

However, the RBI’s annual policy of 2001-02 relaxed the requirement of PLR being the floor rate and allowed banks to offer loans at below-PLR rates to exporters and other high credit borrowers. While banks were required to declare the maximum spread they charged above the PLR, the wide disparity in PLR and spreads across banks became a cause of concern.

PLR also failed to move in tandem with the direction of rates in the economy. It was with an aim to introduce appropriate pricing of loans and also getting PLR to represent actual cost to banks that the RBI announced the Basic Prime Lending Rate (BPLR) system in 2003. The BPLR was to be computed taking into account the cost of funds, operational expenses, minimum margin to cover regulatory requirement and profit margin. Sound familiar?

Yes, the method for arriving at the BPLR rate was similar to that of the existing base rate. But the RBI stayed away from micromanaging it, and left the methodology and computation to individual banks. While the BPLR system was expected to represent a benchmark rate against which banks would lend, the system failed on a number of counts.

For one, after banks were allowed to lend at sub-BPLR rates, it was found that banks seldom tweaked their BPLR rate to reflect the movement of policy rates. Instead, they continued to lend at sub-PLR rates, much like the present where banks prefer to tinker with the spread than the base rate, which would impact all loans. Under the BPLR system, the share of loans priced below the benchmark rate shot up during 2002 and 2008 — from 28 per cent in March 2002 to an alarming 77 per cent in September 2008.

It was because of these drawbacks that the base rate system was introduced in 2010. This is when the RBI set a broad framework for calculating the base rate. The proposed base rate was to include the cost of funds, the negative carry in case of maintaining CRR and SLR, other unallocated overhead costs and a profit margin. It now enforced these guidelines by putting in place a more rigid structure.

The base rate became the floor rate, below which banks could not lend. The actual lending rates were fixed above a certain percentage points to the base rate, depending upon risk and tenor of the loan among other things.

The existing base rate system has been in force now for five years, and the regulator and the government are still worried about lack of transparency in loan-pricing and inadequate transmission. To address the issue of opacity, the RBI has now asked banks to spell out the rationale for charging differential spreads to borrowers and to display lending rates on their websites.

To tackle the issue of transmission, the central bank recently tweaked the norms for base rate calculations. The base rate now has to be calculated on the basis of deposits which have the largest share in the banks fund base, rather than in the arbitrary fashion they were arrived at. But these efforts are only half the solution.

For one, banks source only a minuscule share of their funds from the repo window. The amount has hovered at 1 per cent or slightly more of their fund base. With banks relying significantly on longer term deposits, changes to policy rates don’t immediately impact their cost of funds.

With the bulk of their deposits untouched by the rate changes, banks are reluctant to pass on policy actions to lending rates. Many bankers and experts have thus argued that rather than allowing banks to fix their own base rate, it may be easier to anchor the base rate to the policy repo rate or the bank rate.

That way any rate action by the RBI will immediately reflect on banks’ cost of borrowings. But such a measure not only smacks of micromanagement but also poses a threat to small banks that will be unable to compete on the cost front with larger banks.

Rather than linking banks’ base rate directly to the policy rate, the regulator can facilitate greater competition from the bond market. Currently, short-term market instruments do not tie in with the rates that banks offer on deposits of similar tenure. This is because retail investors are still not active participants in the bond market.

A deeper bond market will help rates to seamlessly flow between various markets. Banks will also be forced to price their deposits more realistically against benchmark instruments across different tenures. This will ensure quicker transmission of market rates to banks’ deposit rates and hence ensure faster action by banks on lending rates.

But all this is contingent on a mature bond market. For starters, the RBI’s gradual reduction of SLR requirement is a step in the right direction. This will help in less crowding out of private credit. It will also do away with a captive market for government securities, and re-align cost of borrowings to market determined rates.

There is also a need to improve the liquidity of corporate bonds in the secondary market, by putting in place proper market making mechanisms. To enable more issuances of lower-rated corporate bonds, it is imperative that the investment norms for pension funds and insurance companies are relaxed.

This will help widen their scope of investment. The setting up of the Public Debt Management Agency as indicated in the Budget is also a positive move for bond markets as it aims at improving liquidity.