Base lending rate ensures transparency : Economic Times: 19th Feb 2010

The base lending rate is an improvement over the PLR as it reflects the actual cost to banks that has to be covered through their lending operations. The PLR has lost relevance, given the opacity in its determination and the tendency for several loans to be reckoned at sub-PLR rates.
The guidelines announced by RBI on base rates of banks are interesting for several reasons. The definition provided by RBI has four components: cost of deposits, negative carry on CRR and SLR, overheads cost and returns on net worth.
Based on this formula and the numbers available for 2008-09, the base rate has been calculated for a set of banks.
Based on the 2008-09 numbers, the base rate varies from 5.22% for Citi to 8.91% for OBC. Broadly speaking, foreign banks have the lowest rate followed by public sector banks and then private banks. Given that the present PLR is 11-12%, the difference with the calculated base rate varies from 3-7% points, which is quite significant. However, there is a major exclusion here in the base rate calculation, which is a provision for NPAs. Given that the ratio of gross NPA to total advances varies between 1% and 2% points for banks, this has to be included for the base rate calculation. By including this provision, the base rate moves up to between 6.5% and 11%.
The basic question is, how should these components be fixed? The past profit ratio may not be indicative of the future, as normally adaptive expectations are followed where banks factor in an increase in this ratio, which will impart an upward bias to this number. Similarly, overhead costs by their nature are fixed in size and increase at a trend rate and are not linked with movements in business numbers. While the SLR and CRR would be more or less fixed or change proportionately for all banks, the cost of deposits will change dynamically, depending on how overall policy rates move, and will hence be variable.
The reason for having a base rate as a substitute for the PLR is that today there are a number of loans that are reckoned at sub-PLR level, which makes this benchmark irrelevant. In fact, the average return on advances for most loans lie in the region of 8-11%, of which only part may be explained by the legacy issue of loans being provided at a lower rate in the past. Housing loans, for example, are usually at sub-PLR while there are others which are fixed by RBI and linked to the PLR such as farm loans or export finance. The creation of a base rate will provide the minimum that has to be covered by the bank. The final lending rate would simply be the base rate, plus the risk-cost attached to the credit rating perception of the borrower by the bank.
At the ideological level, the question to be posed is whether RBI should be fixing such a formula in a free-banking system. While transparency is needed, as banks should let the customers know about their rates, the method of arriving at the rate should be left to the banks as they should have the power to decide on the levels for each of the components, especially overheads and profits. In fact, RBI should decouple various kinds of finance to the base rate or PLR as the case may be, to reflect free pricing, especially since there are anyway quantitative norms to lending that have to be adhered to by banks.
Today, the PLR of banks are more or less the same across banks. An interesting outcome would be that once the base rate scale is known to all and varies according to a uniform predetermined formula, potential customers would have a choice provided the banks have the willingness. It would be interesting to observe as to how would the higher base-priced banks respond in such a situation.