Base rate is good change, but...: Financial Express: 2nd JUly 2010

The concept of a base rate is laudable and should be welcomed for the high level of transparency it brings to the system. The PLR concept ceased to be relevant when a large number of loans were being sanctioned at a lower rate, leading to the term sub-PLR (distinct from ‘sub-prime’ that has other connotations). Of the two sets of issues that come up for discussion on this concept, the first pertains to operational aspects and the second to more ideological aspects about formulation.

When looking at base rate calculation, RBI has laid down a formula. It includes the cost of retail deposits, negative carry for CRR and SLR, operational expenses and a return on net worth. Implicitly, it includes a profit component. In the spirit of prudent business operations, banks should not lend below this rate as it means they would be at a loss.

First, how often would this rate be calculated? Should the rate be based on FY10 financials or on a revolving basis? Quarterly results are announced periodically and the same can be done for rates. This question is pertinent because if the number is revised upwards, it is acceptable as RBI thinks banks should not be lending at less than cost. But, in a declining interest rate scenario, the base rate could come down and banks would have to lend at a higher minimum rate. If quarterly rates are acceptable, then why not daily? Since over 85% of banking operations are computerised, it should be possible to have a rate every day. Clarity is needed on periodicity.

Second, currently, most borrowers are paying an interest rate of the PLR plus a premium. Now that the base rate has come down to between 3-4% less than the PLR, a potential borrower would be aghast at the margin that the bank will charge. For example, the rate today could be reckoned as 3% over PLR, based on risk perception, etc. Now, the borrower would face the psychological block of having to pay 3-4% over base rate. Banks will have to now redefine cost of risk when quoting a rate linked to the base rate.

Third, the base rate is not to apply to loans of durations of less than 1 year, although the total sub-base rate loans cannot exceed 15% of incremental lending, with non-priority lending having a sub-limit of 5%. This provides an escape clause to banks to use this limit of sub-base rate to roll over loans to their customers. Operationally, a question could arise when this 15% norm is juxtaposed with surplus liquidity situations, where banks will have to invest in the reverse repo at a lower rate rather than lend at a sub-base rate.

Fourth, banks often see clients as a relationships where deals go beyond the money that is being loaned. In such cases, the bank may like to provide loans at a lower rate for relationship building, ignoring commercial profit. How do they get around the dilemma?

Fifth, as the base rate applies only to lending, will there be an incentive to use commercial paper (CP), after weighing the relative cost (of issuance, stamp duty etc)? Credit-like instruments (CP, bonds, debentures) may emerge to be more popular, where rates are driven by the market and not by statute.

While these are practical issues that will need to be tackled once these rates are operational, ideologically critics have pointed out two aspects of such an approach.

The first is that while the base rate is to apply to all loans, other exceptions have been made; like for exports, where loans would be at the base rate and not at specified basis points lower than the PLR. The point argued by critics is that once we are going in for a base rate concept on sound financial principles, there should not ideally be exceptions based on priorities, unless the amount is being reimbursed to banks. Else it violates the tenet to begin with.

The other interesting issue is the manner in which the rate has been fixed. While the formula is sound, the issue raised is whether the regulator should get involved in the process of fixing the price of any product. By doing so it would indirectly be involved with the commercial viability of the regulated unit. As a corollary, are we going back to the pre-reforms days? There are evidently arguments on both sides against the background of the financial crisis.