The base rate issue has come to the fore again in the context of the tardy transmission mechanism from the repo rate. The problem really is that repo transactions constitute not more than 1% of lending activity by the Reserve Bank of India through the LAF, which is a maximum of Rs 95,000 crore. A 1% change in repo rate affects banks by just Rs 950 crore on an annual basis, which is very small relative to total interest income of banks of around Rs 8.5 lakh crore (in FY14). Therefore, prima facie, the rate change on its own cannot really alter the dynamics of the base rate.
What should the ideal base rate be? Looking broadly at the functioning of banks, the average rate that can be charged would be a sum of five components. These are the cost of funds (deposits and borrowing), return on capital, intermediation cost, cover for asset quality and compensation for negative carry on pre-emption. One way to build this number is to theoretically impute values for the banking system.
These numbers would vary across banks depending on their balance sheets and the point of reckoning of the same. Based on the 2013-14 balance sheets of all banks (RBI data), on an average out of every Rs 100 of liabilities, Rs 88 emanates from borrowings, Rs 7.5 from capital (reserves and equity) and Rs 4.5 as other liabilities.
The outline provided here is a template that could be considered by logically looking at the cost of banking operations. There is nothing sacrosanct about these numbers and the assumptions can be changed to get a different result. The repo cost would be a very small component of the 5.25% cost of funds in the table. The table uses data for 2013-14 and 2014-15 to calculate an idealised base rate, which comes to 10.83% under certain assumptions.
The RBI has brought out fresh draft guidelines on what should go into the base rate, which looks at the issue from the point of view of marginal cost. This is based on the premise that when looking at the base rate, the average would not hold as rates change only for incremental components. For example, while non-term loans should be at new rates, only incremental deposits can be adjusted with the new rates as the older deposits would have been contracted at the older rates. Similarly all new borrowings of banks would be subjected to the new rates which should ideally get reflected in the new base rate.
The extent to which the base rate gets affected will depend on how the various components move. The cost of funds would definitely change while the other four components will tend to remain unaffected though the negative carry on the CRR would be affected provided the government securities yields do change — which has not been witnessed in the past year or so.
Now Rs 88 in the balance sheet is through deposits and borrowings. Of this Rs 78 comes from deposits and Rs 10 from borrowings. Further, out of these borrowings, around half is from external sources which is not affected by domestic rate changes. Assuming CASA of 35%, Rs 51 would be time deposits. Hence, the sum of Rs 51 and Rs 5, that is, Rs 56 would be subjected to the new rates when the RBI changes the repo rate.
Now assuming growth of 15% in these two components, Rs 8.4 would be subjected to the new rate, and hence a 25 bps cut in interest rates, if fully reflected in the new deposit rates as well as borrowing, will change the base rate by 0.02%, which is quite insignificant.
This is probably the reason why banks are not able to really lower the base rate to the same extent even when driven by a formula. The crux will be the reduction in deposit rates, and if the same is delayed or is not equivalent to the extent of repo rate change, then the base rate will remain sticky.
At an ideological level, three questions arise. The first is whether the concept of a base rate is right. While announcing a benchmark is required for transparency, having a rate by statute based on an objective well-defined formula does come in the way of the independence of the system to choose their rates.
Second, while the RBI does expect base rates to follow suit, banks can still charge the same rate or higher rate to the customer based on risk perception. Third, in a deregulated set up, can any authority compel banks to lower rates? If the ideal system is one where there is independence in monetary policy formulation, arguably the same must also hold for decisions taken by banks, which should be guided by commercial considerations. Interest rate changes will take place under the force of circumstance when companies move to the CP or bond market.
What should the ideal base rate be? Looking broadly at the functioning of banks, the average rate that can be charged would be a sum of five components. These are the cost of funds (deposits and borrowing), return on capital, intermediation cost, cover for asset quality and compensation for negative carry on pre-emption. One way to build this number is to theoretically impute values for the banking system.
These numbers would vary across banks depending on their balance sheets and the point of reckoning of the same. Based on the 2013-14 balance sheets of all banks (RBI data), on an average out of every Rs 100 of liabilities, Rs 88 emanates from borrowings, Rs 7.5 from capital (reserves and equity) and Rs 4.5 as other liabilities.
The outline provided here is a template that could be considered by logically looking at the cost of banking operations. There is nothing sacrosanct about these numbers and the assumptions can be changed to get a different result. The repo cost would be a very small component of the 5.25% cost of funds in the table. The table uses data for 2013-14 and 2014-15 to calculate an idealised base rate, which comes to 10.83% under certain assumptions.
The RBI has brought out fresh draft guidelines on what should go into the base rate, which looks at the issue from the point of view of marginal cost. This is based on the premise that when looking at the base rate, the average would not hold as rates change only for incremental components. For example, while non-term loans should be at new rates, only incremental deposits can be adjusted with the new rates as the older deposits would have been contracted at the older rates. Similarly all new borrowings of banks would be subjected to the new rates which should ideally get reflected in the new base rate.
The extent to which the base rate gets affected will depend on how the various components move. The cost of funds would definitely change while the other four components will tend to remain unaffected though the negative carry on the CRR would be affected provided the government securities yields do change — which has not been witnessed in the past year or so.
Now Rs 88 in the balance sheet is through deposits and borrowings. Of this Rs 78 comes from deposits and Rs 10 from borrowings. Further, out of these borrowings, around half is from external sources which is not affected by domestic rate changes. Assuming CASA of 35%, Rs 51 would be time deposits. Hence, the sum of Rs 51 and Rs 5, that is, Rs 56 would be subjected to the new rates when the RBI changes the repo rate.
Now assuming growth of 15% in these two components, Rs 8.4 would be subjected to the new rate, and hence a 25 bps cut in interest rates, if fully reflected in the new deposit rates as well as borrowing, will change the base rate by 0.02%, which is quite insignificant.
This is probably the reason why banks are not able to really lower the base rate to the same extent even when driven by a formula. The crux will be the reduction in deposit rates, and if the same is delayed or is not equivalent to the extent of repo rate change, then the base rate will remain sticky.
At an ideological level, three questions arise. The first is whether the concept of a base rate is right. While announcing a benchmark is required for transparency, having a rate by statute based on an objective well-defined formula does come in the way of the independence of the system to choose their rates.
Second, while the RBI does expect base rates to follow suit, banks can still charge the same rate or higher rate to the customer based on risk perception. Third, in a deregulated set up, can any authority compel banks to lower rates? If the ideal system is one where there is independence in monetary policy formulation, arguably the same must also hold for decisions taken by banks, which should be guided by commercial considerations. Interest rate changes will take place under the force of circumstance when companies move to the CP or bond market.
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