Base Rate by Sumedha Fiscal Services Ltd

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BDO India

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Sumedha Fiscal

Sl. No. Particulars Pg No.1. Introduction 32. History of RBI Intervention 43. Reviewing Methodology: Formation 5

of Working Group4. Findings of the Group 65. RBI Notification 66. Introduction of Base Rate 107. Base Rates for most of our Banks 118. BPLR Vs Base Rate 139. Downward Stickiness 1510. Teaser Rate 1711. Transparency 1812. Effect on NIM 1913. Effect on Short Term Loans 2014. Cross-Subsidization of Loans 2115. Effect on Long Term Loans 2216. Effect on Home Loans 2217. Effect on Corporate Loans 2318. Effect on parallel Market; such as CPs etc. 2319. Importance of CASA 2520. Effect on Deposit Rates 2521. Sunset Clause 2522. Drawbacks 2623. Conclusion 2824. Annexure 2925. References 2926. Abbreviations 30

Contents

The New Regime-Base Rate asagainst its predecessor BPLR, willhenceforth, act as a minimumlending rate below which lending isprohibited barring some exceptionalcases (viz. Export credit, loans tobank employees, loans against fixeddeposits, DRI scheme outsideambit). Responsibility of calculationlies with the respective Banks whoby using a stringent methodologyset by RBI have to publish theirrespective Base Rates every quarterof a year, and will henceforth bescrutinized by the RBI. The RBIdescribes Base Rate as the minimumpossible lending rate achievable byrespective Banks keeping in view itsCost of Deposits, CRR and SLR setby RBI, Unallocatable OverheadCost & Average Return on NetWorth of the Bank. The proposedBase Rate will be applicable to allnew loans as well as existing loanswhich come up for renewal.Existing borrowers are free to switchto new system.

This new regime aims atimprovising the banking system inIndia to great leaps forward; greatertransparency along with greatereffectiveness of government policiesmark the most important aspects ofthis change. India desperatelyneeded re-evaluation of the existingsystem which looked so lethargicunder times of extreme stress. Newera is expected to make the systemmore flexible as well as moredynamic. But, this move shouldonly be as a start to a more vibrantIndian economy; the destination ofwhich still lies a long way aheadalthough the move looks like one inthe desired direction, at least in itsinduction phase. Although, RBI has given completefreedom to every bank, so that theycan come up with their own cost ondeposits and hence, their Base Rate,RBI can ask for any justification ofdetails provided, ensuring anextensive monitoring of Base Rate.

With world’s changingoutlook towards India, itis impossible for us tostay the same forever.Indian banking hasentered a new era on 1stJuly, 2010 when animproved method of loanpricing is finallyactivated. The move to amore transparent regime,Base Rate, compared toits predecessor BPLR,that will act as abenchmark for the pricingof all loans dished outby banks is welcomed bymajority of borrowers.

Introduction

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Sumedha Fiscal BDO India

= The ultimate objective of Banklending is to promote economicgrowth by channeling resourcesto the most productive uses atreasonable rates. Therefore, thelevel and structure of interestrates are critical determinants ofthe economic efficiency withwhich resources are allocated inan economy. Interest ratedistortions in any form may leadto a misallocation of resources.Accordingly, lending rates ofbanks need to be appropriate andreasonable from the point ofview of both lending institutionsand borrowers.

= Lending rates which are eithertoo high or low and out of syncwith the realistic pricing of creditcould have implications forcredit quality and cause concernsabout financial stability. Lendinginterest rates should also beresponsive to the monetarypolicy actions, if they are toachieve the desired objective.

= Till the late 1980s the interestrate structure in India was largelyadministered in nature and wascharacterized by numerous rateprescriptions for differentactivities, and borrowers werecharged vastly different rates forthe same loan amount therebydistorting the structure of

lending rates. On account of thecomplexities of the interest ratestructure under the administeredrate structure, efforts since 1990has been of rationalization of theinterest rate structure so as toensure price discovery andtransparency in loan pricingsystem.

= In Sept 1990, Rates rationalizedinto six slabs. Banks free to setrates of over 2 Lacs, with theRBI prescribing minimum rates,then in 1993 six slabs for lendingrates compressed to three. Theprocess of rationalizationculminated in almost completederegulation of lending rates inOctober 1994. The freeing up oflending rates of scheduledcommercial banks for creditlimits of over 2 Lacs along withthe introduction of PLR systemin 1994 was a major step in thisdirection aimed at ensuringcompetitive loan pricing.

= In 1997, Banks were allowed toprescribe separate PLRs, both forloans as well as cash creditcomponents, then subsequentlyin Oct, it was asked to announcea separate prime term lendingrate. In 1999, tenor linked primelending rates were introduced.Later in 2000, Banks wereallowed to charge fixed/floating

rates on their lending for creditlimit of over 2 Lacs. Then, PLRceased to be the floor rate forloans more than 2 Lacs in Apr,2001.

= Then finally, System ofBenchmark Prime Lending Rate(BPLR) introduced in 2003 wasexpected to serve as a benchmarkrate for banks’ pricing of theirloan products so as to ensure thatit truly reflected the actual cost.

= However, the BPLR system hasfallen short of its Originalobjective of bringingtransparency to lending rates.Competition has forced thepricing of a significant proportionof loans far out of alignment withBPLRs and in a non-transparentmanner, undermining the role of

the BPLR as a reference rate.

= There was also widespread publicperception that the BPLR systemhas led to cross-subsidization interms of under pricing of creditfor corporate and overpricing ofloans to agriculture and small andmedium enterprises. The AnnualPolicy Statement 2009-10 notedthat since the bulk of bank loanswere lent at sub- BPLR rates, thesystem of BPLR evolved in sucha manner that it had lost itsrelevance as a meaningfulreference rate.

= The lack of transparency in theBPLR system also causedimpediment to the effectivetransmission of monetary policysignals. In view of the concernspertaining to the shortcomings in

the BPLR system raised by thepublic and those recognized bythe Reserve Bank, the AnnualPolicy Statement of 2009-10announced the constitution ofWorking Group on BPLR toreview the BPLR system andsuggest changes to make creditpricing more transparent.

As per the actual lending rates forborrowers, it would be the Base Rateplus the borrower-specific charges likepremium related to maturity of loans.Hence, it can be said that Base Rateis the approximate lending rate atwhich it will disburse loans to its mostfavored customers, the ones withAAA Grade Credit Rating as theyhardly qualify for any borrower-specific premium. But please do note that these newguidelines are impacting only banks.Other NBFC lending institutions donot come under the purview of theBase Rate and can still lend on thebasis of the erstwhile BPLR system.Also, since the Base Rate will be theminimum rate for all commercialloans, banks are not permitted toresort to any lending below the BaseRate, the current requirement thatBPLR will be the ceiling rate for loansup to 2 Lacs will stand withdrawn,the central bank stated in its draftguidelines.

History of RBI Intervention inLending Rates

The Reserve Bank announced the constitution of theWorking Group on Benchmark Prime Lending Rate(BPLR) in the Annual Policy Statement of 2009-10(Chairman: Shri Deepak Mohanty) to review the BPLRsystem and suggest changes to make credit pricing moretransparent. The Working Group was assigned thefollowing terms of reference

i) To review the concept of BPLR and the manner ofits computation;

ii) To examine the extent of sub-BPLR lending and thereasons thereof;

iii) To examine the wide divergence in BPLRs of majorbanks;

iv) To suggest an appropriate loan pricing system forbanks based on international best practices;

v) To review the administered lending rates for smallloans up to 2 Lacs and for exporters;

vi) To suggest suitable benchmarks for floating rateloans in the retail segment; and

vii) Consider any other issue relating to lending rates ofbanks.

Reviewing Methodology: Formation of aWorking Group

Source: RBI

76


The BPLR seems to have been tended out of sync withmarket conditions and does not adequately respond tochanges in monetary policy. In addition, the tendencyof banks to lend at sub-BPLR rates on a large scaleraises concerns of transparency. The Working Groupalso noted that on account of competitive pressures,banks were lending at rates which did not make muchcommercial sense.

After carefully examining the various possible options,views of various stakeholders from industry associationsand those received from the public, and internationalbest practices, the Group is of the view that there ismerit in introducing a system of Base Rate to replacethe existing BPLR system.

Findings of Working Group

ToAll Scheduled Commercial Banks (excluding RRBs)Guidelines on the Base Rate

In the light of the comments/suggestions received, it has beendecided that banks switch over to thesystem of Base Rate. The BPLRsystem, introduced in 2003, fellshort of its original objective ofbringing transparency to lendingrates. This was mainly because underthe BPLR system, banks could lendbelow BPLR. For the same reason, itwas also difficult to assess thetransmission of policy rates of theReserve Bank to lending rates ofbanks. The Base Rate system isaimed at enhancing transparency inlending rates of banks and enablingbetter assessment of transmission ofmonetary policy. Accordingly, thefollowing guidelines are issued forimplementation by banks.

BASE RATEi. The Base Rate system will replace

the BPLR system with effectfrom July 1, 2010. Base Rateshall include all those elements ofthe lending rates that arecommon across all categories ofborrowers. Banks may chooseany benchmark to arrive at theBase Rate for a specific tenorthat may be disclosedtransparently. An illustration forcomputing the Base Rate is setout in the Annex. Banks are freeto use any other methodology, asconsidered appropriate, providedit is consistent and are madeavailable for supervisoryreview/scrutiny, as and whenrequired.

ii. Banks may determine their actuallending rates on loans andadvances with reference to the

Base Rate and by including suchother customer specific charges asconsidered appropriate.

iii. In order to give banks sometime to stabilize the system ofBase Rate calculation, banks arepermitted to change thebenchmark and methodologyany time during the initial sixmonth period i.e. end-December2010.

iv. The actual lending rates chargedmay be transparent andconsistent and be made availablefor supervisory review/scrutiny,as and when required.

APPLICABILITY OFBASE RATEv. All categories of loans should

henceforth be priced only withreference to the Base Rate.However, the followingcategories of loans could bepriced without reference to theBase Rate: (a) DRI advances(b) loans to banks’ ownemployees (c) loans to banks’depositors against their owndeposits.

vi. The Base Rate could also serve asthe reference benchmark rate forfloating rate loan products, apartfrom external market benchmarkrates. The floating interest ratebased on external benchmarksshould, however, be equal to orabove the Base Rate at the time ofsanction or renewal.

vii. Changes in the Base Rate shallbe applicable in respect of allexisting loans linked to the Base

Rate, in a transparent and non-discriminatory manner.

viii. Since the Base Rate will bethe minimum rate for allloans, banks are not permittedto resort to any lending belowthe Base Rate. Accordingly, thecurrent stipulation of BPLR asthe ceiling rate for loans upto 2 lacs stands withdrawn. Itis expected that the abovederegulation of lending ratewill increase the credit flow tosmall borrowers at reasonablerate and direct bank finance willprovide effective competition toother forms of high cost credit.

ix. Reserve Bank of India willseparately announce thestipulation for export credit.

REVIEW OF BASE RATEx. Banks are required to review the

Base Rate at least once in aquarter with the approval of theBoard or the Asset Liability

Following the announcement in the Annual Policy Statement for the year2009-10, Reserve Bank of India constituted a Working Group onBenchmark Prime Lending Rate (Chairman: Shri Deepak Mohanty) to reviewthe present benchmark prime lending rate (BPLR) system and suggestchanges to make credit pricing more transparent. The Working Groupsubmitted its report in October 2009 and the same was placed on theReserve Bank’s website for public comments. Based on the recommendationsof the Group and the suggestions from various stakeholders, the draftguidelines on Base Rate were placed on the Reserve Bank’s websitein February 2010.

RBI NotificationGuidelines on the Base Rate

Dated: 1st April 2010

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Management Committees (ALCOs) asper the bank’s practice. Sincetransparency in the pricing of lendingproducts has been a key objective, banksare required to exhibit the informationon their Base Rate at all branches andalso on their websites. Changes in theBase Rate should also be conveyed tothe general public from time to timethrough appropriate channels. Banks arerequired to provide information on theactual minimum and maximum lendingrates to the Reserve Bank on a quarterlybasis, as hitherto.

TRANSITIONAL ISSUESxi. The Base Rate system would be

applicable for all new loans and forthose old loans that come up forrenewal. Existing loans based on theBPLR system may run till theirmaturity. In case existing borrowerswant to switch to the new system,before expiry of the existing contracts,an option may be given to them, onmutually agreed terms. Banks, however,should not charge any fee for suchswitch-over.

xii. In line with the above Guidelines,banks may announce their Base Ratesafter seeking approval from theirrespective ALCOs/ Boards.

EFFECTIVE DATExiii. The above guidelines on the Base Rate

system will become effective on July1,2010.

b - Negative Carry on CRR and SLR = [[ ]*100] - Dcost

Negative carry on CRR and SLR balances arises because the return on CRR balances is nil, while the return on SLRbalances (proxied using the 364-day Treasury bill rate) is lower than the cost of deposits. Negative carry on CRRand SLR is arrived at in three steps. In the first step, return on SLR investment was calculated using 364-day TreasuryBills. In the second step, effective cost was calculated by taking the ratio (expressed as a percentage) of cost of deposits(adjusted for return on SLR investment) and deployable deposits (total deposits less the deposits locked as CRR andSLR balances). In the third step, negative carry cost on SLR and CRR was arrived at by taking the difference betweenthe effective cost and the cost of deposits.

Unallocatable Overhead CostUnallocatable Overhead Cost = [Uc/Dply] * 100Unallocatable Overhead Cost is calculated by taking the ratio (expressed as a percentage) ofUnallocated overhead cost and deployable deposit.

Average Return on Net WorthAverage Return on Net Worth = [(NP/NW)*(NW/ Dply)]*100Average Return on Net Worth is computed as the product of net profit to net worth ratio and net worth to deployabledeposits ratio expressed as a percentage.

Annex 1: IllustrativeMethodology for theComputation of theBase Rate

Negative Carry on CRR and SLR

Base Rate =a + b + c + da - Cost of Deposits= Dcost

(benchmark)b - Negative Carry on CRR and SLR =

[[ ]*100] - Dcost

c - Unallocatable Overhead Cost = [Uc/ Dply] * 100

d - Average Return on Net Worth = [(NP/NW)*(NW/TL)]*100

Where:

Dcost ∶ Cost of Deposits/fundsD ∶ Total Deposits = Time Deposits + Current Deposits

+ Saving DepositsDply ∶ Deployable Deposits = Total deposits less share of

deposits locked as CRR & SLR balances = 𝐷∗ [1−(𝐶𝑅𝑅+𝑆𝐿𝑅)]

CRR : Cash Reserve RatioSLR : Statutory Liquidity Ratio 𝑇𝑟 ∶ 364 T-Bill RateUc ∶ Unallocatable Overhead CostNP : Net Profit NW : Net Worth = Capital + Free Reserves

{Dcost – ( 𝑆𝐿𝑅∗𝑇𝑟)}{ 1− (𝐶𝑅𝑅+𝑆𝐿𝑅)}

{Dcost – ( SLR *Tr)}

{ 1− (CRR+SLR)}

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Oct 20, 2009: Working group's report Says Base Ratewill include:i) The card interest rate on retail deposits with one-year maturity ii) Adjustment for the negative carry for CRR, SLR iii) Unallocatable overhead costsiv) Average return on net worth* Suggests ban on lending below Base Rate. Sub-Base Rate lendingto priority and non-priority sectors to be capped at 15% ofincremental lending. * Actual lending rates to factor in product-specific operating costs,credit risk premium and tenor premium.

Feb 10, 2010: RBI issues draft circular Criteriafor Base Rate determination to be based on:i) Cost of depositsii) Adjustment for the negative carry for CRR, SLR iii) Unallocatable overhead costs iv) Profit margin * Will include product-specific operating costs, credit risk premiumand tenor premium * No lending below Base Rate. Export credit, small-ticketdifferential rate of interest (DRI) scheme loans to be kept out * Base Rate to replace BPLR from April 1

April 9, 2010: Final guidelines issued* Banks free to choose benchmark * Given freedom to decide methodology * All loans to be benchmarked to the Base Rate. Export credit,loans to bank employees, loans against fixed deposits, DRIscheme outside ambit * System to kick in from July but banks free to alter methodologytill December 2010

Sl. No. Bank Name Base Rate*

1. State Bank of India 7.50

2. State Bank of Mysore 7.75

3. Punjab National Bank 8.00

4. Bank of Baroda 8.00

5. Allahabad Bank 8.00

6. Canara Bank 8.00

7. United Bank of India 8.00

8. UCO Bank 8.00

9. Oriental Bank of Commerce 8.00

10. Bank of India 8.00

11. Central Bank 8.00

12. Indian Bank 8.00

13. IDBI 8.00

14. Dena Bank 8.25

15. Dena Bank 8.25

16. Indian Overseas Bank 8.25

17. Syndicate Bank 8.25

18. Vijaya Bank 8.25

Introduction Of Base Rate…Welcomed by many

A Glance at the Base Rate of some of our major BanksNATIONALISED BANK


1. Yes Bank 7.00

2. Dhanlaxmi Bank Ltd. 7.00

3. IndusInd Bank Ltd. 7.00

4. ING Vysya Bank 7.25

5. Kotak Mahindra Bank 7.25

6. HDFC Bank 7.25

7. Axis Bank 7.50

8. ICICI Bank 7.50

9. Corporation Bank 7.75

10. The Ratnakar Bank Ltd. 8.00

11. Catholic Syrian Bank Ltd. 8.00

12. Jammu & Kashmir Bank Ltd. 8.25

13. Karur Vysya Bank Ltd. 8.50

14. Nainital Bank Ltd. 8.50

15. Tamilnad Mercantile Bank Ltd. 8.50

16. City Union Bank Ltd. 8.50

17. Lakshmi Vilas Bank Ltd. 8.75

18. Karnataka Bank Ltd. 8.75

PRIVATE BANKS


1. RBS N.V India 6.50

2. Deutsche Bank 6.75

3. HSBC 7.00

4. DBS India 7.00


5. CITI BANK 7.25

6. Standard Chartered Bank 7.25

7. DCB 7.75

8. Federal Bank 7.75

FOREIGN BANKS

Source: Bank Websites *As per published for the 1st quarter, FY 11

1312


9.008.758.50

8.25

8.00

7.75

7.50

7.257.00

6.756.50

1 2 3 4 5 6 7 8 9 10 191817161514131211

Nationalised Banks

Private Banks

Foreign Banks

DILEMMA ON COST OF DEPOSITSThe difference in Base Rates between Foreign & IndianBanks is very much evident from the above graph. Oneprobable reason could be that the base rate does notmatter much for foreign banks, which are mostly notinto long-term lending and retail lending. They basicallylend to big corporates on short term basis only to fundtrade financing. Hence, the base rates from foreign banksare relatively lower.Due to the unavailability of guidelines for the Cost ofDeposit, there is still some confusion prevailing in themarket. For instance, SBI has taken the six-monthdeposit rate as its main input to calculate its Base Rate.The lender said its growing share of low cost depositshad helped it reduce its cost. Mr. Bhatt said by takingthe six-month average cost of deposit, the transmissionof monetary policy signals will be much more effective.“If we had taken one-year cost, it might not havereflected the current cost, while a three-month costwould not have reflected the historic cost. So, wethought a six-month cost will be the most appropriate”.Bank of Baroda, in contrast, has taken the average cost

of deposits in the last quarter to arrive at its Base Rate.While Punjab National Bank (PNB), Chairman andManaging Director Mr. K R Kamath, told that the bankhad fixed the Base Rate on the basis of cost of depositsat the end of the March quarter, which was 4.88 percent. The low-cost deposit share was a deciding factorfor banks to fix their Base Rate.

This is unlike the BPLR regimewhere the BPLR was supposed totake into account the same set ofparameters but no documentationwas required and it was not open toRBI scrutiny. This is a significantdifference between the two regimessince this forces the banks to followa consistent methodology for thecalculation of the Base Rate unlikethe BPLR.The BPLR system has been drawingflak from various quarters since theBanks have been lending to theirhigh-rated corporate borrowersmuch below their benchmark rate,while a substantial premium wascharged from other borrowersconsequently, the system becamepartial and unjust; moreover, itconsistently seeded a strongsentiment of distrust amongborrowers. This practice of sub-BPLR lending in turn culminatedin the increase of spread of lendingrates. Bankers say that the Base Rate

system will be helpful in cutting thearbitrage advantage which some topcorporate borrowers enjoy. Theyalso added that the loans extendedto larger companies lately have beenunder-priced and the volumes lenttoo have been very large.Henceforth, Banking Sector will bemore competitive than ever beforebecause of greater transparency. Nowthe banks can no more rely only onteaser rates to woo customers. Theywill be more literate than ever beforeand will now have a commonplatform, a common benchmark tocompare. With greaterunderstanding of their own riskpremium now the banks will have toactually woo customers by theirservice and ease of access which willbe the key in the lending marketwhere the interest rates are almostthe same. Banks with better servicesand huge chain of branches will bemuch better posed compared to its peers.

Whilst each bank canchoose its ownbenchmark for the costof funds they will haveto document thedetailed formula for thecalculation of the BaseRate, the methodologyundertaken and followit consistently (exceptduring a brief six monthtransition period).Moreover, This formulawill need to bedisclosed to RBI forfurther scrutiny

BPLR Vs Base Rate

BASICS

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Maximum and Minimum Lending Ratesof Public Sector Banks

Maximum and Minimum Lending Ratesof Private Sector Banks

Maximum Interest Rate Modal BPLR Minimum Interest Rate

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VARIATION AMONG BANKS

Source: RBI

RBI Publication Reports

BPLR, Base Rate & Actual lending rates vary from Bank to Bank. But the spread in case of BPLR was much widerthan the latter, sometimes stretching over 4 percent, ranging between 11 percent and 15.75 percent among banksresulting in wide-spread disparity among banks. On the other hand, the Base Rate for majority of the Banks fallswithin the spread of 1.50 percent, hence bringing in more stability as well as simplicity in the market. As is evidentfrom the graph shown above, there is almost no correlation between the maximum and minimum lending rates ofPublic and Private Sector Banks. With the evolvement of Base Rate which varies in a relatively small interval, at leastminimum lending rate would not vary much and consequently, such a wide variation in lending rates is expected tobe curtailed down.

Dismal Failure of BPLR in forcing Banks to Respond to the Policy Changes

A word widely used in banking sector expressing thewide-spread practice of Indian Banks on manipulationof the benchmark rates in response to policy & marketchanges for instance, BPLR refuses to go down (or goesdown reluctantly and at a slower pace) when bank’s costof funds were at record low-levels on account of easedpolicy rates in time of slowdown(Dec ’08 to June ’09),though it was quick to go up when their cost of fundswere high for most of the preceding years.

In effect consumers continued to pay higher interest rateseven in a falling interest rate market but are forced to pay

more when interest rates go up. As taking a loan(primarily home loan) becomes more prevalent as itaffects millions of middle class households and the furorover this non- transparent method of fixing floating rateloan products has reached feverish pitch.

The banks on their part give a curious argument to justifycharging more to their existing home loan consumerswhilst doling out lower rates to attract new customers.They claim that as interest rates fall only for the newincremental deposits since the existing consumers arefunded from existing deposits (which are at a higherrate), they cannot be given the benefit of the fall in ratesimmediately. The reason this argument does not appearreasoned is because by this token when interest rates rise,only the new customers should be paying the higher rate(since only they are funded from the new high costdeposits) whilst the existing loan consumers shouldcontinue to pay less. Of course this never happens.

In actuality the problem is how the cost on deposit iscalculated, as under BPLR it was more profitable forbanks to calculate marginal cost* of funds rather thanaverage cost* of funds which was not the actual cost. Butunder new guidelines things stand to change. Firstly as

Now with reviewing of Base Rates every quarter and subsequent scrutiny thereafter will make it quite impossible forBanks to ignore policy changes for more than a quarter, as the key policy ratios have an inherent effect on thecalculation of the Base Rate.

According to draft guidelines, the RBI has proposed that the actual lending rate charged to borrowers would be theBase Rate plus borrower-specific charges including product-specific operating cost, credit-risk premium and tenurepremium.

Bank Group All Public Sector Banks All Private Sector Banks 5 Major Foreign Banks

Increase in Repo Rate Lagged (one quarter) Contemporaneous and Contemporaneous Lagged (two quarters)

Decrease in Repo Rate Contemporaneous No significant impact No significant impact

Increase in Reverse No significant impact No significant impact No significant impactRepo Rate

Decrease in Reverse No significant impact No significant impact No significant impact Repo Rate

Increase in Weighted Contemporaneous Contemporaneous Contemporaneous Average Call Money Rate

Decrease in Weighted Lagged (two quarters) Contemporaneous and No significant impactAverage Call Money Rate Lagged (one quarter)

ACTUAL RATE OF LENDING

Downward Stickiness

1716


changes in the effective interest rate for the customer willdepend on the average cost of funds rather than themarginal cost of funds hence, any increases in marketrates will take time before they are fully passed on to theborrower. Whilst this is beneficial when interest ratesincrease it is also not so bad when interest rates decreaseas, unlike the current situation, the consumer is likely toget some decrease immediately compared to none or verylittle in the current scenario.

*Difference between average and marginal cost of fundsAssume a bank currently has funds of 100 crore at anaverage cost of 10% (total cost of funds is 10 crore or

2.50 crore per quarter).

Now the cost of funds in the market goes up by 1% p.a.On an arithmetic basis the banks cost of funds shouldgo up by 1 crore per annum or 25 lacs per quarter.However since a lot of the bank’s funds are in timedeposits which are at a fixed cost - where the cost willrise only when the deposit comes up for renewal -immediately its cost may go up by only say 12.50 lacsfor this quarter or only 0.50% p.a. Of course over aperiod of time as all the fixed deposits mature and arerenewed at new higher rates the cost of funds will go upto 11 crore per annum or 2.75 crore per quarter.Thus the average cost -10% in this example changing to10.50% or a change of 0.50% only will always changeslower than the marginal cost - +1% in this example

CURIOUS CASE OF PRIVATEBANKS:There was always a consistent differencebetween BPLR of Public and Private SectorBanks of around 1% from 2004 to 2006.Post-2006 was the time when liquiditystarted picking up at a much rapid rate andconsequently, RBI brought in significantchanges in policy rates, such as CRR, Repo,Reverse Repo etc. to suck in excess liquidity.Post-2006, things looked nice and shiny tillthe 2nd quarter of 2008, this was the timewhen economy started showing signs ofdistress i.e. the time when recession took off.And hence, RBI started easing policy rates tokeep the economy afloat as a significantdearth of foreign as well as domesticinvestments in the market was expected dueto global slowdown. This is precisely the timewhen BPLR became extremely incapacitated;BPLR proved its mettle in squeezing theexcess liquidity of the market, but was highlyinefficient vice-versa. Private Banks werenever forced to induct the policy changes andas the market was bleeding, it became eventougher for any deserving borrower to get asanction and even for the ones who managedto get a sanction, they seriously lacked thenegotiating power due to the dearth ofalternatives. Hence when liquidity wastightened, they were the first to react whilewhen it was eased, the incentives were notpassed on to the customers.

Let us analyze BPLR with the help of a chart

Source: RBI

Teaser Rate is a terminology usedto refer to an enticing initialinterest rate for a loan on floatingrate basis, where the actual lendinginterest rate for major part of thetenure is much higher. This ratewill be typically, well below theongoing market rates and is used asa bait to woo new borrowers andalso to make the floating rate loansa more attractive option.For instance, the ‘teaser' homeloans have a fixed interest rate fora buffer period of one to two yearsafter which the rates jump to ahigher level. If interest rates wereto rise sharply, there is a possibilitythat borrowers' ability to repay willget affected. Like all financialproducts, there are some aspects ofthese loans that are beneficial andothers that might catch you bysurprise, especially if you are notfamiliar with how loans work.The beneficial aspect of these loansclearly is that during the earlytenure of the loan it makes loansmore affordable than what theymight have otherwise been, andoffers families the opportunity tofulfill their dream of buying ahome. Clearly, this is a good thing.The concern is that lenders aretempting customers to get this loanwithout adequately educatingthem of what their EMI could bewhen the rate shifts from the lowintroductory rates to a higherfloating rate. And, indubitably wedo not want to see familiesstruggling to pay this higher EMI.The point being made was thatwhen the “teaser rate” period isover (2-3 years in most cases) and

interest rates shifts to the normalfloating rates prevalent at thattime, the consumers may not beable to cope up with the resultantincreases in EMIs (especially if, aswidely expected, interest rates goup significantly in the meanwhile).For Instance, in a very typical case,An increase of 100 basis points ininterest rates (prime lending rates),which translates into an averageincrease of 1000-1200 bps inmonthly repayments, can beabsorbed. But if rates were toincrease by more than 100 bps,borrowers could find it difficult topay; it might outstrip the growthin income which revolves around800-1200 bps.It was expected that by now, RBIwould come up with some sternregulations to curb teaser rates, buttill date, we have hardly seen anyconcern by the RBI in thisdirection. It is still a very commonpractice among our major Banks.For instance, considering a homeloan of 60 lacs from our largestbank SBI, will attract 8% interestrate for the 1st year, 9% for thenext two years, henceforth the ratesare Base Rate + 2.25%, which bycurrent standards is 9.75% andmoreover, if you opt for a fixed rateof interest (available with resetfrequency of 5 years) it will attracta hefty BR + 3.5%, which bycurrent standards is 11.00%.

Teaser Rate

1918


The most sincere question at thispoint of time would be that if themethodology of calculating BPLR &BR is similar, then how is the systemsupposed to make any significantdifference?

If there is any answer to thisquestion, then it has to be thetransparency.

CRISIL Research says, “We expectthe transition from the benchmarkprime lending rate (BPLR) to theBase Rate system from July 1, 2010to increase transparency in lendingrates and help small borrowersnegotiate better rates with banks".

While each bank can choose its ownbenchmark for the cost of funds, itwill be mandatory for each of thesebanks to document the detailedformula for the calculation of BaseRate and follow the methodology

consistently (exceptduring a brief, six-month transitionperiod). Theunderlying formulawill have to bedisclosed to theRBI, which in turnwill ensure that it isbeing followedconsistently. This isunlike the BPLRregime, whereBPLR wassupposed to take

into account the same set ofparameters but no documentationwas required and it was not open toRBI scrutiny. This is a significantdifference as it forces banks to followa consistent method of calculatingthe Base Rate. Also previously, banksused to price the loans with referenceto a complicated system calledbenchmark prime lending rate(BPLR), whereby each bank had itsnon-transparent BPLR methodologywhich made it even more difficultfor borrowers to compare rates acrossbanks.

We all know that Priority Sectorslike blue chip corporates etc. arealways able to get good rates frombanks. They are likely to beborrowing at interest rates very closeto the Banks’ Base Rates. Whenmarket interest rates fall, they will

naturally expect to get better ratesand unlike before they cannot do itwithout bringing down benchmarkrate, the banks will be forced to droptheir Base Rate if they still want tomaintain their market share. Thiswill exert downward pressure on thebanks’ Base Rates when marketinterest rates fall which in turnwould decrease all the existing loanslinked to the Base Rate. This clausetends to make the Base Rate self-corrective in nature.

RESPONSIVENESS TOPOLICY RATESIf the transparency is so built in, thenwhy the doubt on whether the systemwill be effective?

Because while the system is moretransparent than BPLR, there is norequirement that the detailedformula of each bank’s Base Rate bemade public, moreover all thesechanges depends solely on the extentto which it is forced, according toregulations it will be only availablewith the RBI for reviewing. Hence,the effectiveness of the new systemmajorly depends on the extent of theenforcement of this rule. As far ascalculation of the Base Rate isconsidered, it can be a trickybusiness. Hence, overall Base Rateevokes a positive vibe but it will bevery amateurish to concludeanything at this stage.

Transparency

Post-Base Rate, major changes in NIM areneither expected nor aimed at by the RBI.Bankers say that even if lending rates arehiked in some areas, they have to be keptlow in other areas. Thus the overall yieldwould turn out to be more or less the same.According to Mr. S S Ranjan, ChiefFinancial Officer, State Bank of India, therewould not be any effect on the bank's NIMas the yield from lending would remainunchanged.However Mr. S Sridhar, CMD Central Bankof India, has a different view. He expects arise in the bank's lending rate with theimplementation of Base Rate and feels thiswould positively impact the banks' NIM.As Private Banks have kept their Base Ratesat sufficiently lower levels than PublicSector Banks, the question asked herewould be, will they be able to sustain. ThisPractice, if not discontinued soon may hitthe NIMs of private sector banks whichhave always been working on sufficientlybetter margins than PSBs. Moreover, Bankswith higher NIMs can sustain lower BaseRate; hence Base Rates and NIMs shouldat least be slightly correlated to each other.Let’s review the exact status of the market.

Here we can see that majority of the Banks with NIM greater than 3has their Base Rates fixed at around 7.25-7.5%. While Banks’ havingNIM in the lower 2 or higher 1 range has higher Base Rates.But, the proposed deregulation of savings bank deposit rates is likelyto put banks in a fix. Banks may have to raise the interest rates onthese deposits following deregulation so as to gain competitiveadvantage. This may affect the net interest margins (NIMs) of banks

Nationalised BanksSl. No. Bank Name NIM* Base Rate

1. Punjab National Bank 3.57 8.002. Bank of Baroda 3.12 8.003. State Bank of Mysore 3.10 7.754. Allahabad Bank 2.88 8.005. Canara Bank 2.80 8.006. Indian Overseas Bank 2.74 8.257. UBI 2.71 8.008. SBI 2.66 7.509. Oriental Bank of Commerce 2.56 8.0010. UCO Bank 2.38 8.0011. Syndicate Bank 2.35 8.25

Private BanksSl. No. Bank Name NIM* Base Rate

1. Kotak Mahindra Bank 6.30 7.25 2. HDFC Bank 4.20 7.25 3. AXIS Bank 3.75 7.50 4. Karur Vysya 3.23 8.50 5. ING Vysya Bank 3.21 7.25 6. Yes Bank 3.20 7.00 7. Dhanlaxmi Bank 2.70 7.00 8. IDBI 1.23 8.00

Effect On Net Interest Margin (NIM)

Source: Bank Websites *For the Year, 2009-10

2120


if they are unable to manage the higher costs that would be incurred in the process.“There were a lot of costs involved in running savings accounts, including the daily interest rates and the deregulationof interest rates would only affect the NIM of banks further”, said Ms. Renu Challu, Managing director, State bankof Hyderabad (SBH)

SBI's NIM had fallen to 2.93% from 3.1% on high cost of deposits and lower yield on advances in the fourth quarterending in March 2010, but the bank wants to improve it by 20 basis points in 2010-11. Bank of Baroda also doesn'texpect much impact on its NIM due to the Base Rate. "We will try to protect our NIM. The sub-PLR borrowerswill be migrating to the CP market to a certain extent” said Mr. MD Mallya, CMD of the bank.

There was always this strong feeling of disgust among SMEs loan-seekerswho witnessed paying such high rates of interest compared to theircorporate counterparts because of their lack of negotiating power as wellas non-transparency in the system made them takers while Big Corporateswere choosers of the market.But with Base Rate, now, there is a limit below which Banks are prohibitedto lend and moreover this limit is obtained via calculation, methodologyof which is set by RBI. Thus, bringing in parity among Banks as well asloan-seekers. Previously there was this lack of knowledge among borrowers about therate at which loan is disbursed to big companies, along with the Banksubiquitous practice of keeping those rates confidential, added to their woesbut now it will be very certain that it would not be below the Base Rate,hence there will be sufficient transparency on what is the extra rate ofinterest they are paying for their lesser credit-worthiness. Moreover, thepractice of lending at very low rates to the big corporate will compel Banksto keep the Base Rates low at all times.But, still with Base Rate not open to any public Scrutiny & no guidelinesover what should be the Cost of Deposit there are still some holes left tobe plugged. It would be interesting to find out whether the general publiccan, under RTI, access a specific bank’s calculation of Base Rate that isavailable with the RBI

It is the region where a massive change of events isexpected in the near future. Many Popular figures inBanking arena share the same perspective.Mr. M Narendra, Executive Director, Bank of India, saidshort term lending is bound to see a correction once theBase Rate regime sets in.

"Introduction of the Base Rate mechanism will enhancecompetition in the short-term lending space. However,competitive pressures are unlikely to impact the overallprofitability of the banking system materially" Crisil said.

The Base Rate system, which is to be in place from July

1, is likely to lead to an increase in short-term lendingrates. This is because banks will be forbidden fromlending below the Base Rate, which is decided based ontheir cost of funds and is likely to be around 8%.

A possible consequence of this could be to encouragethese better rated firms to search for alternative fundraising routes in the debt markets, thereby facilitating theincrease in its breadth and depth. Corporations and non-banking finance companies (NBFCs) could prefer short-term (less than a year) money market instruments likecommercial papers (CPs), with tenor between 15-365days and with rates linked to the yield on the one-yeargovernment bond or non-convertible debentures, overbank loans, especially for their short-term funding needs.It will also set the stage for the higher rated companiesto raise capital through the external commercialborrowings (ECB) route, especially given the ultra-lowinterest rates across much of developed world. Astrengthening rupee (vis-a-vis dollar) will only increasethe attractiveness of such fund raising.

"Highly rated corporate availing short-term loans(estimated at 7 to 10 per cent of total corporate loans)will look to transit to the more attractive debt capitalmarkets through short-term instruments and choosebanks with lower Base Rates," Crisil said.

However, Base Rate will not have animpact on longer-term loans, henoted. “Currently some of the majorinfrastructure projects are financed at10% to 11%. That will not see amajor change,” Banks pushing the administrators toallow sub-Base Rate lending at leastto the loans with tenure of few days.

“A large AAA-rated company wasavailing loan for 4.5-5 per cent fortenure as short as seven days. Now,they are not ready to pay 7.5-8 percent for the same product,” said thechairman of a public sector bank whoattended the meeting.Besides, a senior executive with a largepublic sector bank pointed out thatduring a pre-policy meeting bankershad pointed out that in certainsegments, such as the letter of creditbusiness, the state-owned entities hadlost market share to private players,which had settled for lower BaseRates. Moreover, our largest Bank SBIis of the opinion that lending to aborrower even for a few days is betterthan parking surplus funds with theCentral Bank through the reverserepo route.

Effect On Short Term Loan

Cross-Subsidization ofLoans

2322


“In the long run all of us are dead”- John Keynes

Base Rate will not lead to any changes in the interest rateson the long term loans in the near future. But when farinto the future is considered Base Rate will have positiveeffect for the consumers. Under the current practice, whereby the current Retail& Corporate Loans does not have any substantialcorrelation, will come under the hammer because of the

inherent nature of the Base Rate under which ensures astrong correlation between interest rates of Corporate &Retail Loans. Retail Borrowers who are still into first one or two yearsof loan where rates are fixed at or around 8-9% shouldnot switch, while those who are under variable rate withbenchmark as BPLR should shift to the new regimebecause it will ensure a reasonable interest rate. WhileAAA-Grade Corporate borrowers borrowing at sub-BPLR rates might have extra incentive to stay under thepurview of BPLR as long as possible. But, this might notwork for long considering the Banks point of view ofdealing administratively with two major Benchmark rates.Hence soon it will be in interest of Bank as well to makethese organizations switch. But, “The impact won’t bemuch for long-term money which was always costlier at9-11 per cent” said, Mr. N K Kakani, Executive Director,Simplex Infra. “In the long-term lending space, however,a material shift in the market share of banks is unlikely”quoted Credit rating agency CRISIL.

Credit growth in the Indian mortgagefinance market improved to 13 percent in 2009-10 from 10 per cent inthe previous fiscal due to factors suchas a healthier operating environment,expectations of appreciation inproperty prices and attractive interestrate schemes offered by banks andhousing finance companies (HFCs).As the Corporate loans under newregime might take a backseat, Retailloans with its considerable growth willbecome the new area of focus for theBanks where they look to recover thelost revenues, which might witness aseries of very competitive rateshereafter. And with greater negotiating

power in the hands of borrowers,things look brighter for home loanborrowers. Moreover, over 90 per centof all mortgage loans are estimated tobe at floating rates of interest whichmade the borrower much vulnerableto interest rate spreads. To make sure you get the best spread,manage your credit profile because thatis among the important parametersdetermining your spread. Having agood credit profile will create a windowof opportunity for you to bargain withbanks to lower the spread.But, Housing Development FinanceCorporation and LIC Housing

Finance which are two major playersin the home loan market comes underthe purview of non-banking financialinstitution category, hence areexcluded from the Base Rate system.

Effect on Long Term Loan“Currently, banks saddled with surplusliquidity and lack of avenues to deployfunds, have been providing short-termloans to large corporate with a healthycredit profile at rates as low as 5.5% or6%. Moving to the proposed BaseRate system would make it impossiblefor banks to lend at these rates, which,consequently, would lead to corporatesconsidering alternative sources,” aCRISIL report said.

But Presently, not much is expectedout of the change as Banks have beensuccessful in keeping their Base Ratesquite low, which might not trigger aserious change in events as for ourBiggest Banker things seem to be incontrol at present, as, "Corporate loansas of now priced less than 7.50% isonly 3% of the loan book," ChairmanO.P.Bhatt. But things might notremain the same forever, as RBI is allset to tighten liquidity which will forceBanks to increase their Base Rates tounprecedented levels. With increasingpolicy rates, large borrowers will have

lesser bargaining power than before.

But, the present arrangement by banksfor funding against letters of credit(LCs) and bill discounts would beseverely affected by the Base Ratesystem as loans are given atsubstantially-reduced rate due toguaranteed payments. Banks used topark their excess liquidity with AAAcustomers which would not bepossible now, hence they will have topark it with RBI which is sufficientlylower than AAA-Grade CorporateLending rates, this will forceCorporate to float their own CPs, hence a surge in CP market isexpected soon.

This regime might not prove to be veryprofitable for Banks with hugeCorporate Lending base as they willhave to always keep a check on theBase Rate because Base Rate Elasticityof Revenue can become very high atsome key values of Base Rate. So theywill have to keep a very thorough

check on their Cost of Deposit whichis expecting an overall increase

The bank will add credit premium,tenure premium and allocatable cost tothe Base Rate while deciding the exactlending rate to the borrower. For someborrowers, effective interest rate underthe Base Rate mechanism will behigher, while for others it will be lower.SBI's Bhatt indicated that segmentswhich are more risky may see theireffective lending rates going up.

Effect on Corporate Loan

Introduction of Base Rate will have anirreversible change on Letter of Credit,Short term Working Capital Loans offew weeks as these loans majorlyvacillates in the sub-Base Rate region.For a long time Big companies withgood credit rating have been the bestsafe havens to park the surplus

liquidity in the short term better thanRBI which gives lower Interest Rate.Base Rate will definitely make CPs amore attractive investing option, asclearly evidenced by the fact thatraising of funds through commercialpapers (CPs) has surged within amonth of the country's banks shifting

to base rates (the new benchmark forpricing loans in a transparent manner).In July, companies raised an estimatedamount of 25,889 crore throughCPs, a short-term money marketinstrument. This was almost doublethe 13,321 crore garnered in June,according to the latest Reserve Bank of

Effect on Parallel Markets; Such as CP etc.

Effect on Home Loan

2524


India (RBI) data. With this emergence, CRISIL estimatesthat demand for CPs would be around 1680 billion.A very strong inherent shortcoming of Base Rate incomparison to CP (evidenced by the graph shown under)is that, it may not be as variable (flexible) as the latter,especially on the downside; if banks reduce their base rate,they will have to re-price their existing Base Rate linkedshort and long-term loans, across borrowers, impacting theirprofitability. At same time, Banks are expected to invest inCPs of their corporate customers, to remain in their goodbooks. And also, it is in bank’s own interest to park theirexcess liquidity with CPs rather than with RBI.

Thus, we have strong reasons to believe that corporates aregoing to shift towards lesser demanding CPs, NCDs, etc.Many popular Analysts & Industrialists share the samemindset. “Currently, we are more comfortable with bank credit as weget it at sub-BPLR. But after the introduction of the BaseRate, we may opt for CPs, public deposits and NCDs toraise funds,” said Mr. R Ravi, Chief Financial Officer atPennar Industries.“The introduction of a Base Rate will certainly be a steptowards the development of the debt market and in the timeto come, more corporates will shift from bank loans to CPsand short-term NCDs to meet short-term working capitalrequirements,” concurs Mr. Ram Yadav, Head of Financeand Strategies at Orbit CorporationBut we have to be Cautious, as being a short-term financinginstrument; the interest rates for CPs are quite sensitive toliquidity conditions. Hence many Bankers are of theopinion that the conditions might not be in favour of CPsforever. According to the head of treasury with a large publicsector bank, with RBI raising key policy rates and tighteningof liquidity in the system, raising short-term funds is goingto be a costly affair. Moreover, the coming months may notsee a similar level of activity as the SBI official apprehendsthat RBI may also come up with rules that would make ittougher to invest in CPs below base rate.

CP RateSBAR

Variability of CP Rates Vis-a-vis BPLR16%14%12%10%8%6%4%2%0%

Apr

-08

Apr

-09

May

-08

May

-09

Jun-

08Ju

l-08

Jun-

09Ju

l-09

Aug

-08

Sep

-08

Oct

-08

Nov

-08

Dec

-08

Aug

-09

Sep

-09

Oct

-09

Nov

-09

Dec

-09

Jan-

09Fe

b-09

Mar

-09

Jan-

10Fe

b-10

Mar

-10

Source: RBI

Source: figures (CRISIL Research)

Mutual Funds which have been thelargest investor segment in CPs are nowexpecting a major hike in the supply ofCPs. The Net estimated demand of CPsof around 1680 billion is more thantwice the current level of MFinvestments in CPs. By issuing CPs,India’s corporates can collectively nowsave up to 11.7 billion on interestcosts, thereby increasing their net profitsby as much as 1 percentage point.Previously, due to the dearth in supplyof CPs, Investments from MFs in bankcertificates of deposits (CDs) and fixed

deposits (FDs) were more than thricetheir investments in CPs. But, now,with Base Rate, supply of CPs is goingto increase. Accordingly, MFs will havemore diverse as well as efficient marketto invest. Hence, MFs which have had fewoptions to invest in so far, will now lookto invest directly in CPs, rather thanindirectly lending to them throughbank CDs. Thus saving the differentialyield which according to CRISIL, canrange from 25 basis points to 100 basispoints. Considering even the most

conservative figure, 25-basis pointhigher yield on CPs in relation to CDs,the MFs can obtain up to 6 billion ashigher interest by investing in CPs,rather than in CDs and FDs.

Significant Restructuring of Mutual Fund’s Investments

CASA stands for current and savingsaccount. The CASA ratio shows out ofthe total deposits available with abank, how much is attributable tocurrent and savings deposits.An increased CASA ratio thereforewould infer an increased source offunds from current and savingsaccount deposits. CASA providesmore liquidity as compared to termand demand deposits.As the whole Structure of Base Raterevolves around the Effective Cost on

Deposits, CASA is bound to play ahuge role. Gainer will be the ones withhigher CASA as it will ensure liquidityas well as lower Cost on Deposits, thistogether with the upcoming mandateof RBI for de-regularization of theinterest rate on savings accounts isgoing to make Banker’s life tougherwith time, while on the other handdepositor’s are sure to witness brightfuture ahead.But, again de-regularization of theinterest rate on savings accounts will

lessen the differences between bankswith varying CASA ratios to someextent.

Importance of CASA

System is all set to witness some hikein Deposit rates, with de-regularization of interest rates ofSavings account, increment in policyrates along with added competitionfrom different horizons (CP, NCDetc.) will definitely shift Deposit Ratesto higher frontiers. Many Banks havealready increased their deposit Ratesby around 50 basis points.The introduction of Base Rate was

aimed at and is expected to bringgreater transparency in lending rates.As a corollary, another silent butsignificant change is taking place onliabilities. According to bankers,deposit mobilization will become moredisciplined and banks will be cautiousbefore raising their deposit rates,especially for corporate bulk deposits.Those banks with Base Rate below 8%may feel the heat. So, they may go for

a hike in deposit rates by 25-50 bps.

Effect on Deposit Rates

Though the banks have shifted to theBase Rate from July 1 at the behest ofthe RBI, they have to maintain twosystems—one for the new borrowersfollowing the Base Rates and anotherfor those who had borrowed loans inbench mark prime lending rate(BPLR) regime—which is acumbersome exercise.

“What is happening now is the bankscan't force the existing customers toshift to Base Rate. Hence they arecompelled to announce two kinds ofstandard lending rate, the Base Rateand the benchmark prime lending rate(BPLR),” said State Bank of India’s,Mr. O.P Bhatt, he also said “We hopethat the RBI will bring into force asunset clause and ask those borrowers

under the retail segments, who hadopted for the fixed rate of interest, tomigrate to the Base Rate regime byJune 30 next year.”“The basic idea behind hiking theBPLR is to make existing customersshift to the Base Rate,” said Mr. SureshGanapathy, head of financial researchteam at Macquarie Securities.

Sunset Clause

2726


Due to Delay in Sunset Clause, Banksare looking forward to increase BPLRto entice customers to the new regimeto overcome the two-foldadministrative cost and the extraconfusion among Banks formaintaining both the rates. Clearlyevidenced by, PNB raised its BPLR by75 basis points (one basis point is one-hundredth of a percentage point) to11.75% from August 1. IDBI Bankreviewed its BPLR and increased it by50 basis points to 13.25% effectiveAugust 5. Corporation Bank andUnion Bank have also raised theirBPLR by 50 basis points to 12.50%and 12.25%, respectively, effectiveAugust 4.)

Flip Side of the Sunset Clause:RBI had introduced the Base Ratesystem with the aim of making pricingof loan far more transparent and toensure transmission of the monetarypolicy. While doing so, the centralbank also instructed banks that all newloans from July 1, 2010, should belinked to the Base Rate. For loansgiven prior to July 1, banks shouldreprise them at Base Rate at the timeof renewal. RBI also told banks that a

customer should be allowed to shift toBase Rate even before the loan comesfor renewal, without chargingcustomers any penalty. Among the types of loans provided bybanks, working capital loans and termsloans are renewed every year, personalloans are short-tenure fixed rate loansand auto loans are either on fixed orfloating loans for 3-5 years. Homeloans, availed at floating rate are thelongest tenure loans which do not havea renewal clause. In case of fixed ratehome loans, most banks have inserteda clause that the rate would bereviewed after every 3-5 years, andthus, these loans would be renewed atBase Rate. But the share of fixed ratehome loan is very low in the entirehome loan portfolio. Now that RBIhas rejected the sunset clause, bankersfeel that unless they make an attractiveoffer for existing PLR customers, theymay not move to the Base Rate system.RBI is resisting a move to introduce asunset clause as it fears that such aclause would give banks an upper handover its customers — mainlyindividuals who lack the bargainingpower to get a fair deal after theswitchover.

It is common knowledge that the influx of deposits into abank may not necessarily be synchronous with the demandfor credit. Hence banks may need to lend short term to lowrisk borrowers at below Base Rate with the specific intentionof deploying these funds at higher rates later when thedemand for credit turns robust. But, Base Rate might notend this practice as, the bigger customers can still raise fundsby issuing commercial paper (CP) for short periods from15 days to 12 months and many banks, when faced withsurplus liquidity, would willingly invest in the CPs at rateslower than base rate. Though called investment, it is reallylending.You may have noticed that the Base Rate is the minimumrate at which the bank can lend. Hence, banks are allowedto actually lend at much higher interest depending uponthe credit risk of the customer and the nature of theproduct. But till what cap or limit, the RBI has not madeany announcements. Though true, that the bank will try tokeep the spread as low as possible owing to increasingcompetition, there is no stopping to the bank even if it lendsupto say 6% plus Base Rate.This new system can prove very detrimental to the healthof Banks which works on very sleek NIMs (such as IDBI)due to their inherent nature of large share of corporateadvances coupled with large share of term deposits.Now, it will be impossible for these banks to match theircost on deposit with their peer groups who rely more on

CASA for funds. Now, with significant difference in BaseRates Banks working predominantly on term depositswould not be able to make corporate loans to the extentthey have been prior to Base Rate. Hence they will have toimprove CASA as well as retail lending which requires loadsof expenditures (via marketing, more number of branches,greater facilities, better services etc.) which might not bepossible for every bank. Hence it gives inherent advantageto the banks with better CASA and lower Base Rate.

JUST A THOUGHTThe Current environment suggests relative increase in policyrates and increasing deposit rates (been already initiated).In the event Banks will have to eventually increase BaseRate, but with such fierce competition in Banking Sector amarginal change in Base Rate of any Bank might result in alandslide change in its total advances. So for their bestcustomers, they have to be glued to their minimumstructure & as may be comparable to certain TreasuryProducts like Commercial Papers etc. Hence, not passingon the interest rate rise to the Base rate will put Bank’smargins under undue pressure and if base rate is increasedand it is not replicated by its peers, many high credit gradecorporates will move to its peers which on increased volumemight manage with lesser margin. Hence, Banks may faceCatch-22 situation for keeping its best customers & marginsintact, more so, considering that Non-Performing Assets(NPA’s) are also on a rise.

One very disappointing part of thiswhole exercise is banks have still notput methodology on their websites.Announcing rates is not enough. Weneed to know how the rates have beenarrived. As of now Base Rate is justlike BPLR. And no regulationswhatsoever on what Cost of Depositsshould be taken for the calculation ofBR, can make the whole exerciseredundant.Currently, the Base Rates are proposedto be reset every quarter, irrespectiveof time and tenure of monetary policyinstances of RBI. There needs to beparity in timelines. There should besimilar timelines in addition to banks'own policy for resetting the Base Rate.This will ensure monetary policytransmission without gapDuring times of excess liquidity in thesystem, as is presently the case, bankswith comfortable capital adequacywould opt for the commercially-sensible alternative of first scouting forsuitable assets and then financingthem by raising appropriate liabilitiesthat yield an adequate risk adjustedprofit to the bank. Quite often, thiswould involve lending at below thenew Base Rate but in the proposeddispensation, this activity isprohibited. It is difficult to imaginehow this prohibition would servesociety better in as much as it deprivesthe banking system of potential profitsby denying credit to a needy borrowerwho would invest in productive assetsand generate employment, albeit byborrowing at a sub-base interest rate.

Drawbacks

2928


The move by RBI to migrate to a more transparentsystem of pricing loans is certainly beneficial to thecustomer. Does this mean customers should look out forbanks charging lower Base Rate for loans? Looking atonly Base Rate to decide on the bank from which youwill take a loan may not be intelligent. Remember, thebank has the flexibility to determine the spread on yourloan which in turn will determine the interest chargedto you. So while opting for a loan, let the comparisonbe on the overall loan cost and not the Base Rate.Coming onto retail consumers, home loan consumerswon`t get affected in a big way except for 25 bps hereand there. In the retail category, the SME customers willhave a chance to gain a little from the Base Rate sincethey are currently charged much above 9%. But overall,there will not be a significant impact on the retailsegment for the banks.Besides, the new Base Rate system is likely to bring insome innovation in debt instruments and therebydeepen the debt markets. As regards home loan market,home buyers may have to live with worries of frequentchanges in their EMIs as there may be less long termfixed coupon products and more of floating rateproducts available in the market.But as far as responsiveness to changes in policy rates areconsidered, both the present and the new system will belinked to the cost of funds (deposit rates), but the keywill be transparency, requirement to come up with morecompetitive Base Rate among banks, and the powersgiven to the RBI whereby it will scrutinize the rates everyquarter which might make banks respond more quicklyto policy rate and liquidity changes.But the feeling among individuals, borrowing under

flexible rates that they face an opaque system which ischanged or not solely according to the needs of banks,is likely to go away. Things look more effulgent now, asall floating rate loans will be clearly linked to the BaseRate (e.g., 1.5 percentage point more) and, moreimportantly, the rate will automatically and mandatorily

changed in response to Base Rate changes. Currentlyindividual existing borrowers witness a very estrangedbehavior from Banks, whereby interest rates revisions ontheir loans mostly witness upward movements, seldomare they revised downwards. Moreover, New Customersare offered loans at very lower rates relative to theirexisting counterparts who are majorly handicapped bythe lesser negotiating avenues available to them. But nowwith every loan linked to the same Benchmark Rate,existing borrowers are likely to see themselves payingInterest rates in tandem with the industry (rates tend tofloat up over time), and once teaser rates are formallydiscontinued things will become much clearer. As forlarge corporate borrowers negotiating very fine rates forthemselves, that is likely to discontinue as banks no moreoblige them under competitive pressure.The cost of deposits has the highest weight in calculatingthe new benchmark. Banks, however, have the leeway totake into account the cost of deposits of any tenure whilecalculating their BR. For example, SBI took costs of its6-month deposits into account while calculating its BR,which it has fixed at 7.5%, and gave sufficientjustification for not taking last quarter or last yearDeposit Rates. But on the other hand, PNB and Bankof Baroda decided to take average cost of Deposit for thelast quarter as the benchmark Cost of Deposit. Hence,the issue of Cost of Deposit is very subjective and noregulations whatsoever on what Cost of Deposits shouldbe taken for the calculation of BR, can make the wholeexercise redundant. Hence there should be someguidelines on what cost of deposits to take, which willmake the market more uniform and bring all the Bankson the same platform.We therefore believe that it is rather early to arrive at anyconclusion. However the likely benefits of thechangeover to Base Rate system have been stated by RBIand it is expected that RBI will issues suitable directionsto lead the banking system to ensure that the objectivesare met fully.

ConclusionCRRCash reserve Ratio (CRR) is the amount of funds thatthe banks have to keep with RBI. If RBI decides toincrease the percent of this, the available amount withthe banks comes down. RBI is using this method(increase of CRR rate), to drain out the excessive moneyfrom the banks. “Presently, 6.00%”

REPO RATEWhenever the banks have any shortage of funds they canborrow it from RBI. Repo rate is the rate at which ourbanks borrow rupees from RBI. A reduction in the reporate will help banks to get money at a cheaper rate.When the repo rate increases borrowing from RBIbecomes more expensive. “Presently, 6.00%”

REVERSE REPOReverse Repo rate is the rate at which Reserve Bank ofIndia (RBI) borrows money from banks. Banks arealways happy to lend money to RBI since their moneyare in safe hands with a good interest. An increase inReverse repo rate can cause the banks to transfer morefunds to RBI due to this attractive interest rates. It cancause the money to be drawn out of the banking system.Due to this fine tuning of RBI using its tools of CRR,Bank Rate, Repo Rate and Reverse Repo rate our banksadjust their lending or investment rates for commonman. “Presently, 5.00%.”

STATUTORY LIQUIDITY RATIO (SLR)SLR is Statutory Liquidity Ratio. It’s the percentage ofDemand and Time Maturities that banks need to havein any or combination of the following forms:i) Cash ii) Gold valued at a price not exceeding thecurrent market price, iii) Unencumbered approvedsecurities (G Secs or Gilts come under this) valued at aprice as specified by the RBI from time to time.The maximum limit of SLR is 40% and minimum limitof SLR is 24%. This restriction is imposed by RBI onbanks to make funds available to customers on demand

as soon as possible. Gold and G Secs (or Gilts) areincluded along with cash because they are highly liquidand safe assets.

“Presently, 25%”. “364-day, T-Bill: 6.696%”

DRI (Differential Rate of Interest)This scheme offers need based financial assistance tothose who intend taking up any productive activity andhas been tailored for persons whose income is very low.This scheme is generally meant for persons belonging toSC/STs, Adivasis, Village and Cottage Industries,collection of forest products, agricultural operations,Orphanages & Women's Homes etc. Due to its inherentnature, Banks cannot be asked to put a floor rate to thistype of Loan, generally it is very low (around 4%).

BASEL II NORMSBasel II insists on setting up rigorous risk and capitalmanagement requirements designed to ensure that abank holds capital reserves appropriate to the risk. Theunderlying assumption behind these rules is that thegreater risk to which the bank is exposed, the greater theamount of capital the bank needs to hold to safeguardits solvency and overall economic stability. It will alsooblige banks to enhance disclosures.

REFERENCES:1. RBI Publication Reports2. CRISIL Reports3. Business-Standard.com4. Financialexpress.com5. Business Today6. Livemint.com7. Apnapaisa.com8. Economictimes.indiatimes.com9. Thehindubusinessline.com10.Indian Banking Association11.Bank Websites 12.Smartinvestor.in

Annexure

31

BDO India

30

Sumedha Fiscal

Abbreviations:1. BPLR Benchmark Prime Lending Rate2. BR Base Rate3. Bps Basis Points (1 Basis Point = 100th of 1%)4. LC Letter Of Credit5. CP Commercial Papers6. CD Certificate of Deposit7. NCD Non Convertible Debenture8. MF Mutual Fund9. NPA Non Performing Assets10. RBI Reserve Bank of India11. NIM Net Interest Margin12. HFC Housing Finance Companies13. NBFC Non Banking Financial Corporation14. PSB Public Sector Banks

Short form of Various Banks used:1. SBI State Bank of India2. HSBC Hong kong and Shanghai Banking Corporation Limited3. DBS Development Bank of Singapore.4. HDFC Housing Development Finance Corporation Limited5. ING (Vysya) International Netherlands Group 6. ICICI Industrial Credit and Investment Corporation of India7. SBM State Bank of Mysore8. PNB Punjab National Bank9. OBC Oriental Bank of Commerce10. UCO Bank United Commercial Bank11. BOI Bank of India12. IDBI Industrial Development Bank of India13. IOB Indian Overseas Bank14. DCB Development Credit Bank15. RBS Royal Bank of Scotland

This publication has been carefully prepared, but it hasbeen written in general terms and should be seen asbroad guidance only. The publication cannot be reliedupon to cover specific situations and you should not act,or refrain from acting, upon the information containedtherein without obtaining specific professional advice.Please contact BDO Consulting Pvt. Ltd. or SumedhaFiscal Services Limited to discuss these matters in thecontext of your particular circumstances. BDOConsulting Pvt. Ltd. and Sumedha Fiscal ServicesLimited along with its partners, employees and agents

do not accept or assume any liability or duty of care forany loss arising from any action taken or not taken byanyone in reliance on the information in this publicationor for any decision based on it.BDO Consulting Private Limited, a private limitedcompany incorporated in India, is a member of BDOInternational Limited, a UK company limited byguarantee, and forms part of the international BDOnetwork of independent member firms. BDO is the brand name for the BDO network and foreach of the BDO Member Firms.

Disclaimer:

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