Basics Of The Base Rate

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The much-awaited base rate has finally been introduced in the Indian banking system from July 1, 2010, thereby replacing the benchmark prime lending rate (BPLR). There is lot of buzz going around as how it will affect the bank financials and different lenders. We at DSIJ have made a study of what this base rate is, the need for a base rate at this point and how is it going to change things for the lenders.

The base rate is going to replace the current BPLR system and will act as a minimum rate for all the commercial loans. But this will not apply to staff loans, loans against fixed deposits and loans under the differential rate of interest scheme. Most of the banks have announced their base rate and it is found to be ranging from 7 to 8.5 per cent (see table).

Dhanlaxmi Bank has set its base rate the lowest at 7 per cent whereas Karur Vysya Bank has fixed it at 8.5 per cent, the highest till now. This base rate is calculated on the basis of the cost of deposits, adjusting for the cash reserve ratio (CRR) and the statutory liquidity ratio (SLR), other operating costs and profit margins.

Apart from this, the bank will add borrower-specific charges, which will include product-specific operating costs, credit risk premium and tenor premium. This has come at a moment when roughly two-thirds of the outstanding loans by the scheduled commercial banks are issued at sub-BPLR rates.

Though the banks have always lent money to corporates with good credit rating at a rate much below the BPLR for short-term periods, it was more prevalent in the last one year or so due to the banks being loaded with surplus liquidity and lack of avenues to deploy them. According to some estimates, they were lending at a rate as low as 5.5 to 6 per cent to these corporates.

But once the banks adopt a base rate it will be not possible for them to lend at rates lower than the base rate and since no bank has fixed a rate lower than 7 per cent, it will not possible for banks to now lend at earlier rates. Does this mean that the banks were earlier lending at rates lower than their cost of deposits? No, this is not the case since the banks were actually compensating this lower rate by charging higher rates to borrowers with lower credit ratings and moreover it is estimated that short-term loans make for below 10 per cent of the total corporate loans.[PAGE BREAK]

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However, the closing of this avenue (borrowing at sub-BPLR) will drive the corporates to search for other options to borrow money at lower rates. And one of this is to raise money through commercial papers. Commercial papers are an unsecured money market instrument issued in the form of promissory notes and range from 15 days to 365 days. If the recent rates are considered (both base rate and interest rate on commercial paper), the corporates would find raising fund through short-term commercial paper cheaper than borrowing from banks. According to the RBI, by the end of February 2010, the total amount outstanding issued through commercial papers was Rs 96,152 crore and the interest rate ranged from 3.3 to 8 per cent. However, the next question that arises is whether the market has the appetite to absorb any such surge in the issuance of commercial papers. Banks and MFs are the biggest investors in this paper and any such issuance by a better-rated company can only find adequate response. The rest of the companies that do not have good ratings will find it difficult to raise money through this route.

Therefore this entire process will not have much effect on the financials of either the banks or the corporates as these better-rated companies were the ones who used to borrow at similar rates but used to directly raise money through the banks instead of using this money market instrument. But one positive aspect that will emerge from this entire exercise is that the money market will become more vibrant and robust. Let us see how this is going to affect a bank’s financials. According to a report by CRISIL Research, the average yield on bank advances is expected to decline by 10-15 bps over the next two years.

This is because the base rate just provides a floor rate and before lending a bank will add an appropriate ‘mark up’ depending upon the credit profile of the borrower and the tenure for which the fund is being loaned. This will be more or less at the same rate at which they are currently lending. Even A C Pereira, CMD, Bank of Maharashtra believes that “banks will have better returns on their lending because earlier due to competition they were lending at sub-BPLR rates but now it will not take place and the returns will be more stable.” However, companies with lower credit ratings and some retail customers may get marginal benefits because it will be hard for the banks to justify exorbitantly high rates under the disguise of creditworthiness. Therefore, the net interest margins of the banks are not going to be materially affected by the introduction of this new system. Also, loans bearing lower interest rates do not constitute a significant chunk of the entire loan portfolio. For example, out of the total loan book for SBI, loans below 7.5 per cent constitute only 3 per cent of the bank’s corporate loan book.[PAGE BREAK]

Though this new system will not have much of an impact on a bank’s financials, the one thing that will definitely change is the percolation of the monetary policy to the desired levels with the required effects. Of late, the Reserve Bank of India was finding its monetary policy not showing the desired results because the banks were failing to respond according to the change in the RBI’s key policy rates.

This blocked the important transmission channel through which the RBI impacts the real economy. But now the introduction of the base rate will ensure that the banks tune their inertest rates as and when the central bank changes its key policy rates, thus helping the RBI to control important economic parameters like consumption, inflation, etc. As Pereira puts it, “the concept is more transparent now.”  We feel that the base rate is far better than BPLR to ensure more transparency in the banking system. However, this is not the final destination in banking reforms, but only a milestone.

A lot needs to be done to ensure better functioning of the entire financial system because one of the greatest flaws in the announcement of the base rate is that it is not linked to tenure. Therefore we believe that the base rate is a step in the right direction for creating a more vibrant and transparent financial system.