The current system of benchmark prime lending rate (BPLR) is all set to be replaced by base rate (BR) from July 1, 2010. BR is the minimum rate at which banks will be expected to lend once it is implemented. According to Reserve Bank of India (RBI) guidelines released in April 2010, BR will be calculated on the basis of cost of deposits, negative carry on cash reserve ratio (CRR) and statutory liquidity ratio (SLR), unallocable overhead cost and average return on net worth. However, banks will be given time till December 2010 to make the necessary adjustments and are free to use any other methodology as long as it is open to scrutiny.
BR has been introduced primarily to bring about transparency in the system and to overcome the defects in the current BPLR. BPLR is meant to be the rate at which banks lend to the most credit-worthy borrowers. It was introduced in 2003 as the rate below which no banker would lend. Given competition with international rates, RBI allowed banks to lend at sub-PLR rates. However, with this becoming the general practice, sub-PLR loans now account for approximately 70 per cent of the total loans extended by banks. Poor transmission of changes in the constituents of BPLR (cost of funds, asset strategy and market forces) is also largely responsible for keeping it artificially high.
More importantly, the current system of BPLR is subject to what is called the problem of “downward rigidity”, i.e. banks show reluctance in paring down their lending rates in times of loose monetary policy. Thus, it does not provide a good transmission mechanism as it tends to be out of sync with changes in policy rates. PLR changed by only 2-2.75 percentage points from October 2008 to January 2010, while repo rate was reduced by 5.75 percentage points in the same period.
According to the Annual Policy 2010-11 announced by RBI in April 2010, the BR system will facilitate better pricing of loans, enhance transparency and improve the channel of transmission of monetary policy. Though BR will make the system more transparent, it is not likely to ensure a smooth transmission mechanism of changes in key policy rates. Unless deposits are on a floating rate basis, any reference rate will continue to be downwardly rigid.
An argument that can arise in times of excess liquidity is that banks may prefer to push short-term loans at the doors of corporate houses as it is more viable in comparison to parking surplus funds with RBI at low reverse repo rates. The base rate for most banks is expected to be approximately 8-9 per cent, while the current reverse repo rate stands at 3.75 per cent. Hence, it will be profitable for banks to lend at sub-base rates of say, 5-6 per cent than to keep their funds with RBI at a much lower rate.
RBI could, therefore, consider permitting a sub-base rate lending in times of excess supply of liquidity. However, a ceiling on such lending can be stipulated. This way, banks can reduce erosion in their profit margins. Although liquidity has tightened of late owing to the demand for loans for the payment of 3G licence fees and advance tax payments, excess liquidity is a recurring phenomenon. Further, there is a possibility of the current euro turmoil spreading to the Asian continent, thereby affecting the liquidity situation.
Sub-base rate lending may also be desirable when there is competition from international rates. Low international rates tend to lead to a decline in the credit-deposit ratio of domestic banks and, consequently, squeeze their profit margins.
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Another issue that needs to be kept in mind is that BR is not applicable to finance companies. This may result in banks losing on some of their business to finance companies. Even though the cost of funds is usually higher for finance companies, this is offset by the absence of negative cost of carry in their case as against commercial banks.
RBI perhaps needs to take a fresh look at the BR concept. Even though it is likely to make the system transparent, it may fail to ensure proper transmission of changes in key policy rates. Also, RBI should emphasise a proper alignment of deposit rates with lending rates given that floating rate deposits are a distant possibility as of now. Further, sub-base rate lending may be allowed in times of excess liquidity, even if not as a general practice, perhaps with a reasonable ceiling.
The writer is a researcher at Indian Council for Research on International Economic Relations