Benchmark PLR: How will corporates be affected?

Effective rate is the key

G V Nagesware Rao
Managing Director
IDBI Bank

The genesis of benchmark PLR lies in the view that lending rates to borrowers have not come down commensurate with the fall in interest rates and that the range of interest rates charged to borrowers remains wide.

Banks have therefore been advised to adopt a single benchmark PLR based on their cost of funds, operating costs, profit margins and other factors. It will be interesting to watch how the lending rate structure will evolve with the benchmark PLR. Some banks have announced benchmark PLRs at slightly lower than their existing PLRs.

This is mostly due to rationalisation of the structure of PLRs, which were often multiple in number. But it is not clear yet how the effective interest rates will be affected since banks having multiple PLRs will need to renegotiate term, facility and credit premia with borrowers.

The scope for rates to come down for borrowers who are already getting the most competitive rates is limited. Although there might be some short-term impact due to the rigidities of implementing interest rate revisions, in time the effective rates for individual borrowers will settle at the best market rates they can command, as they do even today.

The key to reduction in effective lending rates lies in creating the environment for reduction in the perceived credit risk and, consequently, the credit premia. In the past few years, although interest rates have fallen sharply, credit premia for low-rated borrowers have widened dramatically.

Benefits of lower interest rates thus accrued to the largest extent to the sovereign and top-rated borrowers. But spreads over AAA borrowers have grown sharply as ratings go lower. It is the reason why the range between the minimum and maximum interest rates charged by banks has become so wide. This is not a problem that the benchmark PLR alone can address.

Although a lot has been done and talked about as regards corporate governance, particularly for listed companies, specific actions need to be initiated at system level that are aimed at instilling financial discipline in borrowing entities, whether corporate or non-corporate.

Disclosure and auditing standards need to be improved; legal systems to enforce creditor rights and security interests need to be enhanced. While there is recognition of these issues and some actions have already been initiated, much remains to be done to increase creditor confidence in reliability of information, sharing of information and legal process.

At the same time, lenders also need to enhance their own evaluation and documentation standards in the new business environment. Without all of these, perceived credit risks will remain high. With a single PLR, banks may also need to evolve ways to accommodate changing time premia.

As the yield curve steepens in the future, time premia will rise resulting in the need to reprice loans. Facility-specific pricing related to the structure of the facility has become important.

Mark-ups and mark-downs over the PLR will need to be determined to accommodate these changing needs and individual banks may evolve their own systems. For the borrower, however, the effective interest rate will remain the true comparison point as he looks for the best deal among competing banks.

Rates will be transparent

Sheshagiri Rao
Director Finance
JVSL

Following the Reserve Bank of India's announcement of the credit policy, the Indian Banks' Association (IBA) has formulated certain guidelines to fix a single benchmark prime lending rate (PLR) by each bank. Accordingly, several banks announced benchmark prime lending rates, effective January 1.

Banks have to consider weighted average cost of funds, operating expenses, appropriate provisioning/ capital charge and profit margin etc while fixing the benchmark PLR. Term premia and credit risk charge will be added to the benchmark PLR to arrive at the eventual rate to be charged to each borrowers.

The intended objective in having a benchmark PLR is to bring transparency in pricing various lending products. As the sharp fall in cost of deposits for the last 12 months has not been translated into lowering of lending rates to borrowers across the board, the announcement of benchmark PLR is expected to correct the anomaly of extending the benefit of lower interest rates to only certain classes of borrowers.

It is interesting to note that the benchmark PLR announced by various banks is lower than the old PLR. It does not mean that banks have so far made undue profits but overnight reduced the benchmark PLR below the old PLR as per the directives of Reserve Bank of India.

As banks were lending at sub-PLR to highly rated borrowers prior to this announcement, average margins to banks remain more or less same under both the scenarios. However, softening of interest rates will now probably be felt across the board by all borrowers assuming that banks will not increase the risk/ credit premium profile.

The announcements made so far by various banks do not contemplate increasing the spread over benchmark PLR to retain the current lending rate. Borrowers, currently paying above PLR, stand to gain due to the lower benchmark PLR.

As per IBA guidelines, floating rate products may be priced by using market benchmarks such as MIBOR, government treasuries, call rates etc. The deployment of funds by banks in these products will not be affected due to benchmark PLR.

There are certain classes of loans and advances that need not be priced with reference to benchmark PLR and banks are free to price these loans as per the current practices.

Besides, discounting of bills can also be done without reference to benchmark PLR. As the banks have large portfolios under letter of credit bill discounting, this business is also unaffected in the post benchmark PLR scenario.

This step will undoubtedly bring transparency in arriving at PLR. Borrowers trend to chose the bank having lower benchmark PLR thus encouraging competition among the banks to improve their efficiency. As the spread is determined based on credit risk profile of the borrower and tenor of loan, banks should sharpen their skills in credit risk evaluation to remain competitive.

Even after announcement of benchmark PLR, there are several categories of loans and advances to which the reference benchmark PLR is not applicable. It is therefore yet to be seen whether delivery of credit takes place at lower benchmark PLR to needy borrowers.