A floor for PLR

In the last three weeks, three major banks have reduced their prime lending rates (PLR). Even though these cuts did not follow any rate reduction by the Reserve Bank of India (RBI), it is reasonable to assume that they were being driven by persuasion or "friendly advice" from the central bank.

The RBI had first hinted at creating a benchmark PLR in the monetary and credit policy in April this year. According to the RBI, banks should take into account their actual cost of funds, operating expenses, a minimum margin to cover the regulatory requirement of providing for NPAs and profit margin before arriving at the benchmark PLR.

This was advocated rather strongly in October this year and the current spate of reduction in PLR is a direct consequence of such policy guidelines.

The abundance of liquidity coupled with a slow credit offtake has forced banks to go in for sub-PLR lending. This means that not only the AAA rated corporates but even those rated at a lower level have been raising bank loans at below PLR.

In fact, more than 60 per cent of the Indian borrowers are now able to raise money at rates lower than the banks' PLRs. In this context, what purpose do these reductions in the PLR serve? Indeed, to go further, what purpose does the benchmark PLR serve?

In the present situation, therefore, it makes more sense to focus on a floor rate rather than a ceiling. Undercutting of interest rates have already begun. In the interest of the financial system, banks should not be permitted to go below a certain level of lending rate.

Such a level can be agreed upon in a forum like the Indian Banks Association (IBA). This is the right time to start thinking of a floor given the unease about the home loan rates.

Also, a floor rate will help compensate the reduced earnings from government securities. With more buyback of government securities on the cards, the effective earnings on such investment will drop to less than 6.75 per cent, which in many cases is lower than the weighted average cost of working funds.

The second issue is about the PLR itself. At the moment, there is a bank-specific PLR for all loans irrespective of their profile or maturity. To have one benchmark rate for diverse products such as industrial loans, home loans and personal loans with different NPA levels, underlying securities and cost structure is flawed.

What this means is that there should be different PLRs for different types of loans, depending on their profile and maturity. This doesn't mean doing away with the concept of a benchmark PLR. Indeed, it will work well within that.

All banks will have their benchmark PLR for all products, say 10.25 per cent in the case of SBI. Then, they should load term premia depending on the maturity profile of the loans, product premia, risk premia and another half a dozen premia or discounts depending on the product and profile of the borrowers to arrive at the final rate for the loan of a particular category.

Having done that, no rate can be delinked from the PLR, which is what is happening in the case of home loans at the moment and is a cause for concern.