This month, banks move to a new, more transparent regime of loan pricing. They will jettison the Benchmark Prime Lending Rate (BPLR) and price loans off a “base rate”. Unlike the BPLR that was set somewhat arbitrarily by banks, the base rate will follow an explicit formula that factors in a bank’s cost of deposits, operating costs (expenses of running its branches, for instance), the cost of statutory drafts on bank funds imposed by RBI (the Cash Reserve Ratio and Statutory Liquidity Ratio) and the profit margin. RBI has stipulated that banks cannot charge below the base rate for most loans. (There are a couple of exceptions like agricultural loans and export credit.) While the new model will ensure greater transparency, it need not mean lower lending rates for borrowers. In fact, banks’ blue-chip corporate borrowers could see some increase in their cost of borrowing. The reason is somewhat simple. RBI allowed banks to lend below their prime lending rates and the majority of banks did the bulk of their corporate lending at “sub-PLR rates”. The best “credits” for a bank could drive the hardest bargains. This led to peculiar situations in which a bank whose official BPLR was in the range of 14-16 per cent was found lending to its best customers way below its costs at 5-6 per cent. The incentive for this “irrational” pricing was to keep the ratio of non-performing assets low, particularly in the wake of the global financial crisis when banks’ risk appetite waned and safety got precedence over margins. The base rate regime does away with this.
If the blue-chips stand to lose in the new regime, who stands to gain? Some would argue that banks “subsidised” the low-cost loans to their prime borrowers by charging hefty rates from smaller, riskier borrowers — small and medium enterprises and households, for example. Those who argue this claim that once banks are forced to price loans in line with their costs, these “subsidies” are likely to disappear and the segments that arguably need the money the most are likely to get fairer rates. The other thing that the base rate could prevent to a degree is what regulators term “predation” — the phenomenon of large banks dropping loan rates way below costs to grab market share. There have been recent instances of predation in retail credit markets breeding the risk of credit bubbles building up on the back of these exceptionally cheap loans. From a monetary policy perspective, a transparent basis for credit pricing should make the transmission of policy impulses to actual lending rates more efficient. It would at least provide a better gauge of whether monetary policy changes are making a difference to borrowing and lending rates on the ground. There is a case to be made for some structural changes in the policy rates as well. As the current liquidity crunch in the banking system has shown, the wide gap of one-and-half percentage points between the reverse repo and the repo rates drives large swings in short-term interest rates as the banking system goes from surplus to deficit and vice versa. This volatility is perhaps undesirable and can be ironed out by reducing this gap. A hike in the reverse repo rate, keeping the repo rate unchanged in the July 27 monetary policy could do the trick.
