Is base rate sustainable?

Is Base Rate sustainable?

The Prime Lending Rate introduced early in 1990s and refined as Bench Mark Prime Lending rate (BPLR) in 2003 as a reference rate by the banking system has been given a go bye and in its place the Base Rate has been brought in effective from July 1, 2010.
What difference the Base rate makes to borrower customers and the banking system and how this rate will help the Reserve bank to transmit its monetary policy signals can be assessed or understood only after the rate stabilizes over a period of time?

Basically, the BPLR and the Base rate should reflect the cost of funds ,the risk margin, and the rate of return to the bank but the difference lies exactly in arriving at the cost of funds and the transparency in its computation and application. The computation of base rate is expected to be on a uniform basis and apparently leaves no scope for manipulation. It takes into account the cost of deposits, the operating costs, the negative carry on cost in the maintenance of statutory requirements i.e. Cash Reserve Ratio and Statutory Liquidity Requirements, risk and profit margin.

BPLR and Base Rate

Compared to BPLR, which was basically computed on historical basis, the base rate has to be assessed more on a futuristic basis. The base rate will vary from bank to bank and in a way it should reflect on bank’s efficiency in bringing down the cost of funds and dynamism in the overall management of funds. Unlike in the case of BPLR, the banks cannot lend funds below the base rate except in certain permitted categories of lending under Differential rate of interest schemes, advances against fixed deposits and agricultural advances having subvention from the Government and export credit. This is a major change and will be a challenge for banks to retain major corporate clients as borrowers as hitherto. This should also bring in some changes in the money market operations as some of the borrowers may switch over to short term instruments like commercial paper to raise funds at lower rates than the base rate.

Various banks have announced their base rates and they range between 7.5 percent and 8.5 percent. How they have arrived at the base rates, however, have not been made transparent . The rates are also much higher than the one year FD rates, call money rates, Bank Rate, repo rate, and the yield on Government bonds. They are also reflective of the generally high cost of the funds. The compulsion to maintain the NET Interest Margin at around 3 to 3.5 percent also seems to have influenced banks in fixing the Base rate comparatively at a higher level.

Struggle to maintain customers

Will the banks be able to realistically assess the Base rate reflecting both the past and future trends and will the rate be able to transmit the Reserve Bank’s monetary policy signals effectively are the major doubts lingering in the minds of knowledgeable public?
Although the base rate may come down in the long run, immediately the large borrowers particularly good borrowers who had enjoyed banking funds at less than the BPLR will have to shell out more towards interest as they cannot borrow at less than the base rate. This may naturally lead them to resort to some other means to raise funds or banks will be compelled to compensate them to retain as their customers which is not desirable.

They may go in for Commercial papers or external commercial borrowings or raise deposits from public directly at less than the base rate. In any case this will have an adverse impact on banks’ funds management and profitability. In such a situation, banks will be forced to entertain comparatively risky borrowers adding to their non performing loans and consequent problems.

Good Timing

Although, the concept of Base rate is good to establish healthy credit market and improve banks’ asset liability management down the years , it may in the immediate future upset the corporates’ borrowing programmes and bring some visible changes in the money market operations. In case the base rate stabilizes, it may also pave way to develop corporate Bond market in a big way. Present surplus liquidity situation in the economy and continued persistence of higher level of inflation, however, supports a higher base rate and from that angle the timing of introduction of base rate seems well intended and justifiable.

Dr.T.V.Gopalakrishnan

(This appeared in Business Line Dt July 12,2010).