Fis Term Paper Final 0000000

8/8/2019 Fis Term Paper Final 0000000

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TERM PAPER OF FINANCIAL INSTITUTION AND SERVICES

On

Study on the Changes in the Concept of Bank Lending

By

Commercial Banks

SUBMITTED By

Name: Irfan- Bashir

Reg. no: 10900856-

Roll no-RT1901B-47

MBA -III SUBMITTED TO

Bhavdeep Singh Kochar

Concerned subject

Facuality


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(LIM)

ACKNOWLEDGEMENT

I would like to express my gratitude for the helpful comment and

Suggestions by my teacher.

Most importantly I would like to thank my lecturer Mr. Bhavdeep

Singh Kocher for his days of supervision. His critical direction and

support on work has played a major role in both the content and

presentation of this term paper and his arguments in our tutorial classes

have helped me to complete this term paper as per objectives of the

topic. Also his method of teaching and clearance of doubts regarding

with the topic have made me successful to complete it on time. I would

also thank my friends and related persons for their help in making this

term paper.

I have extended my appreciation to the several sources which provided

various kinds of knowledge base support for me during the course of

this work.


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IRFAN BASHIR

INTRODUCTION

LENDINGRATESIN INDIA

Steps to liberalize interest rates started in the late 1980s. However, the reforms did not gainmomentum until mid-1992 when rates of interest in India were gradually decontrolled in avariety of ways. As on date, Indian banks are free to decide the lending rates which they chargeto their borrowers, except DRI (Differential Rate of Interest). And like in any free market, theprice is determined by the interplay of demand and supply. In modeling a particular rate of

interest, the objective is to explain the behavior of the designated rate on a given financialappliance. Analytically, the rate is taken as the equilibrium yield on the given appliancedetermined by equilibrating its demand and supply.

GENERAL OVERVIEW

Interest rates play a very crucial role in economy. It acts like a throttle on economic expansion.Interest rates veering too high or dipping too low can spell trouble and can become a cause forconcern for credit quality and financial stability. Interest rates directly affect the credit marketbecause higher interest rates make borrowing more costly. To avert any possibility of such a

disaster, Reserve Bank of India (RBI) introduced BASE RATE system to replacing theBenchmark Prime Lending Rate (BPLR) system to reduce the multiplicity and complexity ofinterest rates.Banks set different lending rates on loans to different categories of borrowers and on loans fordifferent purposes in light of instructions given by the Reserve Bank of India. The regulation ofinterest rates was mostly undertaken with a view to maintain them at a low level which, in turn,was regarded necessary for certain purposes. In a planned economy, the priorities and objectivesof development are determined by the authorities. If the course of development is to be in


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keeping with these priorities, the provision of credit with certainty and at low cost in the desireddirection becomes necessary. Like we see that the RBI require banks to lend to certain sectors ofthe economy. Such directed lending comprises priority sector lending, export credit and housingfinance. In the Indian context, there has been striking efficacy with which policy rates haveimpacted money and government securities markets. The effective control over lending rates of

banks is also necessary; (a) To avoid unhealthy competition for borrowing, (b) To maintain akind of uniformity of interest rates, (c) To enable the authorities to avoid frequent changes in theBank Rate. According to business and industry, high cost of credit has pushed up cost of production of business units, which was injured their profit prospects and reduced theircompetitive strength in the international markets. Similarly, if the interest rates continue to rulehigh, it would be difficult to fight industrial recession successfully.So the Administration system of interest rates had been adopted with a view to maintain interestrates stable and at optimum levels. The system was also expected to enhance the predictabilityand efficiency of monetary policy.

SUSTENANCE OF POLICY

Reserve Bank of India began prescribing the minimum rate of interest on advances granted byScheduled Commercial Banks with effect from October 1, 1960. In March 2, 1968, in place ofminimum lending rate, the maximum lending rate to be charged by banks was introduced, whichwas rescinded with effect from January 21, 1970, when the prescription of minimum lending ratewas reintroduced. The ceiling rate on advances to be charged by banks was again introducedeffective March 15, 1976, and banks were also advised, for the first time, to charge interest onadvances at periodic intervals, that is, at quarterly rests.Given the prevailing structure of lending rates of Scheduled Commercial Banks, as it had

evolved over time, characterized by an excessive proliferation of rates, in September, 1990,anew structure of lending rates linking interest rates to the size of loan was prescribed whichsignificantly reduced the multiplicity and complexity of interest rates.An objective of financial sector reform has been to ensure that the financial repression inherentin administered interest rates is removed. Accordingly, in the context of granting greaterfunctional autonomy to banks, with effect from October 18, 1994, RBI has deregulated theinterest rates on advances above Rs.2 lakh and the rates of interest on such advances aredetermined by the banks themselves subject to BPLR and Spread guidelines. For credit limits upto Rs.2 lakh, banks should charge interest not exceeding their BPLR. Keeping in view theinternational practice and to provide operational flexibility to commercial banks in deciding theirlending rates, banks can offer loans at below BPLR to exporters or other creditworthy borrowers,including public enterprises, on the basis of a transparent and objective policy approved by theirrespective Boards. Banks will continue to declare the maximum spread of interest rates overBPLR. Following the deepening of the global financial crisis since September 2008, the ReserveBank took several measures to bring down the policy rates to step up the liquidity in the system.

Banks are now required to obtain the approval of their respective Boards for the Benchmark

Prime Lending Rate, which would be the reference rate for credit Iimits of over Rs.2 lakh. Each

bank's BPLR has to be declared and be made uniformly applicable at all branches.


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Banks are free to determine the rates of interest without reference to BPLR and regardless of the

size in respect of loans for purchase of consumer durables, loans to individuals against shares

and debentures / bonds, other non-priority sector personal loans, etc.

But the BPLR system has been drawing flak from various quarters since banks have been

lending to highly-rated corporate below their benchmark rate, making the system irrelevant. The

BPLR system failed to achieve what it was originally intended for transparency in lendingrates charged by banks.

Banks play a catalyst role in economic development by providing adequate credit to the needysectors on an ongoing basis. Besides availability of credit, its affordability (Interest Rate) alsoplays a decisive role in determining the credit flow in the country. Interest rates veering too highor dipping too low may spell a trouble to the credit quality and ultimately be a cause of concernfor financial stability of the banks as well as for development of the country. Further, the lendingrates of banks are expected to conform to the changes in the Monetary Policy of RBI from timeto time.

The evolution of Interest Rates on loans and advances in India can broadly be classified in to two

phases viz. Regulated and Deregulated regimes.

1. REGULATED INTEREST RATE REGIME:

Till late 1980s, the interest rate structure on loans and advances extended by commercial bankswas largely administered by the RBI and banks did not have any freedom to fix the intereston loan products, irrespective of the nature of advance and the amount lent. Banks were simply

advised to follow the interest rate prescription of RBI, primarily to ensure the flow of adequatecredit to the desired productive sectors of the economy.

2. DEREGULATED INTEREST RATE REGIME:

RBI has initiated a number of steps to simplify and rationalize the complex interest rate structureas well as to bring in transparency in the loan pricing system.

PHASES OF INTEREST RATES POLICY

The period since 1951 can be divided into the following five phases of interest rates policy

(system) in India.

1. 1951 52 to 1960 61 Flexible interest rates system.

2. 1961 62 to 1985 86 Th The system of administered, regulated, and

repressed or suppresses (low) interest rates.

3. 1986 87 to 1990 91 ThThe beginning of liberalization or the system


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with inclination or intend towards liberalization

and flexibility, or a semi- administered system

with the inching up of interest rates.

4. 1991 92 to 1996 97 ThThe system of progressive deregulation and

flexibility, and a significant increase in and

unprecedentedly high interest rates, or the

phase ofderegulation and dear money.

5. Form 1997 98 ThThe system of managed flexibility with nearly

complete deregulation, and one of the lowest

levels of interest rates in India, or the phase of

Cheap money.

Deregulation of Lending Rates

With the objective of providing credit to the productive sectors of the economy, bank lendingrates as well as the allocation of bank credit were closely regulated by the Reserve Bank till thelate 1980s. Furthermore, there were a number of sector-specific, programme-specific andpurpose-specific credit stipulations. With the initiation of financial sector reforms in the early1990s, various steps were taken to deregulate the lending rates of commercial banks. First, thecredit limit size classes of scheduled commercial banks, on which administered rates wereprescribed, were compressed into three slabs in April 1993. Second, a system of prime lendingrate (PLR), the rate charged for the prime borrowers of the bank, was introduced in October1994. The PLR system went through several modifications from a single PLR to multiple PLRs

and then to a Benchmark PLR (BPLR) .

Evolution of Lending Rate Structure in India

Sep.1990

The structure of lending rates was rationalized into six size-wise slabs. Of these, bankswere free to set interest rates on loans of over Rs.2 lakh with minimum lending ratesprescribed by RBI.

April1992

Slabs compressed into four.

April1993

Slabs compressed into three.

Oct.1994

Lending rates for loans with credit limits of over Rs. 2 lakh deregulated.

Banks were required to declare their Prime lending rates (PLRs).Feb.1997

Banks allowed to prescribe separate PLRs and spreads over PLRs, both for loan and cashcredit components.

Oct.1997

For term loans of 3 years and above, separate Prime Term Lending Rates (PTLRs) wererequired to be announced by banks.

April1998

PLR converted as a ceiling rate on loans up to Rs.2 lakh.

April1999

Tenor-linked Prime Lending Rates (TPLRs) introduced.


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Oct.1999

Banks were given flexibility to charge interest rates without reference to the PLR inrespect of certain categories of loans/credit.

April2000

Banks allowed to charge fixed/floating rate on their lending for credit limit of over Rs.2lakh.

April2001

The PLR ceased to be the floor rate for loans above Rs. 2 lakh.

Banks allowed to lend at sub-PLR rate for loans above Rs.2 lakh.April2002

Dissemination of range of interest rates through the Reserve Banks website wasintroduced.

April2003

Benchmark PLR (BPLR) system introduced and tenor-linked PLRs discontinued.

Feb.2010

Draft circular on Base Rate placed on RBI web site for obtaining comments/suggestionsfrom public/stakeholders.

April2010

Base Rate system of loan pricing introduced effective July 1, 2010. Rupee lending ratestructure completely deregulated

4. Another important development during this time was the introduction of a loan system of

delivery of bank credit in April 1995. The objective was to bring about greater discipline in theutilization of bank credit. Furthermore, the Reserve Bank relaxed the requirement of PLR beingthe floor rate for loans above Rs.2 lakh. Thus, in April 2001, commercial banks were allowed tolend at sub-PLR rates for loans above Rs.2 lakh. However, the divergence in PLRs and thewidening of spreads for borrowers continued to persist. The PLRs turned out to be rigid andinflexible in relation to the overall direction of interest rates in the economy. In order to addressthese issues, a BPLR system was introduced in April 2003.

5. However, the BPLR system evolved in a manner that did not meet the objectives.Competition in an environment of excess liquidity had forced the pricing of a significantproportion of loans far out of alignment with BPLRs undermining its role as a reference rate.

Furthermore, there was a growing public perception of under-pricing of credit for corporate andover-pricing of credit to agriculture as well as small and medium enterprises. Several requestswere received by the Reserve Bank from banks suggesting a review of the BPLR system.

6. The lack of transparency in the BPLR system also hindered transmission of monetary policysignals. In view of the concerns pertaining to the shortcomings in the BPLR system raised by thepublic and those recognized by the Reserve Bank, the Annual Policy Statement for 2009-10announced the constitution of a Working Group on BPLR to review the BPLR system andsuggest changes to make credit pricing more transparent. On the basis of the recommendationsof the Working Group (Chairman: Deepak Mohanty) and after taking into account the views ofvarious stakeholders and discussions with banks final guidelines on the base rate system wereannounced on April 9, 2010

RECENT CONCEPT OF LENDING ADOPTED BY INDIAN COMMERICIAL BANKS

IN 2010, the Indian banking sector is going to witness some fast moving and high-impactdevelopments. Indias banking regulator, Reserve Bank of India, is ushering in a new Base RateSystem (BRS) replacing the existing, outdated and non-transparent Benchmark Prime LendingRate (BPLR) system. At present, sub-BPLR lending is rampant in the system. Once the new


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BRS comes into effect, one expects that such a non-transparent and discriminatory system willcome to an end. RBI, in April 2009, announced the appointment of a working group to study therelevance of the existing BPLR and suggest ways to improve the system. The Working Group,headed by Deepak Mohanty, submitted its report in October 2009. Based on therecommendations of the working group, RBI released its draft circular on BASE RATE system

on February 10, 2010. After getting feedback from banks and other stakeholders, RBI had issuedits Final Guidelines on April 9, 2010.The new Base Rate System would be effective from July 1, 2010.The Committeesrecommendations have been partially accepted by RBI. In future, banks will not be able to lendat rates below the Base Rate. The Base Rate will be based on the banks cost of deposits/funds,negative carry on SLR/CRR, unallocatable overhead cost and average return on net worth. Theactual lending rate to be charged to borrowers will be Base Rate plus product-specific overheadcost, credit risk premium and tenor risk premium. So far, no bank has announced its Base Rate.They may announce the Base Rates in the next few weeks before the deadline of July 1, 2010.

EXPLANATION OF BPLR AND ITS COMPARISON WITH NEW RATE SYSTEM

(BASE RATE)Rama Krishna, BOMBA

MEANING OF BPLR:

BPLR (Benchmark Prime Lending Rate) is the interest rate that commercial banks charge their

most credit-worthy customers. According to the Reserve Bank of India banks are free to fix the

Benchmark Prime Lending Rate (BPLR) with the approval of their respective Boards. The PLR

is influenced by RBIs policy rates the repo rate, reverse repo rate and cash reserve ratio

apart from the banks policy. In simple words, availability of funds i.e. liquidity in the banking

system and demand for credit by consumers (both retail and industrial) determine what the

BPLR should be.

For lower grade borrowers like car loans etc., the lending rate normally may be at a suitable

spread above the BPLR and for higher grade borrowers like credit sound corporate customers,

the rate can be equal or less than BPLR. Upto 2 lakhs, the interest rate can be less than or equal

to BPLR without any board approval. As per RBI report for the year 2008-09dt 27.8.2009, the

commercial bank interest rates oscillated between 12.25 to 12.75% and at the year end of March

2009 it oscillated between 11 to 12% due to excess liquidity and less off take by corporates as

the corporates raised their money requirement from ECB.

For several years now, the majority of bank loans have been made at a discount to the BPLR

currently, more than 70% of all loans are below BPLR. This type of loan lower than BPLR is

also called Sub-PLR loans. Most of the banks provide loans and advances at a rate lower than


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the BPLR (Prime Lending Rate) of the bank to customers availing finance for business purposes

or short term funds for various needs but with good credit ratings. This enables them to attract

large volume high end clients, offer bigger amounts of loans since the high credit worthiness is a

likely indicator of customers making regular payments and in turn this helps the banks to

increase business and get more profits from their loans.

Since banks are given the freedom to set the spread from the BPLR at whatever value they

choose for new customers, they are able to provide attractive rates to new customers while

continuing to charge a much higher interest rate for older customers. This is one of the main

objections raised by old bank customers whenever loan rates are reduced for new customers by

banks.

According to the RBI Annual Report (2007-08), in June 2008 the weighted average yield on

loans of public sector banks was 100 basis points (bp) below the upper band of the BPLR; for

private banks, it was 150 bp below the upper band of the BPLR. This was for loans in the

aggregate. For corporate loans, the discounts to BPLR are even higher. Bankers say that, on the

average, corporates are borrowing at around 12-12.75% in the F.Y.2007-08. This implies a

discount of 400-450 bp to the BPLR in private banks and 200-250 bp at public sector banks for

the said year. It is mostly in retail segments two-wheelers, personal loans, credit cards that

banks are charging rates above the BPLR. There is no scientific method of charging the

customers and hence RBI intervention was sought for remedial action.

BPLR normally determined by using marginal costing technique. For example, if the call

deposits received by the bank carry an interest rate of 3%, then banks may think of lending it at

4.5% or 5% leaving 2% margin for their expenses and profit. So banks are having various

lending rates based on various types of deposits received by it and tenure and rate of deposits.

ADVANTAGES OF BPLR BASED LENDING

1. Banks can lend funds to corporate and other clients at Sub-PLR rate in order to

increase profitability and security of funds as huge turnover of funds in short term will

compensate the difference in lending rates.

2. Banks adjust Sub-PLR rates with higher lending rates on retail customers like credit

cards, vehicle and housing loans.

3. Banks funds will not remain idle as they can lend it at their own will after getting

the approval of board in case of any lending below BPLR.


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4. Sound corporate got good bargaining loan rates and their profitability increased.

Perfect competition existed among banks and corporates availed the benefits. No

control of RBI on rates.

5. External Commercial Borrowings (ECB)in which lending rate is very cheap is one

of the factor which influences the bigger banks to lend at SubPLR rate and the BPLR

based lending helps the banks to face the competition from overseas banks.

6. Banks used this lending way in beneficial way even for short term loans in order to

avoid parking funds with RBI at 3.25%.

Disadvantages

1.Banks, in order to face competition from other banks, had to lower their lending

rates below BPLR in order to retain clients and hence face competition from

international banks which lends on ECB platform and the rate is very low. Since

nowadays, most of the big corporate have become global companies, raising of funds

from overseas banks is easy with the approval of RBI and positive Govt. policies for

raising loans outside India. Some of the banks in India suffered profit reduction due to

this due to excess liquidity.

2. Customers who are compelled to take loans in India only have to bear the brunt of

higher than BPLR in order to compensate the loss to banks.

3. Sound corporate clients are the beneficiary of this method commanding on banks to

lend at cheaper rate for them though they got the capacity to bear the BPLR plus rates.

Capacity to bear the rate is compromised in order to retain clients by banks.

4. Discrimination of old customers vs. new customers existed almost in all banks.Banks, for example, give housing loans for lesser interest rates for new customers as

compared to interest rate charged for the same period of lending to existing customers.

5. RBI directed the banks to park the idle funds with it at 3.25% but banks resort to

short term lending at higher rate thus beating the RBI policy of keeping control over

funds in the market.

Due to complaints about indiscriminate lending rates by banks, RBI appointed a committee

headed by RBI executive director Deepak Mohanty. He had suggested discontinuing the usage

of a banks prime lending rate (PLR) as the benchmark for variable rate loans. Instead, he wants

banks to arrive at a base rate that reflects the cost of one-year deposits and price loans over this

base rate. The panel has also proposed a ceiling on the extent of loans that can be granted below

the benchmark rate. Most banks typically pass on the benefit of falling rates only to fresh

customers. RBI governor D Subbarao has repeatedly said though the central bank has slashed its


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repo rate (at which it lends to banks) by 425 basis points in the last one year, prime lending rates

of banks have fallen by only around 200 basis points.

Finally RBI accepted the recommendation of Deepak Mohanty for discontinuing BPLR and in

its place brought Base rate.

Base Rate concept

Recent Initiative

Base Rate

The Reserve Bank of India committee on reviewing the benchmark prime lending rate has

recommended that the nomenclature be scrapped and a new benchmark rate known as BASE

RATE should replace it.

Now, the RBI has come up with guideline recommendations for banks to adhere to with effect

from July 2010.

Now from July 2010 Banks determine their actual lending rates on loans and advances with

reference to the Base Rate. Base Rate shall include all those elements of the lending rates that

are common across all categories of borrowers. While each bank may decide its own Base Rate,

some of the criteria that could go into the determination of the Base Rate are:

a. Cost of deposits;

b. Adjustment for the negative carry in respect of CRR and SLR;

c. Unallocatable overhead cost for banks such as aggregate employee compensation relating

to administrative functions in corporate office, directors and auditors fees, legal and

premises expenses, depreciation, cost of printing and stationery, expenses incurred on

communication and advertising, IT spending, and cost incurred towards deposit

insurance; and

d. Profit margin.

Base Rate = Cost of Deposits + Negative Carry on CRR and SLR + Unallocatable

Overhead Cost + Average Return on Net Worth.

Negative carry on CRR and SLR balances arises because the return on CRR balances is nil,

while the return on SLR balances (proxies using the 364-day Treasury bill rate) is lower than the

cost of deposits.


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Unallocatable Overhead Cost is calculated by taking the ratio of unallocated overhead cost

and deployable deposit.

Average Return on Net Worth is computed as the product of net profit to net worth ratio and

net worth to total liabilities ratio expressed as a percentage.

The actual lending rates charged to borrowers would be the Base Rate plus borrower-specific

charges, which will include product-specific operating costs, credit risk premium and tenor

premium.

Impact of BASE RATE System

All categories of loans should henceforth be priced only with reference to the Base Rate. The

Base Rate could also serve as the reference benchmark rate for floating rate loan products, apart

from the other external market benchmark rates. The floating interest rate based on externalbenchmarks should, however, be equal to or above the Base Rate at the time of sanction or

renewal. By changing the structure of interest rates RBI tries to achieve maximum employment,

stable prices, and a good level of growth.

The base rate will be applicable to all new loans as well as existing loans which come up for

renewal. Accordingly, the current requirement that BPLR will be the ceiling rate for loans up

to Rs. 2 lakh will stand withdrawn. Since the Base Rate will be the minimum rate for all

commercial loans, banks are not permitted to resort to any lending below the Base Rate.

Interest rates on loans under the DRI scheme will continue to be fixed without reference to the

Base Rate. The Reserve Bank will also separately announce the stipulation for export credit.

Since transparency in the pricing of lending products has been a key objective, banks are

required to exhibit the information on their Base Rate at all branches and also on their websites.

Changes in the Base Rate should also be conveyed to the general public from time to time

through appropriate channels. Banks are required to provide information on the actual minimum

and maximum lending rates charged to major categories of borrowers to the Reserve Bank on a

quarterly basis. Apart from transparency, banks should ensure that interest rates charged to

customers in the above arrangement are non-discriminatory in nature.

It is expected that introduction of the BASE RATE system of lending rates will leads to increase

the credit flow to small borrowers at reasonable rate. Thus, direct bank finance will provide

effective competition to other forms of high cost credit as well as escort for smooth operation of

business and this is in turn stimulate economic growth.


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IMPACT OF DEREGULATED INTEREST RATES:

The introduction of BPLR and deregulation of interest rate was a major initiative taken by RBIto achieve the competitive loan pricing in the market.

Extending credit at BPLR implies that the borrower is AAA rated and the associated risk is low.With increasing competition in the banking industry, the BPLR lost its relevance as large chunkof bank lending to the commercial sector happened at sub BMPLR rates i.e. around 7.50% as

against average BPLR of 12.5%. RBI report on BPLR reveals that more than two-thirds creditportfolio of the Banks (excluding small loans and export credit) belongs to sub BPLR categoryand majority of these loans pertains to Corporate Sector / Large Borrowers where as Retail andSmall borrowers continued to pay higher interest rates. Lending to Corporate Sector / LargeBorrowers at relatively low interest rates has a direct bearing on Yield on Advances and NetInterest Margin (NIM) of the banks.

Interest Rate war among banks has caused unhealthy competition and led to unwarranted lowinterest offerings to corporate/large borrowers, detrimental to the interest of banks and stake-holders. Contrarily, banks are reluctant to revise BPLR downwards in respect ofretail loans despite reduction of key rates by RBI.

Based on the Working Group recommendations, RBI issued guidelines to all banks to announceBase Rate, duly taking the said criteria and directed the banks to price the loans accordinglyw.e.f. 01.07.2010. Under this system, banks cannot lend below Base Rate except for certaincategories such as Differential Rate of Interest (DRI) advances, Loans to banks ownemployees, Loans to banks depositors against their own deposits, Interest Subvention Schemesviz., Crop loans, Export credit and Restructured loans. The final lending rates include the BaseRate plus variable or product specific operating expenses, credit risk premium and tenorpremium.

Banks are required to review the Base Rate at least once in a quarter with the approval of theBoard or the Asset Liability Management Committee as per the bank's practice and inform thesame to RBI.


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IMPACT ON PUBLIC SECTOR BANKS:

Cost of deposit constitutes the important component of Base Rate and it crucially depends on thecomposition of low cost deposits of the Bank. The Cost of deposit of Banks (Group-wise) is asunder:

(Percentage)

Category 2007-08 2008-09Public Sector Banks 5.40 5.60

Old Private Sector Banks 5.70 6.20

New Private Sector Banks 5.90 6.40

Foreign Banks 3.80 4.30

Scheduled Commercial Banks 5.40 5.70

(Source: Report on Trend and Progress of Banking in India 2008-09)

PSBs will have an edge over Private Sector Banks in offering a more competitive rate as theyhave a larger deposit base which gives them access to low cost resources. Further, PSBs are

better placed with regard to access to the government/treasury funds and thereby their Cost offunds works out to be lower than Private Sector Banks.

Impact on Corporate Borrowings:

On implementation of Base Rate, borrowing funds from banks may cost more for someCorporate since the proposed rate might be slightly higher by 50 to 100 basis points over theexisting interest rate (sub BPLR). This may warrant Corporate to look for alternate low-cost financing options such as Commercial Paper, Qualified Institutional Placement, ExternalCommercial Borrowing etc., which could result in lower credit off-take of banks. However,PSBs with superior treasury operations can partially offset competitive pressures in the short-

term lending segment by subscribing to the debt market issuances of Corporate.

Impact on Retail Segment:Reduction of interest rates by a minimum of 100 to 200 basis pointsfor Retail borrowers since the Base Rate of the banks is estimated around 7.50% to 8.50% asagainst the average BPLR of 12.50%.


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Impact on Macro Rates:The Base Rate of Banks should be in sync with macro rates and Banksto effect changes in their Base Rate as and when there is a change in CRR, SLR, Repo, ReverseRepo and Bank Rate.

In the above backdrop, a need was felt to introduce transparent and fair credit pricing mechanismto sustain Net Interest Margin besides providing credit to the needy borrowers at reasonableinterest rates.

BASE RATE - POST IMPLEMENTATION SCENARIO:

The present Base Rate vis--vis erstwhile BMPLR of respective banks is furnished here

under:

Name of the Bank Base Rate BPLR

SBI & Associates

State Bank of India 7.50 11.75

State Bank of Bikaner and Jaipur 7.75 12.25

State Bank of Hyderabad 7.75 12.25

State Bank of Mysore 7.75 12.25

State Bank of Patiala 7.75 12.25

State Bank of Travancore 7.75 12.25

Public Sector Banks Base Rate BMPLR

Allahabad Bank 8.00 12.00

Andhra Bank 8.25 12.00

Bank of Baroda 8.00 12.00

Bank of India 8.00 12.00

Bank of India 8.00 12.00

Bank of Maharashtra 8.25 11.25

Canara Bank 8.00 12.00

Central bank of India 8.00 12.00

Corporation Bank 7.75 12.00Dena Bank 8.25 12.50

IDBI Bank 8.00 12.75

Indian Bank 8.00 12.00

Indian Overseas Bank 8.25 12.00

Oriental Bank of Commerce 8.00 12.00

Punjab & Sind Bank 8.20 13.50


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Punjab National Bank 8.00 11.00

Syndicate Bank 8.25 12.00

UCO Bank 8.00 12.25

Union Bank of India 8.00 11.75

United Bank of India 8.00 12.00

Vijaya Bank 8.25 12.25

Private Sector Banks Base Rate BMPLR

Axis Bank 7.50 14.75

Bank of Rajasthan 8.00 15.25

DBS Bank 7.00

Development Credit Bank 7.75 16.75

Dhanlaxmi Bank 7.00 16.00

Federal Bank 7.75 14.25HDFC Bank 7.25 15.75

ICICI Bank 7.50 14.75

IDBI Bank 8.00 12.75

Indusind Bank 7.00 16.75

Jammu & Kashmir Bank 8.25 12.75

Karnataka Bank 8.75 13.75

Karur Vysya Bank 8.50 13.50

Kotak Mahindra Bank 7.25 15.50

Lakshmi Vilas Bank 8.75 15.00

South Indian Bank 8.10

Yes Bank 7.00 16.50

Foreign banks Base Rate BMPLR

Citi Bank 7.25 15.00

Deutsche Bank 6.75

HSBC 7.00 13.75

Standard Chartered 7.25 14.25

An analysis of data reveals that the Base Rate arrived by the Banks is more herd in nature thanadopting transparent and scientific approach. Some of the observations made on Base Rate are asunder:

Base Rates of the Banks are in the range of 6.75% to 8.75%.

SBI set the Base rate at 7.50% and all its subsidiaries fixed the rate at 7.75%.

Majority of Public Sector Banks (other than SBI & Associates), have fixed the Base Rateat 8%.


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SBI Base Rate is the lowest amongst PSBs on account of high composition of low costdeposits.

The BPLR of Private Sector Banks was in the range of 13.50% to 16.75%, where as itwas in the range of 11.25% to 12.75% with regard to PSBs. Contrary to the trend, PrivateSector Banks announced their Base Rates much lower than the Base Rates announced by

SBI / PSBs.

RE-ENGINEERING OF BASE RATE:

As per RBI guidelines, the cost of deposit/funds and unallocatable overhead costs plays animportant and decisive role in fixation of Base Rate. In order to provide competitive loan pricing, some banks are conveniently manipulating the above components to suit theirrequirement. It is observed that some banks have taken six months card rate instead actual costof deposits since the card rate is low compared to actual cost of deposits.

Though the cost of deposit of Private Sector Banks is high compared to Public Sector Banks,

some Private Sector Banks have declared their Base Rate lower than SBI/PSBs. The reason is tooffer finer interest rate to blue chip corporate clients to retain their accounts, besides garnering amarket share in the corporate lending space.

Banks continued to lend at the erstwhile sub BPLR rate with slight marginal changes to most ofthe corporate clients even in the new system as they adjusted their Base Rate to suit therequirements of their Large/Corporate Borrowers. This aspect needs attention of the Regulator tohave a relook on methodology adopted by the Banks in arriving the Base Rate.

The maximum spread that banks used to levy on borrowers was 3.50% during BPLR regimewhere as the present spread is in the range of 5% to 10% on most of the retail segment loans,which is too high and unjustifiable.

It is expected that Banks whose Base Rate is low, should price their loan products relatively lowcompared to banks having high Base Rate. Contrary to the expectations, all banks have adjustedSpread in such a way that interest rates remain the same as that of pre Base Rate interest rates.Further, it is observed that there is no transparency with regard to adoption of methodology bythe banks in arriving Base Rate.

Though, Banks announced Base Rate as directed by RBI, the purpose for which it is introducedis not fulfilled since the interest rates on retail lending remains the same in the post Base Rateregime also.

It is high time that RBI should ensure that banks adopt transparent Base Rate methodologiesespecially with regard to calculation of Cost of deposits/funds and Unallocatable overhead costs.Further, there is an urgent need to have threshold limits on spread to ensure appropriate pricing


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of loans with special reference to Corporate/Large borrowers and also to enable the retailborrowers avail credit at reasonable interest rates.

The evolution of the BPLR can be traced back to September 1990 when the first attempt torationalize the administered lending rate structure was made by removing multiplicity andcomplexity of interest rates. According to this structure, the advances of scheduled commercialbanks were divided into six slabs and progressively higher interest rates were prescribed forlarger advances (subject to a floor rate). While for the lowest slab consisting of advancesamounting up to Rs. 7,500, a minimum interest rate of 10 per cent per annum was prescribed,advances of above Rs. 2 lakh, which fell under the highest slab, were prescribed a minimum rateof interest of 16 per cent per annum. While the above structure was applied to both workingcapital and term loans, concessional rates were offered on term loans to agriculture, small-scaleindustry and specific transport operators.The next major step in the evolution of BPLR took place in April, 1993, in the backdrop of the

financial sector reforms of the early 1990s wherein the credit limit size classes of scheduledcommercial banks, on which administered rates were prescribed, were reduced into three slabs;(i) advances up to and inclusive of Rs. 25,000; (ii) advances over Rs. 25,000 and up to Rs. 2lakh; and (iii) advances over Rs. 2 lakh. In October of the next year with the intent ofderegulation of lending rates, it was decided that banks would determine their own lending ratesfor credit limits over Rs.2 lakh in accordance with their risk-reward perception and commercialjudgment. However, banks were required to declare their prime lending rate (PLR) i.e. the ratecharged for the prime borrowers of the bank, with the approval of their boards taking intoaccount their cost of funds, transaction cost, etc.According to the above scheme, PLR acted only as a floor rate for credit above Rs. 2 lakh andwide scale misinterpretation was registered with banks charging lending rates far higher than

PLR on a significant portion of bank credit to borrowers with credit limit to over Rs. 2 lakh. Inorder to stem this practice, in October 1996, it was made mandatory for banks, while announcingthe PLR, to also announce the maximum spread over the PLR for all advances other thanconsumer credit. The next major improvement was the introduction of the loan system ofdelivery of bank credit in April 1995, whereby banks were given the freedom to charge interestrate on the cash credit and loan components with reference to the prime lending rate approvedby their Boards. This was followed in February 1997 by an additional provision wherein bankswere allowed to prescribe separate PLRs and spreads (over PLRs) for both loan and cash creditcomponents.October, 1997 saw the introduction of the Prime Term Lending Rates (PTLR) according towhich banks were given the freedom to announce separate PTLR for term loans of 3 years andabove while PLR remained applicable to the loans taken for working capital and short-termpurposes. The following year in the month of April, PLR was converted as a ceiling rate on loansup to Rs. 2 lakh with the purpose of removing the disincentive to the flow of credit to smallborrowers below Rs.2 lakh.The next major change in this field was the introduction of the Tenor Linked Lending Rate(TPLRs) on April 1999. According to this system, banks could operate different PLRs fordifferent maturities, provided the transparency and uniformity of treatment that were envisagedunder the PLR system continued to be maintained. A few months later with the intention of


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imparting greater operational flexibility to banks in the applicability of PLR, banks were giventhe freedom to charge interest rates without reference to the PLR in respect of certain categoriesof loans/credit such as loans covered by refinancing schemes of term lending institutions,lending to intermediary agencies, discounting of bills and advances/overdraft against domestic/NRE/FCNR (B) deposits.

The new millennium saw the Annual Policy Statement of 2000-2001 which stated that bankswere permitted to charge fixed/floating rates on all loans with credit limit of more than Rs. 2lakh with PLR as the reference rate. The following year, RBI relaxed the requirement of PLRbeing the floor rate for loans above Rs.2 lakh in its Annual Policy Statement and banks wereallowed to offer loans at below-PLR rates to exporters or other creditworthy borrowers. The nextmajor change was to occur as a result of the abundant liquidity available in the market throughthe years 2001 - 2004. During this period, interest rates in general softened but the same trendwas not reflected in the lending rates across all banks. Keeping this trend in mind, the Monetaryand Credit Policy for the year 2002-03 advised banks to review the present maximum spreadsover PLR and reduce them wherever they were unreasonably high so that credit was available tothe borrowers at reasonable interest rates. Banks were also advised to announce the maximum

spread over PLR to the public along with the announcement of their PLRs.Beginning June 2002, RBI was engaged in intensive monitoring and collection of informationregarding interest rates from various banks. Based on the information collected, the Mid-TermReview of Monetary and Credit Policy for the year 2002-2003 observed that both PLR andspread were seen to vary widely across banks/bank-groups. Following this, with an aim ofintroducing transparency and ensuring appropriate pricing of loans, in the Annual PolicyStatement of April 2003, the Reserve Bank advised banks to announce a Benchmark PLR(BPLR) with the approval of their boards. The BPLR was seen as a reference rate and was to becomputed taking into consideration (i) cost of funds; (ii) operational expenses; and (ii) aminimum margin to cover regulatory requirements of provisioning and capital charge, and profitmargin. At the same time banks were asked to discontinue the practice of tenor linked PLR but

were allowed flexibility in pricing floating rate loans and advances using market benchmarksand time varying spread in an objective and transparent manner. Also, interest rates on a numberof loans and advances such as advances for acquiring residential properties and purchase ofconsumer durables could be determined without reference to BPLR.However, in the backdrop of the implementation of this scheme, banks highlighted the need tohave differential pricing strategies owing to different risks of defaults in different segmentswhich needed different load factors for capital charges. Banks were of the opinion that there wasneed for flexibility in loan pricing to reflect in the interest rate characteristics of the product,including credit and market risks and the structuring required. Banks were also concerned aboutthe fact that transaction costs were different for different sectors such as consumer and corporatebusiness accounts.In view of the above and various other concerns, banks wanted the Reserve Bank to allow separateBPLRs for pricing loans in different sectors. Subsequently, the Mid-Term Review of the Annual PolicyStatement for the year 2005 - 06 observed that the system of BPLR had evolved in a manner that had not

fully met expectations. IN 2010, the Indian banking sector is going to witness some fast movingand high-impact developments. Indias banking regulator, Reserve Bank of India, is ushering ina new Base Rate System (BRS) replacing the existing, outdated and non-transparent BenchmarkPrime Lending Rate (BPLR) system. At present, sub-BPLR lending is rampant in the system.Once the new BRS comes into effect, one expects that such a non-transparent and discriminatorysystem will come to an end. RBI, in April 2009, announced the appointment of a working group


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base rate for public sector banks could be in the region of 9-9.5% and added that he could see a

gain of 40-50 basis points for his bank.

Drawbacks likely to exist:1. The new base rate may account for the cost of getting deposits but will ignore the

cost of non-performing assets. But this can be covered under unallocated overhead

costs by way of non-performing asset rate. Since Base rate is a new concept in Indian

banking industry, some assumptions are to be taken in order to be within the criteria

set by committee and it be reasonable enough to convince RBI, the watch dog of

banking industry.

The base rate will differ from bank to bank. It could be in the range of 7% to 9%. So weakerbanks will have higher rate and find the going tough. The stronger ones will slowly absorb the

weaker ones thus amalgamation of banks would be on the anvil. Competition among banks willreduce and ultimately bank customers may suffer if the banks are not prudent enough to curtailcosts and overheads including NPA

BPLR VS BASE RATE

In banking parlance, the BPLR means the Benchmark Prime Lending Rate. BPLR isthe interest rate that commercial banks normally charge (or we can say they are expected tocharge) their most credit-worthy customers. Although as per Reserve Bank of India rules, Banks

are free to fix Benchmark Prime Lending Rate (BPLR) for credit limits over Rs.2 lakh with theapproval of their respective Boards yet BPLR has to be declared and made uniformly applicableat all the branches. The banks may authorize their Asset-Liability Management Committee(ALCO) to fix interest rates on Deposits and Advances, subject to their reporting to the Boardimmediately thereafter. The banks should also declare the maximum spread over BPLR with theapproval of the ALCO/Board for all advances.1. What is Base Rate?Base Rate is the minimum lending rate below which a bank can not lend to borrowers except in afew cases. Base Rate is being implemented in India with effect from July 1, 2010. From thatdate, the existing Benchmark Prime Lending Rate (BPLR) will cease to exist and the new BaseRate System will come into effect. Base Rate will differ from bank to bank depending on

individual banks cost of deposits/funds and other criteria.

2. Why is RBI changing the loan pricing system?

There is a public perception that banks have been offering lower lending rates to big corporatecustomers, while charging higher rates from small borrowers in the retail, small business andagriculture segments. This amounts to crosses subsidization. RBI has received severalcomplaints to this effect from various industry bodies and associations. RBI has taken this viewinto consideration. For several years especially since the early 2000s, RBI had tried to bring in a


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transparent system of lending rates in the banking system. After trying very hard, RBI hasgenuinely felt that banks BPLRs are not transparent and there is a large-scale sub-BPLRlending.

Downward stickiness in rates:RBI has observed that whenever RBI raises policy rates and reserve ratios, banks are quick toincrease their loan rates. But, when RBI reduces policy rates and reserve ratios, banks respondvery slowly effecting decreased lending rates with a considerable time lag. Such a phenomenonis called downward stickiness in rates. RBI is of the view that it is adversely impacting themonetary transmission mechanism in the banking system. Due to competition, banks have beenoffering loans to first class borrowers with high credit rating at rates much below the BPLR in anon-transparent manner. RBI opines that banks lending at sub-BPLR rates is not in tune withthe central banks objective of bringing transparency to the loan rates. BPLR has fallen short ofRBIs expectations to work as a reference rate or benchmark rate.

Keeping the above in mind, RBI had set up, in April 2009, a committee under the chairmanshipof Deepak Mohanty to look into the existing BPLR system and suggest a suitable alternativesystem for pricing bank loans. The Deepak Mohanty Committees recommendations were madepublic in October 2009, which suggested shifting from the current BPLR to a new system calledBase Rate System. After getting feedback from banks and other stakeholders, RBI had issued itsFinal Guidelines on April 9, 2010.

Why BPLR system failed?

The official stand is that the base rate system is necessitated by the failure of the earlier BPLRsystem to produce transparency in lending rates as well as its inability to effectively transmit

monetary policy signals from the central bank.

But why did the BPLR system, introduced in 2003, fail? The RBI itself says that competition inan environment of excess liquidity had forced the pricing of a significant proportion of loans farout of alignment with BPLRs undermining its role as a reference rate.

The next logical question therefore is: What caused that environment of excess liquidity?

(Note that the liquidity in the money markets in the period since April 2003 was neithertemporary in nature nor was it small in quantum. Analysis of the data shows that the Indianmoney markets have been in surplus mode for 65 out of 85 months between April 2003 and

April 2010. The quantum of surplus ranged broadly between Rs 15,000 crore to as much as inexcess of Rs 1,00,000 crore on a daily average basis!).

The excess liquidity in the money markets was structural and was driven solely by the RBI'smassive intervention in the FX markets and its buying up of dollars. The FX reserves (FC assets)went up in that period from around $70 billion to as much as $290 billion (give or take a fewtens of billions on valuation grounds).


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Therefore, it does seem that the failure of the BPLR system can be traced to the RBI's policiesthemselves. For a long time now, we have had a (highly) accommodative monetary environmentwhich duly got reflected in the financial system's interest rates structure.

Ultimately, these developments only reiterate that interest rates structuring on banks'

deposits/advances is, to quite a large extent, a function of the central bank's monetary policystance.

(Other influences could be liquidity considerations, the composition of the balance-sheet interms of mismatches at any point in time and last but not the least, the level and nature ofcompetition). The central bank, after all, is the biggest player in the money markets.

How do the Banks arrive at BPLR and How it is proposed to calculate Base Rate?

At present, the calculation of BPLR by various banks is not transparent. However, Banknormally take into consideration the factors like cost of funds, administrative costs and a margin

over it. The BPLR of various banks in the month of October, 2009 ranged between 11 per centand 16 per cent.

The proposed Base Rate will include all those cost elements which can be clearly identified andare common across borrowers. The constituents of the Base Rate would include (i) the cardinterest rate on retail deposit (deposits below Rs. 15 lakh) with one year maturity (adjusted forCASA deposits); (ii) adjustment for the negative carry in respect of CRR and SLR; (iii)unallocatable overhead cost for banks which would comprise a minimum set of overhead costelements; and (iv) average return on net After factoring in costs incurred while sanctioning aloan, the proposed base rate could be as low as around 8.50% in the current interest ratescenario (October 2009).

The Indian central bank has in principle agreed to free the administered rates on loans to

exporters, agriculture and small industries. A draft circular on the proposal will be posted on its

website in the next few days, inviting comments from the public.

At the next stage, it may even deregulate savings deposit rates, the last bastion of administered

rates for liabilities, a person familiar with the development said.

Currently, both export loans and loans to small farmers and small-scale industries are mandated

by the banking regulator.

In a parallel move, RBI will also abolish the concept of benchmark prime lending rate (BPLR),

or the rate at which banks are expected to lend money to their top-rated borrowers. The BPLR,

introduced in November 2003, will be replaced by a base rate and no bank will be allowed to

offer any loan at below the base rate.


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RBI's decision to deregulate loan rates follows the recommendations of an internal panel headed

by executive director Deepak Mohanty. The panel was formed in June to review the BPLR

system and suggest an appropriate loan pricing system. The Mohanty panel report was put up on

RBI website in October, inviting comments from public, until 17 November.

"The central bank has by and large accepted the recommendations of the panel with minor

changes," said the person familiar with the development who didn't want to be named.

For instance, the panel recommended the one-year deposit rate as a benchmark for the base rate,

but RBI is not in favour of any benchmark for arriving at the base rate.

All it wants is a transparent process to form the base rate that's non-discretionary. In other words,

no loan can be given at below the base rate.

Currently, around 70% of bank loans are given below BPLR, making a mockery of the concept.

Banks keep their BPLR at an artificially high rate to protect their interest income. This is

because both small loans to farmers and small industries as well as export loans are linked to

BPLR and when the prime rate goes down, the rates on these loans automatically decline,

depressing their earnings.

Loans to exporters are given at 2.5% below a bank's BPLR while small loans of up to Rs2 lakh

given to agriculture, small-scale industries and the so-called weaker sections of society are

capped at BPLR.

For the past few years, banks have been giving small agriculture loans at 7% with the

government offering a 3% subsidy on such loans through a budgetary provision.

"While the new base rate concept will be more meaningful than BPLR, the most significant news

for the financial sector is complete deregulation of lending rates. This will change the way

banking is done in India. It will be interesting to see how banks and consumers respond to this,"

said the banking analyst at a foreign brokerage who declined to be named because the regulator

has not yet made the decision public.

According to him, the base rate will be significantly lower than the BPLR. "It will be in single

digit," he said.

BPLRs of public sector banks vary between 11% and 13% and most private banks charge even

more.


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Despite this, banks' net interest margin (NIM), or the difference between cost of funds and

earnings on deployment of funds, will not be hugely affected as their earnings on those loans

which have so far been administered will go up.

The panel had recommended that once the base rate is introduced, "there will not be any need toextend any concessional export credit", and if "any special dispensation is considered necessary,

it should come explicitly from the government in the form of interest rate subvention".

However, banks' NIM will be hit once they are forced to offer interest rates on a daily average

basis for savings accounts. Although the savings account rate is currently pegged at 3.5%, the

average cost of banks is much lower--at around 2.8%--since they pay interest only on the

minimum balance kept between the 10th and the end of a month. But things will change from

April.

A savings account is the most common operating account for individuals and others for non-

commercial transactions. Banks generally put a ceiling on the total number of withdrawals

permitted and stipulate a certain minimum balance to be maintained in such accounts.

With the rise in cost of savings accounts from April, banks want RBI to bring down the interest

rate from 3.5%. The central bank is not willing to do so and instead it may free this rate. It has

asked the Indian Banks' Association, the national bankers' body, to prepare a report on this.

The option of capping the savings bank rate at the existing 3.5% and allowing banks to fix therate within the cap is ruled out because that will benefit only banks and consumers will not gain.

"We need to study this and see how banks and the consumers get affected if the savings account

rate is freed. It cannot be done in a hurry," said a senior RBI official who did not want to be

named.

1. While the new base rate concept will be more meaningful than BPLR, the most

significant news for the financial sector is complete deregulation of lending rates. This

will change the way banking is done in India. It will be interesting to see how banks and

consumers respond to this," said the banking analyst at a foreign brokerage who declined

to be named because the regulator has not yet made the decision public.

2. According to him, the base rate will be significantly lower than the BPLR. "It will be in

single digit," he said.


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3. BPLRs of public sector banks vary between 11% and 13% and most private banks charge

even more.

4. Despite this, banks' net interest margin (NIM), or the difference between cost of funds

and earnings on deployment of funds, will not be hugely affected as their earnings onthose loans which have so far been administered will go up.

5. The panel had recommended that once the base rate is introduced, "there will not be any

need to extend any concessional export credit", and if "any special dispensation is

considered necessary, it should come explicitly from the government in the form of

interest rate subvention".

6. However, banks' NIM will be hit once they are forced to offer interest rates on a daily

average basis for savings accounts. Although the savings account rate is currently peggedat 3.5%, the average cost of banks is much lower--at around 2.8%--since they pay interest

only on the minimum balance kept between the 10th and the end of a month. But things

will change from April.

7. A savings account is the most common operating account for individuals and others for

non-commercial transactions. Banks generally put a ceiling on the total number of

withdrawals permitted and stipulate a certain minimum balance to be maintained in such

accounts.

8. With the rise in cost of savings accounts from April, banks want RBI to bring down the

interest rate from 3.5%. The central bank is not willing to do so and instead it may free

this rate. It has asked the Indian Banks' Association, the national bankers' body, to

prepare a report on this.

9. The option of capping the savings bank rate at the existing 3.5% and allowing banks to

fix the rate within the cap is ruled out because that will benefit only banks and consumers

will not gain.

10. "We need to study this and see how banks and the consumers get affected if the savings

account rate is freed. It cannot be done in a hurry," said a senior RBI official who did not

want to be named.


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ANALYSIS OF LENDING RATES IN INDIA.

The movements in nominal weighted average lending rate for the banking industry as a wholehas shown a gradual decline. It has come down from a range of 16-17 per cent in most part of the1990s to about 11.5 per cent by 2008-09. The declining trend is clearly visible in the 2000s

(Chart 1). However, wide dispersion persists in actual lending rates owing to substantial sub-BPLR lending.

How does one explain the trend in the lending rates? First, at a fundamental level the declinein the inflation rate between the 1990s and 2000s contributed to lower nominal lending rates .

Second, lower inflation volatility in the 2000s reduced the inflation risk premia. Third,significant productivity improvement in the banking system lowered the intermediation cost(Table 2). Fourth, the observed decline in weighted average lending rates in the banking systemcan be attributed to the improvements in pricing of risk due to the increased space provided byprogressive deregulation of lending rates.

First, at a fundamental level the decline in the inflation rate between the 1990s and 2000scontributed to lower nominal lending rates. Second, lower inflation volatility in the 2000s

reduced the inflation risk premia. Third, significant productivity improvement in the bankingsystem lowered the intermediation cost (Table 2). Fourth, the observed decline in weightedaverage lending rates in the banking system can be attributed to the improvements in pricing ofrisk due to the increased space provided by progressive deregulation of lending rates.

While the lending rates of various categories of borrowers depend on the risk and reward perceptions, the rates have declined for most categories of borrowers over time. At a
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disaggregated level, the weighted average lending rate for personal loans was higher while it wasthe lower for housing loans .

REAL LENDING RATES

From the perspective of borrowers as also from the point of view of sustainability of debt,what matters is the real interest rate. The Fisher equation gives the relationship between the realand nominal interest rates4. In the Fisher hypothesis time preferences of the public andtechnological constraints determining the return on real investment which is assumed to beconstant5. So the nominal rate moves with inflation. The Fisher equation can be used in eitherexante (before) orex post(after) sense. As ex ante inflation is not observable, one could computethe expectations augmented Fisher equation given the desired real rate of return and anexpected rate of inflation over the period of a loan. While there is no unique way to computeexpected inflation, the real interest rate ex postcan be computed as nominal interest rate minusrealized inflation rate.

As investment decisions are made over a medium-term horizon, it is important to consider reallending rates in a medium-term perspective. Borrowers tend to view the nominal lending rate interms of a desired real rate of return and expected inflation. Although several methods, includingsurveys, are employed to calculate expected inflation, it is difficult to assign expected valueswith a reasonable degree of precision given the uncertainty surrounding the future outcomes.This is more pertinent to developing economies like ours which are subject to structuraleconomic factors and unanticipated supply shocks.

Another useful way to address this issue is to derive expectations by smoothing the inflationseries. This presupposes that expectations are adaptive6 which is often the case in economies and
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markets with asymmetric information. Furthermore, given monetary policy credibility, theunderlying inflation expectations are generally stable but for the deviations caused by short termvolatility due to transitory factors7.

In our context, computation of real interest rate, even in an ex postsense, becomes challenging

because of lack of a comprehensive measure of consumer price inflation. Hence, I show herethree alternative ex postmeasures of real lending rates based on: (i) the wholesale price index,which is our headline measure of inflation; (ii) the GDP deflator, the most comprehensivemeasure of inflation; and (iii) the consumer price index for industrial worker (CPIIW), which isthe most representative of consumer price indices. It can be seen that the alternative measures ofreal interest rates have moved in tandem though there have been significant year to year

variations .
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V. CREDIT GROWTH AND REAL LENDING RATES

Now I turn to the relationship betweenreal GDP growth and real lending rates. Technically, the

real GDP growth is a measure of average real rate of return in the economy. Ideally, the real

lending rates should not be too much out of alignment with the real GDP growth rate. The data

for the period 1990-91 to 2008-09 show that real lending rates were higher than real GDPgrowth particularly during 1997-98 to 2002-03. This scenario has clearly changed since 2003-04

concurrent with the high growth phase of the Indian economy. The weighted average real

lending rate has since remained below the real GDP growth rate.

From a business cycle perspective, one could examine relationship between real interest rateand credit growth. The assessment of real lending rate in the context of underlying credit cyclescan potentially throw light on aspects of cyclicality in economic activity and its relationship withfinancial sector dynamics. High (low) real interest rates coincide with low (high) credit growth .


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In terms of real sector activity, approximated by the index of industrial production (IIP), theindustrial growth cycles are also inversely related to the real interest rate cycles. .

The base rate will prompt banks to make a better assessment of risk in pricing of loans. It isexpected to be more responsive to the stance of monetary policy which should facilitatemovement in effective real lending rates consistent with the rates of return in the economy.

Conclusion

First, the introduction of the base rate system along side removal of interest rate ceiling onsmall loans and freeing of rupee export credit interest rate brings to fruition over two decades ofefforts to deregulate the lending rates of banks. This is expected to enhance the allocativeefficiency of the financial intermediation process by banks.

Second, deregulation of lending rates will promote financial inclusion with greater creditflow to agriculture and small business. This, together with other specific measures taken by the


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Reserve Bank for financial inclusion, will draw borrowers away from the informal financialsector to the formal financial sector and thus, facilitate credit penetration.

Third, the base rate system that comes into effect from 1st July 2010 gives completefreedom to banks in their loan pricing decisions while ensuring transparency. Banks have

unlimited access to public deposits and privileged access to the liquidity facility of the ReserveBank. Hence there is a greater need for transparency and responsible lending practices for publicpurposes.

Fourth, the base rates of banks will mirror their relative efficiency and cost structure. Whilelending rates tend to be sticky, it is expected that the base rate system will show greaterflexibility and strengthen both the interest rate and credit channels of monetary transmission.

Fifth, the new system gives the freedom to banks to choose other market relatedbenchmarks besides their base rates for pricing floating rate products. This could promotedevelopment of market benchmarks. It could also deepen the money market to facilitate short-

term liquidity management by banks.

Sixth, there is some apprehension that the base rate system may raise the effective cost ofborrowings. This is unlikely because corporates have access to multiple sources of funds andhence the effective borrowing rates will be determined by market competition.

Seventh, the nominal effective lending rate of the banking system which remained higher inthe 1990s have declined significantly in the 2000s. This can largely be attributed to moderationin overall inflation, reduction in inflation risk premia, interest rate deregulation and increasingefficiency of the banking system.

Eighth, the computation of real lending rate becomes challenging without a comprehensivemeasure of consumer price inflation and difficulties in measuring inflation expectations.Nevertheless, ex postmeasures of real lending rates over the last two decades show a clearpattern. The real lending rates rose in the 1990s and then declined in the 2000s. The realweighted average lending rate was higher than the real GDP growth rate, particularly during the period 1997-98 to 2002-03. Thereafter, the real weighted average lending rate has declinedconcurrent with the high growth phase of the Indian economy.

Finally, credit and industrial output cycles show inverse relationship with real interest rate.However, there is a need for further research to better understand the relationship between creditand interest rate cycles and its implications for sustainable growth


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WHAT ARE THE MAIN RECOMMENDATIONS OF THE BPLR GROUP .

After carefully examining the various possible options, views of various stakeholders fromindustry associations and those received from the public, and international best practices, the

Group is of the view that there is merit in introducing a system of Base Rate to replace theexisting BPLR system.

The proposed Base Rate will include all those cost elements which can be clearly identified andare common across borrowers. The constituents of the Base Rate would include (i) thecard interest rate on retail deposit (deposits below Rs. 15 lakh) with one year maturity (adjustedfor CASA deposits); (ii) adjustment for the negative carry in respect of CRR and SLR; (iii)unallocatable overhead cost for banks which would comprise a minimum set of overhead costelements; and (iv) average return on net worth.

The actual lending rates charged to borrowers would be the Base Rate plus borrower-specific

charges, which will include product-specific operating costs, credit risk premium and tenorpremium.

The Working Group has worked out an illustrative methodology for computing the base rate forthe banks. According to this methodology with representative data for the year 2008-09, theillustrative Base Rate works out to 8.55 per cent.

With the proposed system of Base Rate, there will not be a need for banks to lend below theBase Rate as the Base Rate represents the bare minimum rate below which it will not be viablefor the banks to lend. The Group, however, also recognizes certain situations when lendingbelow the Base Rate may be necessitated by market conditions. This may occur when there is alarge surplus liquidity in the system and banks instead of deploying funds in the LAF window ofthe Reserve Bank may prefer to lend at rates lower than their respective Base Rates. The Groupis of the view that the need for such lending may arise as an exception only for very short-term periods. Accordingly, the Base Rate system recommended by the Group will be applicablefor loans with maturity of one year and above (including all working capital loans).


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Banks may give loans below one year at fixed or floating rates without reference to the BaseRate. However, in order to ensure that sub-Base Rate lending does not proliferate, the Grouprecommends that such sub-Base Rate lending in both the priority and non-priority sectors in anyfinancial year should not exceed 15 per cent of the incremental lending during the financial year.Of this, non-priority sector sub-Base Rate lending should not exceed 5 per cent. That is, the

overall sub-Base Rate lending during a financial year should not exceed 15 per cent of theirincremental lending, and banks will be free to extend entire sub-Base Rate lending of up to 15per cent to the priority sector.

At present, at least ten categories of loans can be priced without reference to BPLR. The Grouprecommends that such categories of loans may be linked to the Base Rate except interest rates on(a) loans relating to selective credit control, (b) credit card receivables (c) loans to banks ownemployees; and (d) loans under DRI scheme.

The Base Rate could also serve as the reference benchmark rate for floating rate loan products,apart from the other external market benchmark rates.

In order to increase the flow of credit to small borrowers, administered lending rate for loans upto Rs. 2 lakh may be deregulated as the experience reveals that lending rate regulation hasdampened the flow of credit to small borrowers and has imparted downward inflexibility to theBPLRs. Banks should be free to lend to small borrowers at fixed or floating rates, which wouldinclude the Base Rate and sector-specific operating cost, credit risk premium and tenor premiumas in the case of other borrowers.

The interest rate on rupee export credit should not exceed the Base Rate of individual banks. As

export credit is of short-term in nature and exporters are generally wholesale borrowers, there isneed to incentivise export credit for exporters to be globally competitive. By this change instipulation of pricing of export credit, exporters can still access rupee export credit at lower ratesas the Base Rate envisaged is expected to be significantly lower than the BPLRs. The Base Ratebased on the methodology suggested by the Group is comparable with the present lending rate of9.5 per cent charged by the banks to most exporters. The proposed system will also be moreflexible and competitive.

At present the interest rates on education loans are linked to ceilings with reference to the BPLR.In view of the critical role played by education loans in developing human resource skills, the

interest rate on these loans may continue be administered. However, in view of the fact that theBase Rate is expected to be significantly lower than BPLR, the Group recommends that there isa need to change the mark up. Accordingly, the Group recommends that the interest rates on alleducation loans may not exceed the average Base Rate of five largest banks plus 200 basispoints. Even with this stipulation, the actual lending rates for education loans would be lowerthan the current rates prevailing. The information on the average Base Rate should bedisseminated by IBA on a quarterly basis to enable banks to price their education loan portfolio.


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In order to bring about greater transparency in loan pricing, the banks should continue to provide the information on lending rates to the Reserve Bank and disseminateinformation on the Base Rate. In addition, banks should also provide information on theactual minimum and maximum interest rates charged to borrowers.

All banks should follow the Banking Codes and Standards Board of India (BCSBI)Codes for fair treatment of customers of banks, viz., the Code of Banks Commitment toCustomers (Code) and the Code of Banks Commitment to Micro and Small Enterprises(MSE Code) scrupulously. The Group also recommends that the Reserve Bank mayrequire banks to publish summary information relating to the number of complaints andcompliance with the codes in their annual reports.

RECOMMENDATION:

The important recommendations are:

The concept of BPLR is outdated and is out of sync with the present market conditions and itshould be replaced with a new Base Rate System .Base Rate would be based on one-year cardrate on deposits, loss incurred by banks for SLR/CRR, overhead cost and average return on networth. The actual rate charged to borrowers would be Base Rate increased by operating costs,credit risk premium, tenor premium and others Banks should not lend below the Base Rate,except in a few cases.At present, the Government administers loans of up to Rs 2 lakh to small borrowers, underpriority sector & others. These administered rates shall be discontinued and these loans can bebrought under the Base Rate system.

.All scheduled commercial banks should switch over from the existing BPLR system to

the new Base Rate System. Banks may choose any benchmark to arrive at the Base Rate for a specific tenor (tenure

of the loan) Banks are free to use any other methodology, provided it is made available for RBIs

scrutiny. All loans and advances should be linked to Base Rate. But, there are a few exceptions

meaning the following loans can be disbursed without linking them to Base Rate:DRI advances

Loans to banks own employees. Loans to banks depositors against their own deposits Until the new system stabilizes, banks are given flexibility to change the benchmark and

methodology any time between July and December 2010.

Base Rate should be used as a reference rate for floating rate loans

RBI should separately announce lending rates for export credit.

Rama The Base Rate system will be applicable to new loans as well as loans that have come up

for renewal.


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Banks shall exhibit the information on Base Rate on their websites and at all theirbranches.

Base Rate should not be linked to the following loans, namely, (i). loans to RBI has notgranted any exception to these two types of loans selective credit control and,(ii). Credit

card receivables.

Base Rate should be applicable to loans No such stipulation by RBI with maturity ofmore than one year.

For loans below maturity of one year, banks No such stipulation should be set free byRBI to charge rates without any link to Base Rate.

Interest rates on export credit should be exceeding Base Rate at or above Base Rate.

Educational loans should be administered No such special treatment to Educational &their rates should not exceed Base Rate loans plus 200 basis points.

Base Rate should be calculated based on one year deposit rate adjusted for CASA cost ofdeposits/funds and other criteria.

ABBREVIATIONS USED:

BPLR: Benchmark Prime Lending Rate

BRS: Base Rate System

CASA : Current Account and Savings Bank Accounts (low-cost deposits)

CD: Certificate of Deposit;CP: Commercial paper;

CRR: Cash Reserve Ratio;DRI: Differential Rate of Interest

G-Sec: Government Security

LAF : Liquidity Adjustment Facility of the RBIMIBOR: Mumbai Inter-bank Offered Rate

PLR: Prime Lending Rate

RBI: Reserve Bank of India; and,

SLR : Statutory Liquidity Ratio

Rama, BOMBAY June 13, 2010

www.


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sBIBILIOGRAPHY AND REFERENCES

http://www.indianexpress.com/news/rbi-forms-panel-to-review-bplr-system/475068/

http://capitalmarket.webtutorials4u.com/home/2010/02

http://www.allbankingsolutions.com

http://www.thehindubusinessline.com/2010/06/22/stories/2010062250951000.htm

http://www.livemint.com/2010/02/08001610/RBI-ready-to-free-all-lending.htm

http://www.adb.org/Statistics/Data/files

http://www.rbi.org.in/scripts/

amadvice.wordpress.com/2010/07/07

http://www.bankbazaar.com http://www.indianexpress.com/news/rbi-forms-panel-to-review-bplr-system/475068/

http://www.caclubindia.com/articles/lending-rates-in-india-6022.asphttp://www.igidr.ac.in/~money/mfc_08/Concept%20of%20Deregulation...KV%20Bhanu%20Murthy%20&%20Ashish%20Tatu%20Deb.pdf
http://www.indianexpress.com/news/rbi-forms-panel-to-review-bplr-system/475068/http://capitalmarket.webtutorials4u.com/home/2010/02http://www.allbankingsolutions.com/http://www.thehindubusinessline.com/2010/06/22/stories/2010062250951000.htmhttp://www.livemint.com/2010/02/08001610/RBI-ready-to-free-all-lending.htmhttp://www.adb.org/Statistics/Data/fileshttp://www.rbi.org.in/scripts/http://www.bankbazaar.com/http://www.indianexpress.com/news/rbi-forms-panel-to-review-bplr-system/475068/http://www.indianexpress.com/news/rbi-forms-panel-to-review-bplr-system/475068/http://www.caclubindia.com/articles/lending-rates-in-india-6022.asphttp://www.igidr.ac.in/~money/mfc_08/Concept%20of%20Deregulation...KV%20Bhanu%20Murthy%20&%20Ashish%20Tatu%20Deb.pdfhttp://www.igidr.ac.in/~money/mfc_08/Concept%20of%20Deregulation...KV%20Bhanu%20Murthy%20&%20Ashish%20Tatu%20Deb.pdfhttp://www.indianexpress.com/news/rbi-forms-panel-to-review-bplr-system/475068/http://capitalmarket.webtutorials4u.com/home/2010/02http://www.allbankingsolutions.com/http://www.thehindubusinessline.com/2010/06/22/stories/2010062250951000.htmhttp://www.livemint.com/2010/02/08001610/RBI-ready-to-free-all-lending.htmhttp://www.adb.org/Statistics/Data/fileshttp://www.rbi.org.in/scripts/http://www.bankbazaar.com/http://www.indianexpress.com/news/rbi-forms-panel-to-review-bplr-system/475068/http://www.indianexpress.com/news/rbi-forms-panel-to-review-bplr-system/475068/http://www.caclubindia.com/articles/lending-rates-in-india-6022.asphttp://www.igidr.ac.in/~money/mfc_08/Concept%20of%20Deregulation...KV%20Bhanu%20Murthy%20&%20Ashish%20Tatu%20Deb.pdfhttp://www.igidr.ac.in/~money/mfc_08/Concept%20of%20Deregulation...KV%20Bhanu%20Murthy%20&%20Ashish%20Tatu%20Deb.pdf

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