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Loan PolicyNote

BPLR/Base rate

The Reserve Bank of India (RBI) has decided to take a more activist (or micro-management) role in

management of banks including the pricing of credit facilities and the calculation of interest on deposits.

The RBI released a draft circular that provided new guidelines for increasing transparency in credit pricing,

wherein the Benchmark Prime Lending Rate (BPLR) was replaced with the Base Rate from April 1, 2010 or

FY11.

This marked a significant development for the Indian banking industry, as it changed the way banks calculate

their lending rates and sub-PLR lending will now come to an end. There exists a wide disconnect between the

BPLR and actual rates For instance, the actual lending rate for Public Sector Banks (PSBs) in September 2009

stood at 4.25 - 18%, as against a BPLR of 11-13.5% for the same period. The same pattern existed for Private

sector banks and foreign sector banks as well.

Banks were lending to small borrowers above the PLR rate - say 10%, the large companies got away with muchcheaper loans. This was due to their bargaining power with the banks. Every bank had a different mix of above

PLR and sub-PLR lending. Hence it was difficult for the regulator to figure out which bank was taking how

much undue risk.

The base rate was proposed to take care of three necessities.

Ensure that monetary policy signals are conveyed to the real side of the economy without much lag anddistortion.

Ensure improved flow of credit at a reasonable price to small borrowers, instead of them subsidisinglarge corporate borrowers.

Make pricing of bank loans more transparent Opportunities of direct financing providing competitition to other forms of high cost credit

Salient Features

The base rate is proposed to be calculated by including the cost of deposits, cost of maintaining the statutory

liquidity ratio and cash reserve ratio, cost of running the bank(unallowable overhead costs like overhead cost of

head office,/corporate office/other administrative offices), and profit margin(average return on banks net

worth(capital +reserves)

This will be the minimum lending rate for banks.

Hence, the actual rate will depend upon the base rate plus borrower specific charges, which will include product

specific operating costs, credit-risk premium, and tenure premium.

Moreover, the guidelines direct banks to disclose their base rate on a quarterly basis and ensure that the interest

rates charged to the customers are non-discriminatory in nature.

Expected Outcome:

The RBI expects an increase in credit flow to small borrowers at reasonable rates at the current stipulation of

BPLR, as the ceiling rate for loans up to Rs.0.2 mn has been withdrawn.

The base rate of banks will now decline to the single digit

The current base rate for the largest bank in India, SBI is 10% p.a effective 13/08/2011. The BPLR has

also been increased from 14.25% p.a to 14.75% p.a

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Shift from BPLR to Base rate

No fee

BPLRdriven by competitive forces and is market driven, linked to the average cost

Base RateMarginal cost

Marginal Standing Facility

Definition

The Reserve Bank of India in its monetary policy for 2011-12, introduced the marginal standing facility (MSF),

under which banks could borrow funds from RBI at 8.25%, which is 1% above the liquidity adjustment facility-

repo rate against pledging government securities.

Salient Features

The MSF rate is pegged 100 basis points or a percentage point above the repo rate. Banks can borrowfunds through MSF when liquidity is expected to tighten sharply owing to advance tax payments.

All scheduled commercial banks that have current account and subsidiary general ledger (SGL)account with RBI are eligible to participate in the MSF scheme.

The central bank has the right to accept or reject partially or fully, the request for funds under thisfacility.

The Reserve Bank of India introduced MSF at its annual policy statement, saying that banks can dipbelow 1% of their statutory liquidity ratio to avail cash from this window.

The banks will use Marginal Standing Facility to borrow overnight money only when they haveexhausted all other existing channels like collateralized borrowing and lending obligation (CBLO) andliquidity adjustment facility (LAF)

An interest rate at 8.25% for banks to borrow money is almost a "penal rate" The fixed width of the corridor between reverse repo rate and the newly introduced Marginal Standing

Facility (MSF) will not only keep the volatility in call market in check, but also improve monetary

policy signalling in the economy.

History

The RBI introduced the Interim Liquidity Adjustment Facility (ILAF) in April 1999, under which liquidity

injection was done at the Bank Rate (Bill discounting rate) and liquidity absorption was through fixed reverse

repo rate

The ILAF gradually transited into a full-fledged liquidity adjustment facility (LAF) with periodic modifications

based on experience and development of financial markets and the payment system. The LAF was operated

through overnight fixed rate repo and reverse repo from November 2004.

The LAF helped to develop interest rate as an instrument of monetary transmission. In the process, two major

weaknesses came to the fore.

First was the lack of a single policy rate. The operating policy rate alternated between repo and reverserepo rates depending upon the prevailing liquidity condition. In a surplus liquidity condition, the

operating policy rate was the reverse repo rate, while in a deficit liquidity situation it was the repo rate.

Second was the lack of a firm corridor. The effective overnight interest rates dipped below the reverserepo rate in surplus conditions and rose above the repo rate in deficit conditions. Moreover, overnight

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call rates became unbounded under occasional liquidity stress. Thus, more often the overnight interest

rate remained outside the corridor.

Present Rate

Against this background, the new operating procedure retained the essential features of the LAF framework with

the following key modifications.

First, the weighted average overnight call money rate was explicitly recognised as the operating targetof monetary policy.

Second, the repo rate was made the only one independently varying policy rate. Third, a new Marginal Standing Facility (MSF) was instituted under which scheduled commercial

banks (SCBs) could borrow overnight at their discretion up to one per cent of their respective NDTL at

100 basis points above the repo rate.

Fourth, the revised corridor was defined with a fixed width of 200 basis points. The repo rate wasplaced in the middle of the corridor, with the reverse repo rate 100 basis points below it and the MSF

rate 100 basis points above it

Retail Credit

Definition

Both the demand and supply side of the economy need credit. Consumers of goods and services constitute the

demand side of the economy and on the supply side, the need for credit arises from the corporate and

government sectors engaged in manufacturing, trading and services. These sectors require bank credit for capital

investment in long term projects and for day-to-day operations

Financing the demand side of the economy namely the large consumer base of consumers is called retail

banking also termed as the mass banking

Financing the supply side of the economy, which is more customized in nature and calls for specialized skills, is

called wholesale banking or corporate banking or class banking

Salient Features

Major product segments of retail credit include housing finance, auto finance, personal loans, consumerdurable loan and credit cards to name a few.

Housing constitutes the biggest segment of 48% of the entire retail credit; followed by the auto loanssegment which constitutes almost 27.8%. While the balance retail credit is used by consumer durablesat 7.2%, educational and other personal loans take the remaining 16%.

This financial assistance is extended by banks by way of demand loan/term loan with a clear paymentschedule but repayment at demand

Interest rate is cheaper than wholesale credit C/C, O/D facilities are not encouraged In addition to the above credit for production/business actions is extended also by

Working capital finance by way of C/C, O/D, BP/BD etcOverview of the present Scenario

The Indian financial sector (including banks, non-banking financial companies, or NBFCs, and housing finance

companies, or HFCs) reported a compounded annual growth rate (CAGR) of 19% over the last three years and

their credit portfolio stood at close to Rs. 49 trillion (around 62% of 2010-11 GDP) as on March 31, 2011. Totalbanking credit stood at close to Rs. 39 trillion as on March 25, 2011 and reported a strong 21.4% growth in

2010-11

As for banks retail lending, this continued to lag overall credit growth during 2010 -11. Retail credit grew by

17% in 2010-11 against the overall credit growth of 21%, although the 17% figure marked a significant increase

over the 4.1% reported in 2009-10