The biggest complaint of loan consumers in India who have taken loans on a floating rate has been that lenders are quick to raise rates for them when interest rates rise in the market but are very reluctant to reduce their interest rates when market interest rates drop.
Till June 30, 2010 the floating rate products were priced with reference to their Benchmark Prime Lending Rate (BPLR). Clearly the BPLR system was not functioning in a transparent manner. After setting up a committee to examine the issue and a draft note inviting public suggestions the guidelines relating to the new Base Rate system have been made effective for all loans issued or renewed on or after July 1, 2010. So will this new Base Rate system be effective?
This article examines the difference between BPLR and Base Rate regime and the potential impact of the Base Rate system.
The rate is ‘to be computed taking into consideration (i) cost of funds; (ii) operational expenses; and (ii) a minimum margin to cover regulatory requirements of provisioning and capital charge, and profit margin. No this RBI pronouncement is not about the Base Rate but about the Benchmark PLR.
If you see the non-binding illustrative methodology for the Computation of the Base Rate in the guidelines, it also more or less lays out the same set of parameters but just in greater detail.
So if the calculation method is similar how will Base Rate system make a significant difference?
For starters there are two big differences. Whilst each bank can choose its own benchmark for the cost of funds they will have to document the detailed formula for the calculation of the Base Rate and the method of calculation and follow it consistently (except during a brief six month transition period). This formula will need to be disclosed to RBI, which can also scrutinize that it is being followed consistently.
This is unlike the BPLR regime where the BPLR was supposed to take into account the same set of parameters but no documentation was required and it was not open to RBI scrutiny. This is a significant difference between the two regimes since this forces the banks to follow a consistent method of calculating the Base Rate unlike the BPLR.
The second big difference is that, unlike the BPLR, banks are not allowed to lend below the Base Rate (again there are a few exceptions but they are not very relevant for this purpose). Now we all know that blue chip corporates are always able to get good rates from the banks. They are likely to be borrowing at interest rates very close to the banks current Base Rates.
When market interest rates fall they will naturally expect to get better rates and naturally the banks will be forced to drop their Base Rates if they still want to maintain their share of this market. So apart from the point mentioned in the first paragraph, this factor will also exert downward pressure on the Base Rate when market interest rates fall.
If the transparency is so built in then why the doubt on whether the Base Rate system will be effective or not? Clearly the Base rate system is designed to be more transparent than BPLR. But unfortunately there is no requirement that the detailed formula of each bank’s Base Rate be made public (it is only to be available for review and scrutiny by RBI).
Clearly RBI will need to set up a machinery to monitor and review these calculations to ensure that they are consistent, which given their focus on ensuring transparency is likely to function as an effective check on the proper implementation of the Base Rate system. It would be very interesting to find out whether the general public under RTI can access a specific bank’s calculation of Base Rate that is available with RBI.
As is likely the effective functioning of the Base Rate regime will significantly change the retail lending industry in India. Firstly as changes in the effective interest rate for the customer will depend on the average cost of funds rather than the marginal cost of funds any increases in market rates will take time before they are fully passed on to the borrower (see box for difference between average and marginal cost of funds).
Whilst this is beneficial when interest rates increase it is also not so bad when interest rates decrease as, unlike the current situation, the consumer is likely to get some decrease immediately compared to none or very little in the current scenario.
Difference between average and marginal cost of funds
Assume a bank currently has funds of Rs. 100 crores at an average cost of 10% (total cost of funds is Rs. 10 crores or Rs. 2.50 crores per quarter). Now the cost of funds in the market goes up by 1% pa. On an arithmetic basis the banks cost of funds should go up by Rs. 1 crore per annum or Rs. 25 lacs per quarter.
However since a lot of the bank’s funds are in time deposits which are at a fixed cost – where the cost will rise only when the deposit comes up for renewal – immediately its cost may go up by only say 12.50 lacs for this quarter or only 0.50% p.a. Of course over a period of time as all the fixed deposits mature and are renewed at new higher rates the cost of funds will go up to Rs. 11 crore per annum or 2.75 crores per quarter). Thus the average cost -10% in this example changing to 10.50% or a change of 0.50% only – will always change slower than the marginal cost – +1% in this example)
If you have an existing loan should you shift to the new Base rate regime?
Firstly there is no automatic shift to the new regime. You will have to ask your bank to shift you to the new Base rate regime for which they are not supposed to charge you any fees. If you are on an existing fixed rate loans (or in the teaser period where rates are still fixed) where the rate is lower than the current floating rate of 8.50% – 9% than wait till you are on a floating rate basis for shifting to the new regime.
If you are paying interest rate in double digits then shift to the new regime immediately. If your existing lender is not giving you good terms for the shift or is not acting fast enough to shift you to the new regime then you should seriously consider shifting to a new lender altogether)
The National Housing Bank (NHB) which regulates the housing finance companies HDFC, LIC Housing Finance, etc.- will also be forced to come out with a similar system for HFCs which will be good for the home loan consumers. Similarly the scheme will have to be extended to NBFCs also by RBI though that is likely to have a smaller impact on the loan consumers.
In any case the impact of this fundamental change will be felt only over a period of time at least 6-12 months as interest rates change (likely to increase) during that period. Here’s hoping that this change has a fundamental impact on all loan consumers.