Concept of Base Rate

A RBI working group chaired by Sh. Deepak Mohanthy submitted “Report of the Working Group on Benchmark Prime Lending Rate (BPLR)” in October 2009. It was directed to review the BPLR system and suggest changes to make credit pricing more transparent. In the mean time, Committee on financial reforms chaired by Shri Raghuram G. Rajan, had also deliberated on the issue of interest rate ceilings for small loans. They concluded that bulk of the loan is disbursed at rates below the PLR — popularly known as sub-PLR. Nearly 70% of the loan is at sub-PLR rates. On account of competitive pressures, banks were lending part of their portfolio at rates which did not make much commercial sense. In short, the present lending system is suffering from the lack of transparency. 

BPLR – The Present System
BPLR or Benchmark Prime Lending Rate is the rate charged by commercial banks to their most credit worthy customers. According to the Reserve Bank of India, banks are free to fix their BPLRs but the interest rates charged by them have to bear relevance to the BPLR. Banks are free to fix BPLRs for credit limit beyond Rs.2 lakhs. Lending rates for the agricultural sector was set by the RBI.
The Reserve Bank of India does not set these rates, but in a broad way stipulates the interest rates in the economy.
The PLR is influenced by RBI's policy rates - the repo rate and cash reserve ratio - apart from the bank's policy. In simple words, availability of funds in the banking system and demand for credit by consumers (both retail and industrial) determine what the BPLR should be.
Some facts:

• RBI introduced the concept of Prime Lending Rate in 1994
• Commercial banks were allowed to lend at sub-PLR for loans above Rs. 2 lakh
• The system of Benchmark Prime Lending Rate (BPLR) introduced in 2003 with the objective of bringing operational flexibility in deciding their lending rates.
• PLR remained the ceiling rate for loans up to Rs. 2 lakh

Failure of BPLR
Banks were fixing their BPLR in non transparent manner and they were offering several BPLR rates each for different category of loans. Some were having two benchmark rates for home loan borrowers. When rates went down in the system, the banks simply announced another lower PLR with a different name for the new customers.

What is a 'spread'?
Spread is the difference between the BPLR (prime lending rate) and the loan interest rate. This can be "x" plus or "x" minus the BPLR rate fixed by the bank.

What are Sub-PLR Loans?
Some banks provide loans and advances at a rate lower than the BPLR (Prime Lending Rate) of the bank to customers availing finance for business purposes or short-term funds for various needs (usually large companies, major exporters and some individuals etc.) with high credit ratings.  This enables them to attract bigger clients, offer bigger amounts of loans since the high credit worthiness is a likely indicator of customers making regular payments and this in turn helps the banks to increase business and get more profits from their loans.
Due to the current economic slowdown, most banks had stopped giving out Sub-PLR loans for some time. With improved liquidity conditions, banks are back on the trend of disbursing loans at discounted rate that is below benchmark prime lending rates (BPLR).  Majority of fresh loans, around 65 per cent to 70 per cent are being disbursed at sub-PLR rates now as opposed to the situation some time back. This trend is prevalent currently to encourage credit growth, which has been facing a slump as an after effect of the global recession.
 

What is Base Rate?
Base rate is the rate, below which no bank can lend to its customers.
The base rate would be calculated by banks based on four major factors:

1. cost of deposits
2. cost of adjustment for negative carry in respect of CRR and SLR
3. unallocated overhead costs
4. profit margin

In addition, Borrower’s specific costs due to product, its tenur and borrower’s credit risk will be added. Product related costs mean that an unsecured loan would have a higher cost.  The Credit rating of the borrower with Credit Information Bureau of India Ltd (CIBIL) will now come into play and people having good credit scores will see lesser charges related to their risk, means lower rates. Tenure related cost means longer the period, higher the cost.
Since this system allowed every bank to price its loan individually so each bank would price its loan according to the cost of funds and operating efficiencies. This implies that a bank with a higher CASA ratio will benefit more than the one with a lower ratio.
CASA stands for current and savings account. The CASA ratio shows out of the total deposits available with a bank, how much is attributable to current and savings deposits. An increased CASA ratio therefore would infer an increased source of funds from current and savings account deposits. CASA provides more liquidity as compared to term and demand deposits. This infers that banks with high CASA ratios will benefit themselves and banks with base rates at the higher end are sure to have a tuff time competing in this highly competitive business. But in this race the customer seems to be in a win-win scenario. As the banks fight for the best lending rate, the customer gets to have the cherry of the cake.

What could happen if Base rate comes into effect?
Borrowing could become expensive for short-term borrowers, especially the corporate. Bankers say that this doesn’t mean that they would be giving two base rates, one for short-term and the other for long-term borrowers. Instead, they expect short-term borrowers especially the corporate to shift to the commercial paper market to raise short-term and cheap funds from the market. This could also means that they could shift to the private sector banks in case private banks keep their base rate lower than PSU banks so PSU banks will take a hit on margins

RBI Guidelines:

• The Base Rate system will replace the BPLR system with effect from July 1, 2010. Base Rate shall include all those elements of the lending rates that are common across all categories of borrowers.
• Banks may choose any benchmark to arrive at the Base Rate for a specific tenor that may be disclosed transparently. Banks are free to use any other methodology, as considered appropriate, provided it is consistent and are made available for supervisory review/scrutiny, as and when required.
• Banks may determine their actual lending rates on loans and advances with reference to the Base Rate and by including such other customer specific charges as considered appropriate.
• In order to give banks some time to stabilize the system of Base Rate calculation, banks are permitted to change the benchmark and methodology any time during the initial six month period i.e. end-December 2010.
• The actual lending rates charged may be transparent and consistent and be made available for supervisory review/scrutiny, as and when required.
• All categories of loans should henceforth be priced only with reference to the Base Rate with exceptions (a) DRI (Differential rate of Interest) advances (b) loans to banks’ own employees (c) loans to banks’ depositors against their own deposits.
• The Base Rate could also serve as the reference benchmark rate for floating rate loan products, apart from external market benchmark rates. The floating interest rate based on external benchmarks should, however, be equal to or above the Base Rate at the time of sanction or renewal.
• Changes in the Base Rate shall be applicable in respect of all existing loans linked to the Base Rate, in a transparent and non-discriminatory manner.
• Since the Base Rate will be the minimum rate for all loans, banks are not permitted to resort to any lending below the Base Rate. Accordingly, the current stipulation of BPLR as the ceiling rate for loans up to Rs. 2 lakh stands withdrawn.
• Reserve Bank of India will separately announce the stipulation for export credit.
• Banks are required to review the Base Rate at least once in a quarter with the approval of the Board or the Asset Liability Management Committees (ALCOs) as per the bank’s practice.
• 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 to the Reserve Bank on a quarterly basis.
• The Base Rate system would be applicable for all new loans and for those old loans that come up for renewal. Existing loans based on the BPLR system may run till their maturity. In case existing borrowers want to switch to the new system, before expiry of the existing contracts, an option may be given to them, on mutually agreed terms. Banks, however, should not charge any fee for such switch-over.