The Reserve Bank of India's directive to banks to switch over to a base rate system was implemented from July 1. Almost all banks announced their base rates quickly.
The very next day the RBI hiked the repo and the reverse repo rates by 0.25 percentage point each, a move that is intended to dampen inflation by making an immediate impact on the lending rates. Its efficacy would, however, depend on how well the monetary transmission mechanism works. That is where the significance of the new base rate mechanism is seen.
It might be a coincidence and is certainly not very obvious but the new base rate mechanism has one of its objectives a better transmission of monetary policy signals. To understand this of course one has to look at the new system in its entirety and see how it can be an improvement over the previous method adopted by banks in fixing lending rates.
Transparency
Under the new system, banks have been asked by the RBI to ensure uniformity and transparency in calculating the base rate, which is the floor rate for all loans.
Each bank will calculate its own base rate taking into account the cost of funds, possible loss incurred in complying with the reserve requirements, administrative costs and the profit element. The actual lending rate to the borrower will be higher.
To the base rate will be added borrower-specific charges, product specific operating costs, and premia on account of credit risks and tenure.
The base rate will set the floor for interest rates on all types of loans. There would be very few exceptions. Staff loans, loans under the differential interest rate scheme, advances against fixed deposits and a few other categories will be charged interest rates that are quite independent of the base rate mechanism.
It is this near universal coverage coupled with the transparency in its computation that is supposed to give the base rate system an edge over the BPLR (Bench mark prime lending rate). Will it deliver what the old system could not?
Knowledgeable observers have pointed that the base rate is actually a resurrection of a system that was in vogue in the early 1990s. The Prime Lending Rate (PLR) system was diluted over time as many types of borrowers sought to be exempted from its review. By 2001 it had become just a reference rate. The rate charged by banks had very little nexus with the PLR. In fact, a large proportions of loans have till recently been made at below PLR rates. Sub-PLR loans in India have very little connection with loans of the same nomenclature that were wildly popular in the U.S. Risky lending on a massive scale to less than credit worthy borrowers was one of the factors that brought about the collapse of the financial sector in the U.S.
In India, sub-PLR loans are a sign of strength to the borrowers who, in the name competition, can browbeat banks, usually the public sector ones, into sanctioning loans at below PLR. The losers are the small and medium enterprises which will have to bear higher interest charges to subsidise the large corporate borrowers.
Pernicious practices
In theory, at least such pernicious practices will be minimised if not eliminated altogether when the new system settles down.
But knowledgeable observers doubt whether a level playing treatment is at all possible to all types of borrowers. There will be a subjective element always while sanctioning loan and fixing interest costs.
The new system is also expected to score over the old system in another way. To the extent it will cover nearly all borrowers: the base rate will more truly reflect interest rate changes arising out of monetary policy. For instance, when the recent repo rate hikes are factored in, the base rates of most banks are expected to be marked up. Correspondingly, the lending rates will also go up. Under the old system — the PLR, being just a reference rate — any variation did not necessarily reflect policy changes. Even if they did, there was no guarantee that the borrowers would be charged more.
The latest policy rate hikes have a contextual significance as they have been announced after the base rate mechanism has been introduced. It is too early to tell whether the banks will raise their base rates and consequently the lending rates. Indications are that deposit rates might be hiked first.
