Will The Base Rate Really Make The Floating Rate Loans More Transparent?

Loan rates set to be more transparent screamed newspaper headlines on,Thursday,after a draft RBI circular asked banks to shift to a base rate mechanism from the existing BPLR
w.e.f April 1, 2010.

The existing BPLR structure for pricing floating rate,loans,has exhibited what bankers politely call downward stickiness, which means that the BPLR refuses to go down (or goes down reluctantly and at a slower pace)
when bank’s cost of funds fall, though it is quick to go up when their cost of funds go up.

In effect existing,loan,consumers continue to pay higher interest rates even in a falling interest rate market but are forced to pay more when interest rates go up. As taking a loan (primarily home loan ) becomes more prevalent it affects millions of middle class households and the furore over this non- transparent method of fixing floating rate loan products has reached feverish

The banks on their part give a curious argument to justify charging more to their existing home loan consumers whilst doling out lower rates to attract new customers. They claim that as interest rates fall only for the new
incremental deposits and since the existing consumers are funded from existing deposits (which are at a higher rate), they cannot be given the benefit of the fall in rates immediately. The reason this argument does not appear wash is because by this token when interest rates rise, only the new customers should be paying the higher rate (since only they are funded from the new high cost deposits) whilst the existing loan consumers should continue to pay less. Of course this never happens.

When interest rates go up, they go up for both the new and old customers. Bankers again have a justification for even this. According to them when interest rates go up their existing depositors break their lower cost deposits to make fresh deposits at higher rates. There is no data presented by them
to support this contention (of customer churn old deposits for new deposits at higher costs) and it is difficult to believe that a large body of Indian depositors overcome their legendary inertia just to take advantage of a 0.25% or 0.50% increase in deposit rates.

In any case this completely overlooks the fact that managing the treasury is a core function of the bank and it cannot pass on this responsibility (or cost) to its loan customers. Another argument given by bankers is that if the true cost of this treasury management was to be included in the loan pricing then all loans will be more expensive to start with (though they will be transparent). I am willing to stick my neck out and say that given the choice between a cheaper but non-transparent loan to a slightly more expensive but transparent loan, most consumers will opt for the latter. In fact this presents a unique opportunity for a consumer bank but more of that later.

Now coming to the draft RBI circular which differs from the recommendations of the Mohanty committee in two very crucial aspects. Firstly the committee had recommended that the Base Rate be calculated in a very specific manner with the starting point being the bank’s 1 year deposit rate. What the RBI circular says is While each bank may decide its own Base Rate, some of the criteria that could go into the determination of the Base Rate are: (i) cost of deposits; (ii) adjustment for the negative carry in respect of CRR and SLR; (iii) unallocatable overhead cost for banks. In effect each bank will be able to fix its own base rate without necessarily having to justify its calculations. This does not give much confidence that anything much will change from the BPLR dispensation. There have been numerous exhortations from the regulator that BPLR was to be fixed with reference to the cost of funds of a bank.
Secondly the committee had recommended that the Base Rate be revised at least once every quarter which is again not insisted on in the RBI’s draft circular.

So unless something changes dramatically, the expectation that loan interest rates will be fixed in a more transparent manner, is likely to take a long time to realise. There is one (unintended?) impact of the draft circular. The artificial cap on interest rate on,education loan,may no longer apply and hence this crucial (but risky product from the bank’s perspective) may at last take off.

To conclude here, I think that the path to more transparent loan pricing will have to be traversed through legislation rather than from regulation.

Let’s see if our political class will come to the rescue of the loan consumer whereas regulator has been unable to do so.

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