The base rate implications

From July 1, 2010, lending rate decisions of all banks will be made with reference to a pre-announced base rate which will have to be reviewed atleast once a quarter. This change is being done in an attempt to improve transparency in banks’ lending rates and to enable better assessment of transmission of monetary policy. And an immediate manifestation of the greater transparency was the fact that the newly announced base rates of banks were in the range of 7-8%, while the BPLR was in the 11-16% range.

Unlike in the old Benchmark Prime Lending Rate (BPLR) regime, where atleast 70% of loans were given below the BPLR, banks will no longer be permitted to lend below the base rate floor (except in case of agriculture loans and export credit). The base rate will be more transparent in so far as it will be a function of the banks' costs on its capital (or cost of deposits), operating costs, statutory requirements (CRR, SLR etc), credit-risk of the borrower, and the allowable profit margin.

All banks will be required to disclose information on base rates at all branches and on their website, and the basis of computation will be auditable by RBI. This is expected to increase the transparency in movement of floating rates of consumer loans, besides improving the efficiency of the transmission of monetary policy changes to actual lending rates.

This will naturally ensure that the larger business clients, who used to access loans at much lower than the BPLR, will no longer be able to avail loans at below the base rate. However, this is not likely to adversely affect the investment prospects since during the recent downturn, when bank credit supply got constrained, businesses continued to raise funds through non-bank sources - mutual fund redemptions, equity market placements, CP etc.

A possible consequence of this could be to encourage these better rated firms to search for alternative fund raising routes in the debt markets, thereby facilitating the increase in its breadth and depth. Corporations and non-banking finance companies (NBFCs) could prefer short-term (less than a year) money market instruments like commercial papers (CPs), with tenor between 15-365 days and with rates linked to the yield on the one-year government bond, or non-convertible debentures, over bank loans, especially for their short-term funding needs. At the longer end of the spectrum, this would incentivize firms to access the equity and bond markets. Further, in view of the fact that the higher-rated firms are more likely to access these markets, it will also contribute towards ensuring that they remain liquid and vibrant.

It will also set the stage for the higher rated companies to raise capital through the external commercial borrowings (ECB) route, especially given the ultra-low interest rates across much of developed world. A strengthening rupee (vis-a-vis dollar) will only increase the attractiveness of such fund raising.

On the other side, this will curtail the practice of cross-subsidizing the loans to favored clients by charging higher rates on the smaller firms and on consumer, student and home loans.

Update 1 (8/7/2010)
Businessline reports that following the base rate coming into effect, companies have stepped up enquiries with entities such as banks and mutual funds about investing in their commercial paper issues to keep funding costs down.