Is Base rate equivalent to LIBOR or reflective of effective lending rate?
Unfortunately, it is neither! RBI see Base Rate as mirror reflection of LIBOR capturing monetary policy impact. Since, LIBOR is short term money market rate across 1 day to 1 year, it is fair on the part of RBI to expect 50 bps rate cut impact on Base Rate derived from equivalent impact on sovereign debt, in this case T-bill YTM curve. It is also fair for borrowers to get this beneficial impact having opted for floating rate of interest.
On the other side, Banks (and most borrowers) see Base Rate as close to effective lending rate with significant portion of loan book priced at (or marginally above) Base Rate in credit products across Term Loan or Cash Credit or Working Capital Demand Loan. Since Banks are prohibited from lending sub Base Rate, most companies borrow outside Banking system for cost advantage (or arbitrage) using CC limits for raising funds through CP issuance at 1-2% sub Base Rate. While Banks are made to provide capital on limit sanctioned (even if significant portion remain unutilised over time), inefficiency from lower deposit rate (below sovereign yield) or holding huge excess SLR go unnoticed. RBI needs to do lots to bring in level playing field across stakeholders, instead of forcing in cosmetic adjustment in Base Rate. The theme should be around building clarity and transparency in pricing of funds (source/deposit or use/credit) not providing advantage to some at the cost of many!
RBI is correct in saying that changes in marginal cost of funds should be reflected in the base rate, and RBI is not seen in interference on the effective lending rate to the borrowers. It is not fair when both parties have settled for floating rate and marginal benefit is retained by Banks and not passed on to the borrowers. It is also necessary to reduce financial intermediation by non-bank entities through back-door CP route against unutilised CC limit. Had Banks been allowed to lend sub Base Rate, it would have given them the opportunity to lend at premium to the sovereign yield, thus shifting the excess SLR investment book to loan book. The issues (and restrictions) around Base Rate and inefficiencies in realistic pricing of credit need to be resolved for effective policy transmission on the ground.
It is immediate need to allow Banks to lend sub Base Rate. As a floor, Banks may be allowed to set Prime rate reflecting the Bank risk over sovereign risk, given the differentiation in risk profile. A risk premium of 25-50 bps over sovereign yield is adequate for this purpose. It is also desirable to build Prime rate curve across tenors (short, medium and long term) similar to LIBID curve (but stretched beyond 12 months), which can be used for pricing term deposit (and Time liability) products. Any adjustments in Prime rate should have parallel shift in Base rate.
What about transparency in pricing lending rates? Banks need to take into account statutory cost, credit risk premium, tenor/liquidity premium and margin, adjusted for relationship discount (for multi-hook non-credit products/services which generates CASA and fee income) while setting the lending rate. The transparency and clarity for the borrowers is highly inadequate. The bottom-line impact for Banks for credit exposure on the borrowers is from the NIM (adjusted for FTP) and fee contributing to RoA, which needs to be captured in pricing policy to be transparent and above board.
Immediate steps ahead to build efficiency and to ensure alignment with monetary policy transmission
1. Banks should set Prime rate across tenors for Time liabilities pricing, capturing the tenor premium/discount. The premium over sovereign yield curve may be 25 bps for AAA rated banks, 50 bps for AA and 75 bps for others. This will give the depositors the benefit of risk differentiation between Banks.
2. Base rate should cover the statutory and operative cost over the Prime Rate, also ensuring to avoid cost subsidisation across products with different cost structure.
3. The effective lending rate (over Base rate) should cover credit risk premium, desired margin and relationship discount.
4. Banks should have the flexibility to lend between Prime rate and Base rate on marginal cost and yield basis. This will help to recover fixed costs from top line business build up.
All these will lead to capturing the monetary policy transmission impact on Sovereign yield curve, and to ensure parallel shift and alignment of the change in the Prime rate and the Base rate. There can be no issue on application of marginal cost on legacy credit portfolio, post contract for floating rate till maturity. Allowing banks to lend between Prime and Base rate will help to avoid slippage in credit portfolio (by cutting shift of CC limit to investment book of non-bank entities), and to provide level playing field for all stake holders across Banks, borrowers and non-bank fund managers.
Just thinking aloud as food for thought! The system should not need a stick for control and ensuring policy transmission; putting in place fool-proof frame work will help to build efficiency for better on-ground effectiveness!
Moses Harding
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