Kudos to Rajan: RBI move on base rate will make loan pricing more transparent

The Reserve Bank of India (RBI) is making last ditch effort to revive the lost element of transparency in the functioning of base rate mechanism and thus save the very idea of effective monetary transmission in the banking system. On Monday, the apex bank spoke of three major aspects with respect to base rate, or minimum lending rate of banks. One, banks should revise their base rates on a quarterly basis. Two, the methodology to calculate the base rate can be reviewed every three years instead of five years earlier. Three, banks should stick to a board approved policy when it comes to pricing of loans for different category borrowers, existing or new. The quarterly revision of base rates is nothing new. That was already the case ever since base rate system was introduced in the July 2010. By emphasizing this part, the RBI is reminding banks to be sensitive to the rate signals from the central bank and the liquidity, demand conditions in the financial system. If banks indeed heed this call, it should be beneficial for the borrower, especially in a falling interest rate scenario. [caption id=“attachment_2055139” align=“alignleft” width=“380”]  AFP image[/caption] Similarly, the flexibility to decide the methodology to calculate the base rate more frequently will enable banks to align their benchmark lending rate in line with the character of their overall borrowing costs. Calculation of the base rate comprises of multiple factors besides the deposit rates. At present, some banks use the average cost of deposits to calculate the base rate, while some use the marginal cost of funds. The RBI doesn’t have any issue with banks choosing any methodology, provided they stick to the method in a transparent manner. While the above two are more or less enablers to make the functioning of base rate system more smooth, the critical part to be noted here is the RBI’s emphasis on the spread. The central bank has specifically said that the price differentiation should be in line with a board-approved policy and though banks can decide the loan pricing for a particular category of borrower, it should spell out the rationale for deciding the rate. This will remove the existing opacity in loan pricing. At present, despite the base rate mechanism in place, banks have hardly followed the RBI signals to change their base rate. When the RBI has been hiking rates successively in the last two years, not many banks have taken the cue, same is the case when the RBI has begun cutting rates. Even when banks change their base rates, they still managed to control the ultimate rate charged to a particular borrower by playing with the premium charged above the base rate, regardless of the base rate movement. If base rate is 10 percent, the bank can charge base rate plus 200 basis points (bps) for an existing company and base rate plus 300 bps for a new loan in the same category. One bps is one hundredth of a percentage point. This generated the concern that the RBI rate signals often fail to have an impact in the banking system. Thus, base rate became somewhat irrelevant. To be sure, even now, banks can decide the final pricing of the loan but they need to have a board approved policy to effect this rate. Such a condition will minimise the imbalances and opacity in the base rate system and would make the pricing more transparent. In the revised guidelines, the RBI has said that the spread charged to an existing borrower should not be increased except on account of deterioration in the credit risk profile of the customer or change in the tenor premium. The change in tenor premium should not be borrower-specific or loan-class-specific. It should be uniform for all types of loans for a given residual tenor. Some bankers feel that this will result in mild increases in the rate of interest for certain category of loans such as home loans of the same tenure premium is applied for all type of loans. But one should wait and watch how it evolves ultimately. Under Raghuram Rajan, the RBI has made meaningful efforts to make monetary policy more effective both in the macro economy. The central bank is now moving towards reviving the lost impact of the RBI’s monetary transmission in the banking system. The changes suggested will make banks more responsive to the rate signals from the Mint Street and put in place some fair rules when it comes to pricing of credit.