SBI cuts base & benchmark prime lending rates; what should you do?

State Bank of India, the country’s largest bank, had two announcements last week. One, it cut base rate by 25 basis points to 9.75 percent; second, it cut benchmark prime lending rate by 25 basis points to 14.50 percent. Confused why the bank is cutting its rates twice and what are your options? Read on to know more.

BPLR and base rate: Prior to 1 July 2010 all loans were pegged to BPLR. Though this was supposed to be a benchmark rate, banks tweaked it to their advantage. How so? When overall interest rates rose, banks quickly increased the BPLR for all customers, existing and new.

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But when the rates fell, they offered lower rates to new borrowers and kept the rate for the existing borrowers high. So the existing customers were held captive at rates that were 2-5 percentage points higher than new customers.

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This nullified the benefit of a floating rate loan. Also, banks had different BPLRs for different categories of loans. Moreover, the system was opaque as banks never revealed how they arrived at a BPLR.

In order to bring about transparency, the Reserve Bank of India (RBI) introduced the base rate, a rate below which banks are not allowed to lend.

The central bank said this is more transparent than the BPLR ( Benchmark Prime Lending Rate) system as it is arrived at using a formula. Unlike BPLRs, banks had just one base rate. The rate has to be reviewed once a quarter.

For example, suppose you are on a home loan at 12 percent interest rate. Your rate is made of two parts banks’ base rate (say 10 percent) and 2 percent (spread, which varies case to case). When your bank cuts base rate, from 10 percent to 9.5 percent, your new interest rate will be 9.50 percent + 2 percent= 11.50 percent. When a bank decreases its base rate, all customers, irrespective of whether new or old, should benefit from it. In other words, banks’ customer discrimination should end.

Has this been effective?

Unfortunately, no. That is what banks’ recent rate actions prove. Base rate has failed to lived up to expectations as existing borrowers are discriminated against still. For instance, SBI cut its rate on 2 August. The move was a throw back to the BPLR system, as the bank just tinkered with its rates without cutting its base rate. In other words, only new costumers benefited from the rate cut. The existing customers were left in the lurch.

According to the bank, the new rates were applicable only for new borrowers. Existing customers had pay a conversion fee of 1 percent to shift to new rates. Many banks followed and cut rates on various loans, but kept the base rate intact.

But SBI, after the RBI cut banks’ cash reserve ratio on 17 September by 25 basis points to 4.5 percent, reduced its base rate, thus benefiting both the new and old borrowers. CRR is the proportion of deposits banks need to park with the RBI.

The base rate was cut as the reduction in CRR resulted in an infusion of Rs 17,000 crore of funds into the banking system, thus resulting in a fall in cost of funds for banks. Cost of funds is a key factor in arriving at a bank’s base rate. With SBI cutting the base rate, more banks are expected to follow.

What should you do: Even though base rate has not lived up to expectations, it still makes sense to be on the base rate rather than BPLR. This is because base rate is still formula-driven and banks will have to reduce this as and when the cost of funds falls.

Also, it is always better to be on a new system. Banks will be more than happy if you are on the BPLR system since that is advantageous for them. To change to base rate system, you just need to give a written application. Bear in mind that banks cannot charge you for converting to the base rate system. When you shift to the base rate system your rate of interest will not change.

Though the key terms and conditions would remain the same even after the shift, there is scope for you to negotiate for better terms and even rate. If you have been regular in paying your instalments, your bank may give you a better deal.