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In this article,
we would discuss the RBI’s new base rate guidelines.

On September 1, the Reserve Bank of India (RBI) released the draft
guidelines on computation of base rate (minimum rate below which banks are not
supposed to lend to its customers) based on marginal cost of funds. While the
central bank asserts that this would enable monetary policy transmission,
financial experts and rating agencies feel that this overhaul would lower
banks’ profitability.

What prompted the
action?

The RBI decreased repo rate (rate at which the central bank
lends to commercial banks) by 0.25 percentage points each in January and February.
However, banks delayed implementation of the rate cuts citing reasons like
rising cost of funds, mounting NPAs, etc, thereby disappointing scores of
customers awaiting a drop in their EMIs on loans.

Minister of State for Finance Jayant Sinha stated that 70
banks, including 23 PSBs, failed to pass on the benefit of lower rates to
customers. It was only when the central bank came down heavily on them did they
finally cut rates in April, nearly three months after the first repo rate cut.

Marginal-cost-of-funds
approach

RBI declared in July 2010 that the base rate would be the
benchmark for banks’ lending rates. It is calculated using different methods-the marginal
cost of funds, average cost of funds and the blended cost of funds
(liabilities) method.

The RBI has proposed the calculation of base rate based on
the marginal cost of funds i.e. the cost of funding one additional loan,
assuming that the bank’s cost of funds remains the same.

Calculation of marginal cost should consider all sources of
funds other than equity. Cost of
deposits should be calculated using the latest interest rate/card rate
payable on current and savings deposits and the term/fixed deposits of various
maturities. Cost of borrowings should be arrived at using the average rates at which funds were raised in the
last one month preceding the date of review.

In this approach, while income from loans falls immediately,
cost of funds do not fall correspondingly. This is because funds in the form of
deposits are locked in at fixed rates, which do not get revised.

The RBI has given banks time till April 1, 2016 to adopt and
implement the guidelines.

Why the new guidelines
for calculating base rate?

One of the main reasons the RBI has recommended this approach
is to ensure monetary policy transmission
(occurs when the RBI’s monetary policy decisions result in changes in the
economy, especially price levels). In other words, the policy rate cuts
effected by the RBI result in changes in the money supply, asset prices, credit
availability, exchange rates, and affect market expectations, among other
things.

This is possible only if there is some uniformity in methodologies banks use to calculate base rate.

The RBI also reasoned that lending rates need to be sensitive to policy rates so that customers
benefit from rate changes quicker than before.

Impact on borrowers
and banks

–
One major advantage for borrowers is that they would
not have to endure inordinate delays in reduction of interest rates by banks after
the RBI’s policy rate cuts.

–
This method of computing base rate would
increase volatility of interest rates.  While
a decrease would be favourable for retail loan customers, during a policy rate
hike, the loan rates would also increase faster.

–
However, rating agencies state that this
methodology can lessen banks’ profitability. As per Crisil’s estimates, base
rates would decrease by approximately 50 basis points (or 0.50% as one bps = 0.01%).
Hence, in FY17, the one-time loss would amount to Rs20, 000 crore or 15% of the
banking industry’s total estimated profit for that year.

–
Losses would be pronounced in case of banks that
have floating interest rates and those with more term deposits and less of CASA
(current account and savings account).

–
The only potential gain for banks from a drop in
base rates would be an increase in pace of credit growth. Also, it could improve
their competitive positioning, as presently banks are losing credit-worthy corporates
to capital market sources (bonds and commercial paper).

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