Base rate in the Indian context: A reality check

Abstract

RBI had mandated the use of Base rate which now has been adopted by all banks in India. Under the Base Rate Guidelines announced on April 9, 2010, banks were expected to stabilize the system of Base Rate calculation – the benchmark and the methodology by December 31, 2010. All the new loans would be priced with reference to the Base Rate. The earlier PLR/sub PLR (prime lending rate) regime had some regulatory leverage for banks to lend to customers on differential basis. With base rate coming in, lending to customers will be above a threshold rate. Banks are competing amongst themselves on who can provide the lowest rate and at the same time ensuring that they do not fall too low. This will change the way core banking will work. The looming question is what the real implications will be in short term as well as long term. The primary objective of this paper is to determine the key implications of Base rate on the Banking industry? Will it impact short term Corporate Lending in a big way? Will there be a differential impact on large and small banks and their competitiveness? How effective will the Base rate regime be in increasing transparency in credit pricing and addressing the shortcomings of the BPLR system? Will it be able to respond to changes in monetary policy? We have analyzed the differences in the lending scenario in India under BPLR and Base Rate systems. We have looked into the determinants of spread in lending rates and implications on bank profitability. We have probed into judging how successful the Base Rate has been in bringing about the intended effects in the Indian Financial Sector, including its impact on Banking, Corporate and Retail segments. We have then analyzed the reasons which, perhaps, might have led to the deviations from intended effects. Then, we have looked into an international study on lending scenario in various countries and tried to derive some learnings from their experiences of successfully implementing base rates. We have found out that the degree of correlation between RBI’s benchmark Reverse Repurchase or Reverse Repo Rate and the base Rate of banks is significantly higher than that between Reverse Repo and Prime Lending Rate. As a result of introduction of Base Rate, banks are losing some of their former attractiveness to large corporate borrowers and as such the data available supports our initial hypothesis that Base Rate introduction will increase transaction volume of Commercial Paper in India. We also see that in general the private and smaller banks were more promiscuously evading from transmission of monetary policies in the economy compared to state owned banks - may be due to increased pressure on profitability and financial constraints. We have also observed that the degree of correlation between bank lending rate and monetary control rates in developed and mature markets have correlation very near to perfect value of 1. We may state that the situation in India is advancing to the desired high level of correlation or effective transmission of monetary policies. With the passage of time as the old outstanding loans under PLR regime mature, we may hope to see the prominence and effectiveness of introduction of Base Rate more clearly in terms of higher level of monetary policy transmission into the nation’s financial system.