Study of base rate implementation and its implication on financial markets and banking system in India

Abstract

The Benchmark Prime Lending Rate (BPLR) system was introduced in 2004 by the Reserve Bank of India to eliminate drawbacks associated with Prime Lending Rate (PLR) system. But over time it was noticed that BPLR was not serving the purpose it was expected to and to study the same RBI constituted a working group committee under the Chairmanship of Shri Deepak Mohanty in October 2009. The committee in its report came up with various loopholes in the BPLR system and suggested its replacement with Base Rate system to match with the current financial market and economic scenario. Consequently Reverse Bank of India in March 2010 declared the implementation of Base Rate and it was introduced with effect from 1st July 2010. The project aims at studying the various drawbacks associated with previous benchmark prime lending rate and analyze the changes base rate system is going to bring in India’s financial and banking sector. The objectives of the study are given below: 1. Study of previous benchmark lending rate regimes 2. Analysing the implications of Base rate regime on Banking system 3. Study the mechanisms by which Base rate will affect financial markets 4. Understand how the new framework may influence economic growth of India, both directly and through its effect on financial markets Even though BPLR was introduced with an intention to bring about transparency into the banking system, but it failed to realize the same. The various drawbacks associated with benchmark prime lending are: * Poor monetary transmission of policy rates set by RBI: It was found that the responsiveness of the bank’s lending rate is very poor to that of the policy rates such as repo and reverse repo rates and hence RBI was not able achieve the desired macroeconomic goals. * Lack of transparency: The BPLR system allowed the banks to get involved in the process of lending below the BPLR rate and such practices led the banks to hide their additional costs created opaqueness in the system * Sub-BPLR lending: Due to competitiveness in the banking sector, the banks were involved in the process of sub-BPLR lending to various large corporates. The extent of sub-BPLR lending was as high as 66.9% in 2009 and this figure excludes the lending to priority sector and exports. * Cross subsidy: Since the banks were involved in sub-BPLR lending, so in order to take care of the foregoing profitability, the charge higher rates to individual and small borrowers. To eliminate the above drawbacks, Base Rate system was introduced from July 1, 2010. Base Rate is the rate at which the bank can lend money to its most credit worthy customer. The report mentions about the methodology used for computation of Base Rate by a bank. The study found out that this new system can have various impacts on Indian financial and banking system and those are: * Better monetary transmission mechanism: The opaqueness in the system is expected to get eliminated and this in turn would help in better monetary transmission of RBI’s policy rates. The responsiveness of US prime rate to fed fund rate was studied to find out the same. * Issuance of more commercial paper by corporates and development of Corporate bond market: Since raising funds will be costlier for larger corporates, they would prefer to take the route of commercial paper and corporate bonds. Data regarding outstanding amount in commercial paper from 2008 to 2010 shows an increase post Base Rate introduction. * Greater investment by banks in commercial paper and corporate bonds: The restriction for banks to lend below base rate would make them to invest in commercial paper and corporate bonds. The report gives an analysis of relevant data. * Benefit to smaller customers: The practice of cross subsidizing will be eliminated with the new system in place and smaller customers would be able to get the benefit of any changes in policy rates. Hence the study reveals that the system of Base Rate is going to bring about positive changes in Indian financial and banking market and would be a step forward in improving efficiency of the same.