Sumedha Fiscal BDO India

Contents
Sl. No. Particulars Pg No.
1. Introduction 3
2. History of RBI Intervention 4
3. Reviewing Methodology: Formation 5
of Working Group

Introduction
4. Findings of the Group 6
5. RBI Notification 6
6. Introduction of Base Rate 10
7. Base Rates for most of our Banks 11
8. BPLR Vs Base Rate 13
With world’s changing The New Regime-Base Rate as
against its predecessor BPLR, will
This new regime aims at
improvising the banking system in
9. Downward Stickiness 15 outlook towards India, it henceforth, act as a minimum India to great leaps forward; greater
10. Teaser Rate 17 is impossible for us to lending rate below which lending is
prohibited barring some exceptional
transparency along with greater
effectiveness of government policies
11. Transparency 18 stay the same forever. cases (viz. Export credit, loans to mark the most important aspects of
12. Effect on NIM 19 Indian banking has bank employees, loans against fixed
deposits, DRI scheme outside
this change. India desperately

entered a new era on 1st

13. Effect on Short Term Loans 20 needed re-evaluation of the existing
ambit). Responsibility of calculation system which looked so lethargic
July, 2010 when an
14. Cross-Subsidization of Loans 21 lies with the respective Banks who under times of extreme stress. New
15. Effect on Long Term Loans 22 by using a stringent methodology
16. Effect on Home Loans 22 improved method of loan set by RBI have to publish their
era is expected to make the system
more flexible as well as more
17. Effect on Corporate Loans 23 pricing is finally respective Base Rates every quarter
of a year, and will henceforth be
dynamic. But, this move should
18. Effect on parallel Market; such as CPs etc. 23 activated. The move to a scrutinized by the RBI. The RBI
only be as a start to a more vibrant
Indian economy; the destination of
19. Importance of CASA 25 more transparent regime, describes Base Rate as the minimum
possible lending rate achievable by
which still lies a long way ahead
20. Effect on Deposit Rates 25
Base Rate, compared to respective Banks keeping in view its
although the move looks like one in
the desired direction, at least in its
its predecessor BPLR,
21. Sunset Clause 25 Cost of Deposits, CRR and SLR set
induction phase.
22. Drawbacks 26 by RBI, Unallocatable Overhead
23. Conclusion 28 that will act as a Cost & Average Return on Net Although, RBI has given complete

24. Annexure 29 benchmark for the pricing Worth of the Bank. The proposed
Base Rate will be applicable to all
freedom to every bank, so that they
can come up with their own cost on
25. References 29 of all loans dished out new loans as well as existing loans deposits and hence, their Base Rate,
26. Abbreviations 30 by banks is welcomed by which come up for renewal.
Existing borrowers are free to switch
RBI can ask for any justification of
details provided, ensuring an
majority of borrowers. to new system. extensive monitoring of Base Rate.

2 3
 Sumedha Fiscal
As per the actual lending rates for
borrowers, it would be the Base Rate
plus the borrower-specific charges like
premium related to maturity of loans.
Hence, it can be said that Base Rate
is the approximate lending rate at
which it will disburse loans to its most
favored customers, the ones with
AAA Grade Credit Rating as they
hardly qualify for any borrower-
specific premium.
But please do note that these new
guidelines are impacting only banks.
Other NBFC lending institutions do
not come under the purview of the
Base Rate and can still lend on the
basis of the erstwhile BPLR system.
Also, since the Base Rate will be the
minimum rate for all commercial
loans, banks are not permitted to
resort to any lending below the Base
Rate, the current requirement that
BPLR will be the ceiling rate for loans
up to 2 Lacs will stand withdrawn,
the central bank stated in its draft
guidelines.
4 5
History of RBI Intervention in
Lending Rates
= The ultimate objective of Bank
lending is to promote economic
growth by channeling resources
to the most productive uses at
reasonable rates. Therefore, the
level and structure of interest
rates are critical determinants of
the economic efficiency with
which resources are allocated in
an economy. Interest rate
distortions in any form may lead
to a misallocation of resources.
Accordingly, lending rates of
banks need to be appropriate and
reasonable from the point of
view of both lending institutions
and borrowers.
= Lending rates which are either
too high or low and out of sync
with the realistic pricing of credit
could have implications for
credit quality and cause concerns
about financial stability. Lending
interest rates should also be
responsive to the monetary
policy actions, if they are to
achieve the desired objective.
= Till the late 1980s the interest
rate structure in India was largely
administered in nature and was
characterized by numerous rate
prescriptions for different
activities, and borrowers were
charged vastly different rates for
the same loan amount thereby
distorting the structure of
lending rates. On account of the
complexities of the interest rate
structure under the administered
rate structure, efforts since 1990
has been of rationalization of the
interest rate structure so as to
ensure price discovery and
transparency in loan pricing
system.
= In Sept 1990, Rates rationalized
into six slabs. Banks free to set
rates of over 2 Lacs, with the
RBI prescribing minimum rates,
then in 1993 six slabs for lending
rates compressed to three. The
process of rationalization
culminated in almost complete
deregulation of lending rates in
October 1994. The freeing up of
lending rates of scheduled
commercial banks for credit
limits of over 2 Lacs along with
the introduction of PLR system
in 1994 was a major step in this
direction aimed at ensuring
competitive loan pricing.
= In 1997, Banks were allowed to
prescribe separate PLRs, both for
loans as well as cash credit
components, then subsequently
in Oct, it was asked to announce
a separate prime term lending
rate. In 1999, tenor linked prime
lending rates were introduced.
Later in 2000, Banks were
allowed to charge fixed/floating
BDO India
rates on their lending for credit
limit of over 2 Lacs. Then, PLR
ceased to be the floor rate for
=
the BPLR as a reference rate.
There was also widespread public
perception that the BPLR system
the BPLR system raised by the
public and those recognized by
the Reserve Bank, the Annual
loans more than 2 Lacs in Apr,
2001.
has led to cross-subsidization in
terms of under pricing of credit
Policy Statement of 2009-10
announced the constitution of
= Then finally, System of for corporate and overpricing of Working Group on BPLR to
Benchmark Prime Lending Rate loans to agriculture and small and review the BPLR system and
(BPLR) introduced in 2003 was medium enterprises. The Annual suggest changes to make credit
expected to serve as a benchmark Policy Statement 2009-10 noted pricing more transparent.
rate for banks’ pricing of their that since the bulk of bank loans Source: RBI
loan products so as to ensure that were lent at sub- BPLR rates, the
it truly reflected the actual cost. system of BPLR evolved in such
= However, the BPLR system has a manner that it had lost its
fallen short of its Original relevance as a meaningful
objective of bringing reference rate.
transparency to lending rates. = The lack of transparency in the
Competition has forced the BPLR system also caused
pricing of a significant proportion impediment to the effective
of loans far out of alignment with transmission of monetary policy
BPLRs and in a non-transparent signals. In view of the concerns
manner, undermining the role of pertaining to the shortcomings in
Reviewing Methodology: Formation of a
Working Group
i) To review the concept of BPLR and the manner of
its computation;
ii) To examine the extent of sub-BPLR lending and the
reasons thereof;
iii) To examine the wide divergence in BPLRs of major
banks;
iv) To suggest an appropriate loan pricing system for
banks based on international best practices;
The Reserve Bank announced the constitution of the
Working Group on Benchmark Prime Lending Rate v) To review the administered lending rates for small
(BPLR) in the Annual Policy Statement of 2009-10 loans up to 2 Lacs and for exporters;
(Chairman: Shri Deepak Mohanty) to review the BPLR vi) To suggest suitable benchmarks for floating rate
system and suggest changes to make credit pricing more loans in the retail segment; and
transparent. The Working Group was assigned the vii) Consider any other issue relating to lending rates of
following terms of reference banks.
 Sumedha Fiscal BDO India

Findings of Working Group In the light of the comments/

suggestions received, it has been
decided that banks switch over to the
The BPLR seems to have been tended out of sync with system of Base Rate. The BPLR
market conditions and does not adequately respond to system, introduced in 2003, fell
changes in monetary policy. In addition, the tendency short of its original objective of
of banks to lend at sub-BPLR rates on a large scale bringing transparency to lending
raises concerns of transparency. The Working Group rates. This was mainly because under
also noted that on account of competitive pressures, the BPLR system, banks could lend
banks were lending at rates which did not make much below BPLR. For the same reason, it
commercial sense. was also difficult to assess the
transmission of policy rates of the
After carefully examining the various possible options, Reserve Bank to lending rates of
views of various stakeholders from industry associations banks. The Base Rate system is
and those received from the public, and international aimed at enhancing transparency in
best practices, the Group is of the view that there is lending rates of banks and enabling
merit in introducing a system of Base Rate to replace better assessment of transmission of
the existing BPLR system. monetary policy. Accordingly, the
following guidelines are issued for
implementation by banks.
Base Rate and by including such
other customer specific charges as
considered appropriate.
iii. In order to give banks some
time to stabilize the system of
Base Rate calculation, banks are
permitted to change the
benchmark and methodology
any time during the initial six
month period i.e. end-December
2010.
iv. The actual lending rates charged
may be transparent and
consistent and be made available
for supervisory review/scrutiny,
as and when required.
APPLICABILITY OF
BASE RATE
v. All categories of loans should
Rate, in a transparent and non-
discriminatory manner.
viii. Since the Base Rate will be
the minimum rate for all
loans, banks are not permitted
to resort to any lending below
the Base Rate. Accordingly, the
current stipulation of BPLR as
the ceiling rate for loans up
to 2 lacs stands withdrawn. It
is expected that the above
deregulation of lending rate
will increase the credit flow to
small borrowers at reasonable
rate and direct bank finance will
provide effective competition to
other forms of high cost credit.
ix. Reserve Bank of India will
separately announce the
stipulation for export credit.

RBI Notification BASE RATE

i. The Base Rate system will replace
henceforth be priced only with
reference to the Base Rate.

Guidelines on the Base Rate

the BPLR system with effect
from July 1, 2010. Base Rate
shall include all those elements of
To the lending rates that are
All Scheduled Commercial Banks (excluding RRBs) Dated: 1st April 2010
common across all categories of
borrowers. Banks may choose
Guidelines on the Base Rate any benchmark to arrive at the
Base Rate for a specific tenor
Following the announcement in the Annual Policy Statement for the year that may be disclosed
2009-10, Reserve Bank of India constituted a Working Group on transparently. An illustration for
Benchmark Prime Lending Rate (Chairman: Shri Deepak Mohanty) to review computing the Base Rate is set
out in the Annex. Banks are free
the present benchmark prime lending rate (BPLR) system and suggest to use any other methodology, as
changes to make credit pricing more transparent. The Working Group considered appropriate, provided
submitted its report in October 2009 and the same was placed on the
it is consistent and are made
available for supervisory
Reserve Bank’s website for public comments. Based on the recommendations review/scrutiny, as and when
of the Group and the suggestions from various stakeholders, the draft required.
guidelines on Base Rate were placed on the Reserve Bank’s website ii. Banks may determine their actual
lending rates on loans and
in February 2010. advances with reference to the
However, the following
categories of loans could be
priced without reference to the
Base Rate: (a) DRI advances
(b) loans to banks’ own
employees (c) loans to banks’
depositors against their own
deposits.
vi. The Base Rate could also serve as
the reference benchmark rate for
floating rate loan products, apart
from external market benchmark
rates. The floating interest rate
based on external benchmarks
should, however, be equal to or
above the Base Rate at the time of REVIEW OF BASE RATE
sanction or renewal. x. Banks are required to review the
Base Rate at least once in a
vii. Changes in the Base Rate shall
be applicable in respect of all quarter with the approval of the
existing loans linked to the Base Board or the Asset Liability

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 Sumedha Fiscal
Management Committees (ALCOs) as
per the bank’s practice. Since
transparency in the pricing of lending
products has been a key objective, banks
are required to exhibit the information
on their Base Rate at all branches and
also on their websites. Changes in the
Base Rate should also be conveyed to
the general public from time to time
through appropriate channels. Banks are
required to provide information on the
actual minimum and maximum lending
rates to the Reserve Bank on a quarterly
basis, as hitherto.
TRANSITIONAL ISSUES
xi. The Base Rate system would be
applicable for all new loans and for
those old loans that come up for
renewal. Existing loans based on the
BPLR system may run till their
maturity. In case existing borrowers
want to switch to the new system,
before expiry of the existing contracts,
an option may be given to them, on
mutually agreed terms. Banks, however,
should not charge any fee for such
switch-over.
xii. In line with the above Guidelines,
banks may announce their Base Rates
after seeking approval from their
respective ALCOs/ Boards.
EFFECTIVE DATE
xiii. The above guidelines on the Base Rate
system will become effective on July1,
2010.
8 9
BDO India
Negative Carry on CRR and SLR
Annex 1: Illustrative {Dcost – ( SLR *Tr)}
[ ]
Methodology for the b - Negative Carry on CRR and SLR = [
{ 1− (CRR+SLR)}
]*100 - Dcost
Negative carry on CRR and SLR balances arises because the return on CRR balances is nil, while the return on SLR
Computation of the balances (proxied using the 364-day Treasury bill rate) is lower than the cost of deposits. Negative carry on CRR
and SLR is arrived at in three steps. In the first step, return on SLR investment was calculated using 364-day Treasury
Bills. In the second step, effective cost was calculated by taking the ratio (expressed as a percentage) of cost of deposits
Base Rate (adjusted for return on SLR investment) and deployable deposits (total deposits less the deposits locked as CRR and
SLR balances). In the third step, negative carry cost on SLR and CRR was arrived at by taking the difference between
the effective cost and the cost of deposits.
Base Rate =a + b + c + d
Unallocatable Overhead Cost
a - Cost of Deposits= Dcost
Unallocatable Overhead Cost = [Uc/Dply] * 100
(benchmark)
Unallocatable Overhead Cost is calculated by taking the ratio (expressed as a percentage) of
b - Negative Carry on CRR and SLR = Unallocated overhead cost and deployable deposit.
{Dcost – ( 𝑆𝐿𝑅∗𝑇𝑟)}
[[ ]*100] - Dcost Average Return on Net Worth
{ 1− (𝐶𝑅𝑅+𝑆𝐿𝑅)}
Average Return on Net Worth = [(NP/NW)*(NW/ Dply)]*100
c - Unallocatable Overhead Cost = [Uc/ Dply] * 100
Average Return on Net Worth is computed as the product of net profit to net worth ratio and net worth to deployable
d - Average Return on Net Worth = [(NP/NW)* deposits ratio expressed as a percentage.
(NW/TL)]*100
Where:
Dcost ∶ Cost of Deposits/funds
D ∶ Total Deposits = Time Deposits + Current Deposits
+ Saving Deposits
Dply ∶ Deployable Deposits = Total deposits less share of
deposits locked as CRR & SLR balances = 𝐷∗ [1−
(𝐶𝑅𝑅+𝑆𝐿𝑅)]
CRR : Cash Reserve Ratio
SLR : Statutory Liquidity Ratio
𝑇𝑟 ∶ 364 T-Bill Rate
Uc ∶ Unallocatable Overhead Cost
NP : Net Profit
NW : Net Worth = Capital + Free Reserves
 Sumedha Fiscal BDO India

Introduction Of Base Rate… A Glance at the Base Rate of some of our major Banks
Welcomed by many Sl. No.
NATIONALISED BANK
Bank Name Base Rate* Sl. No.
PRIVATE BANKS
Bank Name Base Rate*
Oct 20, 2009: Working group's report Says Base Rate 1. State Bank of India 7.50 1. Yes Bank 7.00
will include:
2. State Bank of Mysore 7.75 2. Dhanlaxmi Bank Ltd. 7.00
i) The card interest rate on retail deposits with one-year maturity
3. Punjab National Bank 8.00 3. IndusInd Bank Ltd. 7.00
ii) Adjustment for the negative carry for CRR, SLR
4. Bank of Baroda 8.00 4. ING Vysya Bank 7.25
iii) Unallocatable overhead costs
iv) Average return on net worth 5. Allahabad Bank 8.00 5. Kotak Mahindra Bank 7.25
* Suggests ban on lending below Base Rate. Sub-Base Rate lending 6. Canara Bank 8.00 6. HDFC Bank 7.25
to priority and non-priority sectors to be capped at 15% of 7. United Bank of India 8.00 7. Axis Bank 7.50
incremental lending.
8. UCO Bank 8.00 8. ICICI Bank 7.50
* Actual lending rates to factor in product-specific operating costs,
credit risk premium and tenor premium. 9. Oriental Bank of Commerce 8.00 9. Corporation Bank 7.75
10. Bank of India 8.00 10. The Ratnakar Bank Ltd. 8.00
Feb 10, 2010: RBI issues draft circular Criteria 11. Central Bank 8.00 11. Catholic Syrian Bank Ltd. 8.00
for Base Rate determination to be based on:
i) Cost of deposits 12. Indian Bank 8.00 12. Jammu & Kashmir Bank Ltd. 8.25
ii) Adjustment for the negative carry for CRR, SLR 13. IDBI 8.00 13. Karur Vysya Bank Ltd. 8.50
iii) Unallocatable overhead costs 14. Dena Bank 8.25 14. Nainital Bank Ltd. 8.50
iv) Profit margin 15. Dena Bank 8.25 15. Tamilnad Mercantile Bank Ltd. 8.50
* Will include product-specific operating costs, credit risk premium 16. Indian Overseas Bank 8.25 16. City Union Bank Ltd. 8.50
and tenor premium
17. Syndicate Bank 8.25 17. Lakshmi Vilas Bank Ltd. 8.75
* No lending below Base Rate. Export credit, small-ticket
18. Vijaya Bank 8.25 18. Karnataka Bank Ltd. 8.75
differential rate of interest (DRI) scheme loans to be kept out
* Base Rate to replace BPLR from April 1
FOREIGN BANKS
April 9, 2010: Final guidelines issued
Sl. No. Bank Name Base Rate* Sl. No. Bank Name Base Rate*
* Banks free to choose benchmark
* Given freedom to decide methodology 1. RBS N.V India 6.50 5. CITI BANK 7.25
* All loans to be benchmarked to the Base Rate. Export credit, 2. Deutsche Bank 6.75 6. Standard Chartered Bank 7.25
loans to bank employees, loans against fixed deposits, DRI 3. HSBC 7.00 7. DCB 7.75
scheme outside ambit
4. DBS India 7.00 8. Federal Bank 7.75
* System to kick in from July but banks free to alter methodology
till December 2010 Source: Bank Websites *As per published for the 1st quarter, FY 11

10 11
 Sumedha Fiscal
9.00
8.75
8.50
8.25
8.00
7.75
7.50
7.25
7.00
6.75
6.50
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19
DILEMMA ON COST OF DEPOSITS
The difference in Base Rates between Foreign & Indian
Banks is very much evident from the above graph. One
probable reason could be that the base rate does not
matter much for foreign banks, which are mostly not
into long-term lending and retail lending. They basically
lend to big corporates on short term basis only to fund
trade financing. Hence, the base rates from foreign banks
are relatively lower.
Due to the unavailability of guidelines for the Cost of
Deposit, there is still some confusion prevailing in the
market. For instance, SBI has taken the six-month
deposit rate as its main input to calculate its Base Rate.
The lender said its growing share of low cost deposits
had helped it reduce its cost. Mr. Bhatt said by taking
the six-month average cost of deposit, the transmission
of monetary policy signals will be much more effective.
“If we had taken one-year cost, it might not have
reflected the current cost, while a three-month cost
would not have reflected the historic cost. So, we
thought a six-month cost will be the most appropriate”.
Bank of Baroda, in contrast, has taken the average cost
12
Nationalised Banks
Private Banks
Foreign Banks
of deposits in the last quarter to arrive at its Base Rate.
While Punjab National Bank (PNB), Chairman and
Managing Director Mr. K R Kamath, told that the bank
had fixed the Base Rate on the basis of cost of deposits
at the end of the March quarter, which was 4.88 per
cent. The low-cost deposit share was a deciding factor
for banks to fix their Base Rate.
BPLR Vs Base Rate
BASICS This is unlike the BPLR regime
where the BPLR was supposed to
take into account the same set of
Whilst each bank can parameters but no documentation
choose its own was required and it was not open to
RBI scrutiny. This is a significant
benchmark for the cost difference between the two regimes
of funds they will have since this forces the banks to follow
a consistent methodology for the
to document the
calculation of the Base Rate unlike
detailed formula for the the BPLR.
calculation of the Base The BPLR system has been drawing
flak from various quarters since the
Rate, the methodology Banks have been lending to their
undertaken and follow high-rated corporate borrowers
much below their benchmark rate,
it consistently (except while a substantial premium was
during a brief six month charged from other borrowers
consequently, the system became
transition period). partial and unjust; moreover, it
Moreover, This formula consistently seeded a strong
sentiment of distrust among
will need to be borrowers. This practice of sub-
disclosed to RBI for BPLR lending in turn culminated
in the increase of spread of lending
further scrutiny rates. Bankers say that the Base Rate
BDO India
system will be helpful in cutting the
arbitrage advantage which some top
corporate borrowers enjoy. They
also added that the loans extended
to larger companies lately have been
under-priced and the volumes lent
too have been very large.
Henceforth, Banking Sector will be
more competitive than ever before
because of greater transparency. Now
the banks can no more rely only on
teaser rates to woo customers. They
will be more literate than ever before
and will now have a common
platform, a common benchmark to
compare. With greater
understanding of their own risk
premium now the banks will have to
actually woo customers by their
service and ease of access which will
be the key in the lending market
where the interest rates are almost
the same. Banks with better services
and huge chain of branches will be
much better posed compared to
its peers.
13
 Sumedha Fiscal BDO India

Now with reviewing of Base Rates every quarter and subsequent scrutiny thereafter will make it quite impossible for
VARIATION AMONG BANKS Banks to ignore policy changes for more than a quarter, as the key policy ratios have an inherent effect on the
calculation of the Base Rate.
22 Maximum and Minimum Lending Rates 32 Maximum and Minimum Lending Rates
20 30 of Private Sector Banks
of Public Sector Banks 28
18
16
14
26
24
22
ACTUAL RATE OF LENDING

Percent
Percent

20
12 18 According to draft guidelines, the RBI has proposed that the actual lending rate charged to borrowers would be the
10 16
14
8 12 Base Rate plus borrower-specific charges including product-specific operating cost, credit-risk premium and tenure
6 10
4 8
6 premium.
2 4
0 2
0
Mar-04

Mar-05

Mar-06

Mar-07

Mar-08

Mar-09
Sep-04
Dec-04

Sep-05
Dec-05

Sep-06
Dec-06

Sep-07
Dec-07

Sep-08
Dec-08
Jun-04

Jun-05

Jun-06

Jun-07

Jun-08

Jun-09

Mar-04

Mar-05

Mar-06

Mar-07

Mar-08

Mar-09
Sep-04
Dec-04

Sep-05
Dec-05

Sep-06
Dec-06

Sep-07
Dec-07

Sep-08
Dec-08
Jun-04

Jun-05

Jun-06

Jun-07

Jun-08

Jun-09
Maximum Interest Rate Modal BPLR Minimum Interest Rate
Maximum Interest Rate Modal BPLR Minimum Interest Rate

Source: RBI
BPLR, Base Rate & Actual lending rates vary from Bank to Bank. But the spread in case of BPLR was much wider
than the latter, sometimes stretching over 4 percent, ranging between 11 percent and 15.75 percent among banks
resulting in wide-spread disparity among banks. On the other hand, the Base Rate for majority of the Banks falls
Downward Stickiness
within the spread of 1.50 percent, hence bringing in more stability as well as simplicity in the market. As is evident more when interest rates go up. As taking a loan
from the graph shown above, there is almost no correlation between the maximum and minimum lending rates of (primarily home loan) becomes more prevalent as it
Public and Private Sector Banks. With the evolvement of Base Rate which varies in a relatively small interval, at least affects millions of middle class households and the furor
minimum lending rate would not vary much and consequently, such a wide variation in lending rates is expected to over this non- transparent method of fixing floating rate
be curtailed down. loan products has reached feverish pitch.
Dismal Failure of BPLR in forcing Banks to Respond to the Policy Changes The banks on their part give a curious argument to justify
Bank Group All Public Sector Banks All Private Sector Banks 5 Major Foreign Banks charging more to their existing home loan consumers
whilst doling out lower rates to attract new customers.
Increase in Repo Rate Lagged (one quarter) Contemporaneous and Contemporaneous They claim that as interest rates fall only for the new
Lagged (two quarters) incremental deposits since the existing consumers are
funded from existing deposits (which are at a higher
Decrease in Repo Rate Contemporaneous No significant impact No significant impact
rate), they cannot be given the benefit of the fall in rates
Increase in Reverse No significant impact No significant impact No significant impact A word widely used in banking sector expressing the immediately. The reason this argument does not appear
Repo Rate wide-spread practice of Indian Banks on manipulation reasoned is because by this token when interest rates rise,
of the benchmark rates in response to policy & market only the new customers should be paying the higher rate
Decrease in Reverse No significant impact No significant impact No significant impact changes for instance, BPLR refuses to go down (or goes (since only they are funded from the new high cost
Repo Rate down reluctantly and at a slower pace) when bank’s cost deposits) whilst the existing loan consumers should
of funds were at record low-levels on account of eased continue to pay less. Of course this never happens.
Increase in Weighted Contemporaneous Contemporaneous Contemporaneous
policy rates in time of slowdown(Dec ’08 to June ’09),
Average Call Money Rate In actuality the problem is how the cost on deposit is
though it was quick to go up when their cost of funds
calculated, as under BPLR it was more profitable for
Decrease in Weighted Lagged (two quarters) Contemporaneous and No significant impact were high for most of the preceding years.
banks to calculate marginal cost* of funds rather than
Average Call Money Rate Lagged (one quarter) In effect consumers continued to pay higher interest rates average cost* of funds which was not the actual cost. But
RBI Publication Reports even in a falling interest rate market but are forced to pay under new guidelines things stand to change. Firstly as

14 15
 Sumedha Fiscal
changes in the effective interest rate for the customer will
depend on the average cost of funds rather than the
marginal cost of funds hence, any increases in market
rates will take time before they are fully passed on to the
borrower. Whilst this is beneficial when interest rates
increase it is also not so bad when interest rates decrease
as, unlike the current situation, the consumer is likely to
get some decrease immediately compared to none or very
little in the current scenario.
*Difference between average and marginal cost of funds
Assume a bank currently has funds of 100 crore at an
average cost of 10% (total cost of funds is 10 crore or
2.50 crore per quarter).
Let us analyze BPLR with the help of a chart
Source: RBI
16
Now the cost of funds in the market goes up by 1% p.a.
On an arithmetic basis the banks cost of funds should
go up by 1 crore per annum or 25 lacs per quarter.
However since a lot of the bank’s funds are in time
deposits which are at a fixed cost - where the cost will
rise only when the deposit comes up for renewal -
immediately its cost may go up by only say 12.50 lacs
for this quarter or only 0.50% p.a. Of course over a
period of time as all the fixed deposits mature and are
renewed at new higher rates the cost of funds will go up
to 11 crore per annum or 2.75 crore per quarter.
Thus the average cost -10% in this example changing to
10.50% or a change of 0.50% only will always change
slower than the marginal cost - +1% in this example
CURIOUS CASE OF PRIVATE
BANKS:
There was always a consistent difference
between BPLR of Public and Private Sector
Banks of around 1% from 2004 to 2006.
Post-2006 was the time when liquidity
started picking up at a much rapid rate and
consequently, RBI brought in significant
changes in policy rates, such as CRR, Repo,
Reverse Repo etc. to suck in excess liquidity.
Post-2006, things looked nice and shiny till
the 2nd quarter of 2008, this was the time
when economy started showing signs of
distress i.e. the time when recession took off.
And hence, RBI started easing policy rates to
keep the economy afloat as a significant
dearth of foreign as well as domestic
investments in the market was expected due
to global slowdown. This is precisely the time
when BPLR became extremely incapacitated;
BPLR proved its mettle in squeezing the
excess liquidity of the market, but was highly
inefficient vice-versa. Private Banks were
never forced to induct the policy changes and
as the market was bleeding, it became even
tougher for any deserving borrower to get a
sanction and even for the ones who managed
to get a sanction, they seriously lacked the
negotiating power due to the dearth of
alternatives. Hence when liquidity was
tightened, they were the first to react while
when it was eased, the incentives were not
passed on to the customers.
Teaser Rate
Teaser Rate is a terminology used
to refer to an enticing initial
interest rate for a loan on floating
rate basis, where the actual lending
interest rate for major part of the
tenure is much higher. This rate
will be typically, well below the
ongoing market rates and is used as
a bait to woo new borrowers and
also to make the floating rate loans
a more attractive option.
For instance, the ‘teaser' home
loans have a fixed interest rate for
a buffer period of one to two years
after which the rates jump to a
higher level. If interest rates were
to rise sharply, there is a possibility
that borrowers' ability to repay will
get affected. Like all financial
products, there are some aspects of
these loans that are beneficial and
others that might catch you by
surprise, especially if you are not
familiar with how loans work.
The beneficial aspect of these loans
clearly is that during the early
tenure of the loan it makes loans
more affordable than what they
might have otherwise been, and
offers families the opportunity to
fulfill their dream of buying a
home. Clearly, this is a good thing.
The concern is that lenders are
tempting customers to get this loan
without adequately educating
them of what their EMI could be
when the rate shifts from the low
introductory rates to a higher
floating rate. And, indubitably we
do not want to see families
struggling to pay this higher EMI.
The point being made was that
when the “teaser rate” period is
over (2-3 years in most cases) and
BDO India
interest rates shifts to the normal
floating rates prevalent at that
time, the consumers may not be
able to cope up with the resultant
increases in EMIs (especially if, as
widely expected, interest rates go
up significantly in the meanwhile).
For Instance, in a very typical case,
An increase of 100 basis points in
interest rates (prime lending rates),
which translates into an average
increase of 1000-1200 bps in
monthly repayments, can be
absorbed. But if rates were to
increase by more than 100 bps,
borrowers could find it difficult to
pay; it might outstrip the growth
in income which revolves around
800-1200 bps.
It was expected that by now, RBI
would come up with some stern
regulations to curb teaser rates, but
till date, we have hardly seen any
concern by the RBI in this
direction. It is still a very common
practice among our major Banks.
For instance, considering a home
loan of 60 lacs from our largest
bank SBI, will attract 8% interest
rate for the 1st year, 9% for the
next two years, henceforth the rates
are Base Rate + 2.25%, which by
current standards is 9.75% and
moreover, if you opt for a fixed rate
of interest (available with reset
frequency of 5 years) it will attract
a hefty BR + 3.5%, which by
current standards is 11.00%.
17
 Sumedha Fiscal BDO India

Transparency Effect On Net Interest Margin (NIM)

consistently (except naturally expect to get better rates
during a brief, six- and unlike before they cannot do it Nationalised Banks
month transition without bringing down benchmark
Sl. No. Bank Name NIM* Base Rate
period). The rate, the banks will be forced to drop
underlying formula 1. Punjab National Bank 3.57 8.00
their Base Rate if they still want to
will have to be 2. Bank of Baroda 3.12 8.00
maintain their market share. This
disclosed to the 3. State Bank of Mysore 3.10 7.75
will exert downward pressure on the
RBI, which in turn banks’ Base Rates when market 4. Allahabad Bank 2.88 8.00
will ensure that it is 5. Canara Bank 2.80 8.00
interest rates fall which in turn
being followed 6. Indian Overseas Bank 2.74 8.25
would decrease all the existing loans Post-Base Rate, major changes in NIM are
consistently. This is 7. UBI 2.71 8.00
linked to the Base Rate. This clause neither expected nor aimed at by the RBI.
unlike the BPLR
tends to make the Base Rate self- Bankers say that even if lending rates are 8. SBI 2.66 7.50
regime, where
corrective in nature. hiked in some areas, they have to be kept 9. Oriental Bank of Commerce 2.56 8.00
BPLR was
low in other areas. Thus the overall yield 10. UCO Bank 2.38 8.00
supposed to take
The most sincere question at this RESPONSIVENESS TO would turn out to be more or less the same. 11. Syndicate Bank 2.35 8.25
into account the same set of
point of time would be that if the parameters but no documentation POLICY RATES According to Mr. S S Ranjan, Chief
Financial Officer, State Bank of India, there
methodology of calculating BPLR &
BR is similar, then how is the system
was required and it was not open to
RBI scrutiny. This is a significant
If the transparency is so built in, then
why the doubt on whether the system would not be any effect on the bank's NIM Private Banks
supposed to make any significant difference as it forces banks to follow will be effective? as the yield from lending would remain
Sl. No. Bank Name NIM* Base Rate
difference? a consistent method of calculating unchanged.
Because while the system is more 1. Kotak Mahindra Bank 6.30 7.25
If there is any answer to this the Base Rate. Also previously, banks transparent than BPLR, there is no However Mr. S Sridhar, CMD Central Bank
2. HDFC Bank 4.20 7.25
question, then it has to be the used to price the loans with reference requirement that the detailed of India, has a different view. He expects a
3. AXIS Bank 3.75 7.50
transparency. to a complicated system called formula of each bank’s Base Rate be rise in the bank's lending rate with the
implementation of Base Rate and feels this 4. Karur Vysya 3.23 8.50
CRISIL Research says, “We expect benchmark prime lending rate made public, moreover all these
(BPLR), whereby each bank had its changes depends solely on the extent would positively impact the banks' NIM. 5. ING Vysya Bank 3.21 7.25
the transition from the benchmark 6. Yes Bank 3.20 7.00
prime lending rate (BPLR) to the non-transparent BPLR methodology to which it is forced, according to As Private Banks have kept their Base Rates
which made it even more difficult regulations it will be only available at sufficiently lower levels than Public 7. Dhanlaxmi Bank 2.70 7.00
Base Rate system from July 1, 2010
for borrowers to compare rates across with the RBI for reviewing. Hence, Sector Banks, the question asked here 8. IDBI 1.23 8.00
to increase transparency in lending
banks. the effectiveness of the new system would be, will they be able to sustain. This Source: Bank Websites *For the Year, 2009-10
rates and help small borrowers
majorly depends on the extent of the Practice, if not discontinued soon may hit
negotiate better rates with banks". We all know that Priority Sectors Here we can see that majority of the Banks with NIM greater than 3
enforcement of this rule. As far as the NIMs of private sector banks which
While each bank can choose its own like blue chip corporates etc. are has their Base Rates fixed at around 7.25-7.5%. While Banks’ having
calculation of the Base Rate is have always been working on sufficiently
benchmark for the cost of funds, it always able to get good rates from considered, it can be a tricky NIM in the lower 2 or higher 1 range has higher Base Rates.
better margins than PSBs. Moreover, Banks
will be mandatory for each of these banks. They are likely to be business. Hence, overall Base Rate with higher NIMs can sustain lower Base But, the proposed deregulation of savings bank deposit rates is likely
banks to document the detailed borrowing at interest rates very close evokes a positive vibe but it will be Rate; hence Base Rates and NIMs should to put banks in a fix. Banks may have to raise the interest rates on
formula for the calculation of Base to the Banks’ Base Rates. When very amateurish to conclude at least be slightly correlated to each other. these deposits following deregulation so as to gain competitive
Rate and follow the methodology market interest rates fall, they will anything at this stage. Let’s review the exact status of the market. advantage. This may affect the net interest margins (NIMs) of banks

18 19
 Sumedha Fiscal
if they are unable to manage the higher costs that would be incurred in the process.
“There were a lot of costs involved in running savings accounts, including the daily interest rates and the deregulation
of interest rates would only affect the NIM of banks further”, said Ms. Renu Challu, Managing director, State bank
of Hyderabad (SBH)
SBI's NIM had fallen to 2.93% from 3.1% on high cost of deposits and lower yield on advances in the fourth quarter
ending in March 2010, but the bank wants to improve it by 20 basis points in 2010-11. Bank of Baroda also doesn't
expect much impact on its NIM due to the Base Rate. "We will try to protect our NIM. The sub-PLR borrowers
will be migrating to the CP market to a certain extent” said Mr. MD Mallya, CMD of the bank.
Effect On Short Term Loan
1, is likely to lead to an increase in short-term lending
rates. This is because banks will be forbidden from
lending below the Base Rate, which is decided based on
their cost of funds and is likely to be around 8%.
A possible consequence of this could be to encourage
these better rated firms to search for alternative fund
raising routes in the debt markets, thereby facilitating the
increase in its breadth and depth. Corporations and non-
banking finance companies (NBFCs) could prefer short-
term (less than a year) money market instruments like
commercial papers (CPs), with tenor between 15-365
days and with rates linked to the yield on the one-year
government bond or non-convertible debentures, over
bank loans, especially for their short-term funding needs.
It is the region where a massive change of events is
It will also set the stage for the higher rated companies
expected in the near future. Many Popular figures in
to raise capital through the external commercial
Banking arena share the same perspective.
borrowings (ECB) route, especially given the ultra-low
Mr. M Narendra, Executive Director, Bank of India, said
interest rates across much of developed world. A
short term lending is bound to see a correction once the
strengthening rupee (vis-a-vis dollar) will only increase
Base Rate regime sets in.
the attractiveness of such fund raising.
"Introduction of the Base Rate mechanism will enhance
"Highly rated corporate availing short-term loans
competition in the short-term lending space. However,
(estimated at 7 to 10 per cent of total corporate loans)
competitive pressures are unlikely to impact the overall will look to transit to the more attractive debt capital
profitability of the banking system materially" Crisil said. markets through short-term instruments and choose
The Base Rate system, which is to be in place from July banks with lower Base Rates," Crisil said.
20
BDO India
Cross-Subsidization of
Loans
There was always this strong feeling of disgust among SMEs loan-seekers
who witnessed paying such high rates of interest compared to their
corporate counterparts because of their lack of negotiating power as well
as non-transparency in the system made them takers while Big Corporates
were choosers of the market.
But with Base Rate, now, there is a limit below which Banks are prohibited
However, Base Rate will not have an
impact on longer-term loans, he
noted. “Currently some of the major
to lend and moreover this limit is obtained via calculation, methodology
of which is set by RBI. Thus, bringing in parity among Banks as well as
loan-seekers.
infrastructure projects are financed at
Previously there was this lack of knowledge among borrowers about the
10% to 11%. That will not see a
rate at which loan is disbursed to big companies, along with the Banks
major change,”
ubiquitous practice of keeping those rates confidential, added to their woes
Banks pushing the administrators to but now it will be very certain that it would not be below the Base Rate,
allow sub-Base Rate lending at least hence there will be sufficient transparency on what is the extra rate of
to the loans with tenure of few days. interest they are paying for their lesser credit-worthiness. Moreover, the
“A large AAA-rated company was practice of lending at very low rates to the big corporate will compel Banks
availing loan for 4.5-5 per cent for to keep the Base Rates low at all times.
tenure as short as seven days. Now, But, still with Base Rate not open to any public Scrutiny & no guidelines
they are not ready to pay 7.5-8 per over what should be the Cost of Deposit there are still some holes left to
cent for the same product,” said the be plugged. It would be interesting to find out whether the general public
chairman of a public sector bank who can, under RTI, access a specific bank’s calculation of Base Rate that is
attended the meeting. available with the RBI
Besides, a senior executive with a large
public sector bank pointed out that
during a pre-policy meeting bankers
had pointed out that in certain
segments, such as the letter of credit
business, the state-owned entities had
lost market share to private players,
which had settled for lower Base
Rates. Moreover, our largest Bank SBI
is of the opinion that lending to a
borrower even for a few days is better
than parking surplus funds with the
Central Bank through the reverse
repo route.
21
 Sumedha Fiscal
Effect on Long Term Loan
“In the long run all of us are dead”
- John Keynes
Base Rate will not lead to any changes in the interest rates
on the long term loans in the near future. But when far
into the future is considered Base Rate will have positive
effect for the consumers.
Under the current practice, whereby the current Retail
& Corporate Loans does not have any substantial
correlation, will come under the hammer because of the
Effect on Home Loan
Credit growth in the Indian mortgage
finance market improved to 13 per
cent in 2009-10 from 10 per cent in
the previous fiscal due to factors such
as a healthier operating environment,
expectations of appreciation in
property prices and attractive interest
rate schemes offered by banks and
housing finance companies (HFCs).
As the Corporate loans under new
regime might take a backseat, Retail
loans with its considerable growth will
become the new area of focus for the
Banks where they look to recover the
lost revenues, which might witness a
series of very competitive rates
hereafter. And with greater negotiating
22
inherent nature of the Base Rate under which ensures a
strong correlation between interest rates of Corporate &
Retail Loans.
Retail Borrowers who are still into first one or two years
of loan where rates are fixed at or around 8-9% should
not switch, while those who are under variable rate with
benchmark as BPLR should shift to the new regime
because it will ensure a reasonable interest rate. While
AAA-Grade Corporate borrowers borrowing at sub-
BPLR rates might have extra incentive to stay under the
purview of BPLR as long as possible. But, this might not
work for long considering the Banks point of view of
dealing administratively with two major Benchmark rates
.Hence soon it will be in interest of Bank as well to make
these organizations switch. But, “The impact won’t be
much for long-term money which was always costlier at
9-11 per cent” said, Mr. N K Kakani, Executive Director,
Simplex Infra. “In the long-term lending space, however,
a material shift in the market share of banks is unlikely”
quoted Credit rating agency CRISIL.
power in the hands of borrowers, Finance which are two major players
things look brighter for home loan in the home loan market comes under
borrowers. Moreover, over 90 per cent the purview of non-banking financial
of all mortgage loans are estimated to institution category, hence are
be at floating rates of interest which excluded from the Base Rate system.
made the borrower much vulnerable
to interest rate spreads.
To make sure you get the best spread,
manage your credit profile because that
is among the important parameters
determining your spread. Having a
good credit profile will create a window
of opportunity for you to bargain with
banks to lower the spread.
But, Housing Development Finance
Corporation and LIC Housing
Effect on Corporate Loan
“Currently, banks saddled with surplus
liquidity and lack of avenues to deploy
funds, have been providing short-term
loans to large corporate with a healthy
credit profile at rates as low as 5.5% or
6%. Moving to the proposed Base
Rate system would make it impossible
for banks to lend at these rates, which,
consequently, would lead to corporates
considering alternative sources,” a
CRISIL report said.
But Presently, not much is expected
out of the change as Banks have been
successful in keeping their Base Rates
quite low, which might not trigger a
serious change in events as for our
Biggest Banker things seem to be in
control at present, as, "Corporate loans
as of now priced less than 7.50% is
only 3% of the loan book," Chairman
O.P.Bhatt. But things might not
remain the same forever, as RBI is all
set to tighten liquidity which will force
Banks to increase their Base Rates to
unprecedented levels. With increasing
policy rates, large borrowers will have
Effect on Parallel Markets; Such as CP etc.
Introduction of Base Rate will have an
irreversible change on Letter of Credit,
Short term Working Capital Loans of
few weeks as these loans majorly
vacillates in the sub-Base Rate region.
For a long time Big companies with
good credit rating have been the best
safe havens to park the surplus
BDO India
lesser bargaining power than before. check on their Cost of Deposit which
But, the present arrangement by banks is expecting an overall increase
for funding against letters of credit
(LCs) and bill discounts would be
severely affected by the Base Rate
system as loans are given at
substantially-reduced rate due to
guaranteed payments. Banks used to
park their excess liquidity with AAA
customers which would not be
possible now, hence they will have to
park it with RBI which is sufficiently
lower than AAA-Grade Corporate
Lending rates, this will force
Corporate to float their own
The bank will add credit premium,
CPs, hence a surge in CP market is
tenure premium and allocatable cost to
expected soon.
the Base Rate while deciding the exact
This regime might not prove to be very
lending rate to the borrower. For some
profitable for Banks with huge
borrowers, effective interest rate under
Corporate Lending base as they will
have to always keep a check on the
Base Rate because Base Rate Elasticity
the Base Rate mechanism will be
higher, while for others it will be lower.
of Revenue can become very high at SBI's Bhatt indicated that segments
some key values of Base Rate. So they which are more risky may see their
will have to keep a very thorough effective lending rates going up.
liquidity in the short term better than to base rates (the new benchmark for
RBI which gives lower Interest Rate. pricing loans in a transparent manner).
Base Rate will definitely make CPs a In July, companies raised an estimated
more attractive investing option, as amount of 25,889 crore through
clearly evidenced by the fact that CPs, a short-term money market
raising of funds through commercial instrument. This was almost double
papers (CPs) has surged within a the 13,321 crore garnered in June,
month of the country's banks shifting according to the latest Reserve Bank of
23
 Sumedha Fiscal BDO India

India (RBI) data. With this emergence, CRISIL estimates

that demand for CPs would be around 1680 billion.
Thus, we have strong reasons to believe that corporates are
going to shift towards lesser demanding CPs, NCDs, etc.
Many popular Analysts & Industrialists share the same
Importance of CASA
A very strong inherent shortcoming of Base Rate in CASA stands for current and savings Deposits, CASA is bound to play a lessen the differences between banks
mindset.
comparison to CP (evidenced by the graph shown under) account. The CASA ratio shows out of huge role. Gainer will be the ones with with varying CASA ratios to some
is that, it may not be as variable (flexible) as the latter, “Currently, we are more comfortable with bank credit as we the total deposits available with a extent.
higher CASA as it will ensure liquidity
get it at sub-BPLR. But after the introduction of the Base
especially on the downside; if banks reduce their base rate, bank, how much is attributable to as well as lower Cost on Deposits, this
Rate, we may opt for CPs, public deposits and NCDs to
they will have to re-price their existing Base Rate linked current and savings deposits. together with the upcoming mandate
raise funds,” said Mr. R Ravi, Chief Financial Officer at
short and long-term loans, across borrowers, impacting their Pennar Industries. An increased CASA ratio therefore of RBI for de-regularization of the
profitability. At same time, Banks are expected to invest in would infer an increased source of interest rate on savings accounts is
“The introduction of a Base Rate will certainly be a step
CPs of their corporate customers, to remain in their good towards the development of the debt market and in the time funds from current and savings going to make Banker’s life tougher
books. And also, it is in bank’s own interest to park their to come, more corporates will shift from bank loans to CPs account deposits. CASA provides with time, while on the other hand
excess liquidity with CPs rather than with RBI. and short-term NCDs to meet short-term working capital more liquidity as compared to term depositor’s are sure to witness bright
requirements,” concurs Mr. Ram Yadav, Head of Finance and demand deposits. future ahead.
Variability of CP Rates Vis-a-vis BPLR
and Strategies at Orbit Corporation As the whole Structure of Base Rate But, again de-regularization of the
16%
14% But we have to be Cautious, as being a short-term financing revolves around the Effective Cost on interest rate on savings accounts will
12% instrument; the interest rates for CPs are quite sensitive to
liquidity conditions. Hence many Bankers are of the
10%
8%
6%
CP Rate
SBAR
opinion that the conditions might not be in favour of CPs
forever. According to the head of treasury with a large public
Effect on Deposit Rates
4% sector bank, with RBI raising key policy rates and tightening System is all set to witness some hike aimed at and is expected to bring a hike in deposit rates by 25-50 bps.
2% of liquidity in the system, raising short-term funds is going in Deposit rates, with de- greater transparency in lending rates.
0% to be a costly affair. Moreover, the coming months may not regularization of interest rates of As a corollary, another silent but
Feb-09
Mar-09

Feb-10
Mar-10
May-08

May-09
Apr-08

Apr-09
Aug-08
Sep-08

Aug-09
Sep-09
Oct-08

Oct-09
Nov-08
Dec-08

Nov-09
Dec-09
Jan-09

Jan-10
Jun-08

Jun-09
Jul-08

Jul-09

Source: RBI
Significant Restructuring of Mutual Fund’s Investments
Mutual Funds which have been the
largest investor segment in CPs are now
expecting a major hike in the supply of
CPs. The Net estimated demand of CPs
of around 1680 billion is more than
twice the current level of MF
investments in CPs. By issuing CPs,
India’s corporates can collectively now
save up to 11.7 billion on interest
costs, thereby increasing their net profits
by as much as 1 percentage point.
Previously, due to the dearth in supply
of CPs, Investments from MFs in bank
certificates of deposits (CDs) and fixed
Source: figures (CRISIL Research)
see a similar level of activity as the SBI official apprehends
that RBI may also come up with rules that would make it
tougher to invest in CPs below base rate.
deposits (FDs) were more than thrice
their investments in CPs. But, now,
with Base Rate, supply of CPs is going
to increase. Accordingly, MFs will have
more diverse as well as efficient market
to invest.
Hence, MFs which have had few
options to invest in so far, will now look
to invest directly in CPs, rather than
indirectly lending to them through
bank CDs. Thus saving the differential
yield which according to CRISIL, can
range from 25 basis points to 100 basis
points. Considering even the most
conservative figure, 25-basis point
higher yield on CPs in relation to CDs,
the MFs can obtain up to 6 billion as
higher interest by investing in CPs,
rather than in CDs and FDs.
Savings account, increment in policy
rates along with added competition
from different horizons (CP, NCD
etc.) will definitely shift Deposit Rates
to higher frontiers. Many Banks have
already increased their deposit Rates
by around 50 basis points.
The introduction of Base Rate was
Sunset Clause
Though the banks have shifted to the
Base Rate from July 1 at the behest of
the RBI, they have to maintain two
systems—one for the new borrowers
following the Base Rates and another
for those who had borrowed loans in
bench mark prime lending rate
(BPLR) regime—which is a
cumbersome exercise.
significant change is taking place on
liabilities. According to bankers,
deposit mobilization will become more
disciplined and banks will be cautious
before raising their deposit rates,
especially for corporate bulk deposits.
Those banks with Base Rate below 8%
may feel the heat. So, they may go for
“What is happening now is the banks under the retail segments, who had
can't force the existing customers to opted for the fixed rate of interest, to
shift to Base Rate. Hence they are migrate to the Base Rate regime by
compelled to announce two kinds of June 30 next year.”
standard lending rate, the Base Rate “The basic idea behind hiking the
and the benchmark prime lending rate BPLR is to make existing customers
(BPLR),” said State Bank of India’s,
Mr. O.P Bhatt, he also said “We hope shift to the Base Rate,” said Mr. Suresh
that the RBI will bring into force a Ganapathy, head of financial research
sunset clause and ask those borrowers team at Macquarie Securities.

24 25
 Sumedha Fiscal
Due to Delay in Sunset Clause, Banks
are looking forward to increase BPLR
to entice customers to the new regime
to overcome the two-fold
administrative cost and the extra
confusion among Banks for
maintaining both the rates. Clearly
evidenced by, PNB raised its BPLR by
75 basis points (one basis point is one-
hundredth of a percentage point) to
11.75% from August 1. IDBI Bank
reviewed its BPLR and increased it by
50 basis points to 13.25% effective
August 5. Corporation Bank and
Union Bank have also raised their
BPLR by 50 basis points to 12.50%
and 12.25%, respectively, effective
August 4.)
Flip Side of the Sunset Clause:
RBI had introduced the Base Rate
system with the aim of making pricing
of loan far more transparent and to
ensure transmission of the monetary
policy. While doing so, the central
bank also instructed banks that all new
loans from July 1, 2010, should be
linked to the Base Rate. For loans
given prior to July 1, banks should
reprise them at Base Rate at the time
of renewal. RBI also told banks that a
26
customer should be allowed to shift to
Base Rate even before the loan comes
for renewal, without charging
customers any penalty.
Among the types of loans provided by
banks, working capital loans and terms
loans are renewed every year, personal
loans are short-tenure fixed rate loans
and auto loans are either on fixed or
floating loans for 3-5 years. Home
loans, availed at floating rate are the
longest tenure loans which do not have
a renewal clause. In case of fixed rate
home loans, most banks have inserted
a clause that the rate would be
reviewed after every 3-5 years, and
thus, these loans would be renewed at
Base Rate. But the share of fixed rate
home loan is very low in the entire
home loan portfolio. Now that RBI
has rejected the sunset clause, bankers
feel that unless they make an attractive
offer for existing PLR customers, they
may not move to the Base Rate system.
RBI is resisting a move to introduce a
sunset clause as it fears that such a
clause would give banks an upper hand
over its customers — mainly
individuals who lack the bargaining
power to get a fair deal after the
switchover.
BDO India
It is common knowledge that the influx of deposits into a CASA for funds. Now, with significant difference in Base
Drawbacks bank may not necessarily be synchronous with the demand
for credit. Hence banks may need to lend short term to low
Rates Banks working predominantly on term deposits
would not be able to make corporate loans to the extent
One very disappointing part of this risk borrowers at below Base Rate with the specific intention they have been prior to Base Rate. Hence they will have to
whole exercise is banks have still not of deploying these funds at higher rates later when the improve CASA as well as retail lending which requires loads
put methodology on their websites. demand for credit turns robust. But, Base Rate might not of expenditures (via marketing, more number of branches,
Announcing rates is not enough. We end this practice as, the bigger customers can still raise funds greater facilities, better services etc.) which might not be
need to know how the rates have been by issuing commercial paper (CP) for short periods from possible for every bank. Hence it gives inherent advantage
arrived. As of now Base Rate is just 15 days to 12 months and many banks, when faced with to the banks with better CASA and lower Base Rate.
like BPLR. And no regulations surplus liquidity, would willingly invest in the CPs at rates
lower than base rate. Though called investment, it is really JUST A THOUGHT
whatsoever on what Cost of Deposits
should be taken for the calculation of lending. The Current environment suggests relative increase in policy
BR, can make the whole exercise You may have noticed that the Base Rate is the minimum rates and increasing deposit rates (been already initiated).
redundant. rate at which the bank can lend. Hence, banks are allowed In the event Banks will have to eventually increase Base
to actually lend at much higher interest depending upon Rate, but with such fierce competition in Banking Sector a
Currently, the Base Rates are proposed
the credit risk of the customer and the nature of the marginal change in Base Rate of any Bank might result in a
to be reset every quarter, irrespective
product. But till what cap or limit, the RBI has not made landslide change in its total advances. So for their best
of time and tenure of monetary policy
any announcements. Though true, that the bank will try to customers, they have to be glued to their minimum
instances of RBI. There needs to be
keep the spread as low as possible owing to increasing structure & as may be comparable to certain Treasury
parity in timelines. There should be
competition, there is no stopping to the bank even if it lends Products like Commercial Papers etc. Hence, not passing
similar timelines in addition to banks'
upto say 6% plus Base Rate. on the interest rate rise to the Base rate will put Bank’s
own policy for resetting the Base Rate.
margins under undue pressure and if base rate is increased
This will ensure monetary policy This new system can prove very detrimental to the health
and it is not replicated by its peers, many high credit grade
transmission without gap of Banks which works on very sleek NIMs (such as IDBI)
corporates will move to its peers which on increased volume
During times of excess liquidity in the due to their inherent nature of large share of corporate might manage with lesser margin. Hence, Banks may face
system, as is presently the case, banks advances coupled with large share of term deposits. Catch-22 situation for keeping its best customers & margins
with comfortable capital adequacy Now, it will be impossible for these banks to match their intact, more so, considering that Non-Performing Assets
would opt for the commercially- cost on deposit with their peer groups who rely more on (NPA’s) are also on a rise.
sensible alternative of first scouting for
suitable assets and then financing
them by raising appropriate liabilities
that yield an adequate risk adjusted
profit to the bank. Quite often, this
would involve lending at below the
new Base Rate but in the proposed
dispensation, this activity is
prohibited. It is difficult to imagine
how this prohibition would serve
society better in as much as it deprives
the banking system of potential profits
by denying credit to a needy borrower
who would invest in productive assets
and generate employment, albeit by
borrowing at a sub-base interest rate.
27
 Sumedha Fiscal
Conclusion
The move by RBI to migrate to a more transparent
system of pricing loans is certainly beneficial to the
customer. Does this mean customers should look out for
banks charging lower Base Rate for loans? Looking at
only Base Rate to decide on the bank from which you
will take a loan may not be intelligent. Remember, the
bank has the flexibility to determine the spread on your
loan which in turn will determine the interest charged
to you. So while opting for a loan, let the comparison
be on the overall loan cost and not the Base Rate.
Coming onto retail consumers, home loan consumers
won`t get affected in a big way except for 25 bps here
and there. In the retail category, the SME customers will
have a chance to gain a little from the Base Rate since
they are currently charged much above 9%. But overall,
there will not be a significant impact on the retail
segment for the banks.
Besides, the new Base Rate system is likely to bring in
some innovation in debt instruments and thereby
deepen the debt markets. As regards home loan market,
home buyers may have to live with worries of frequent
changes in their EMIs as there may be less long term
fixed coupon products and more of floating rate
products available in the market.
But as far as responsiveness to changes in policy rates are
considered, both the present and the new system will be
linked to the cost of funds (deposit rates), but the key
will be transparency, requirement to come up with more
competitive Base Rate among banks, and the powers
given to the RBI whereby it will scrutinize the rates every
quarter which might make banks respond more quickly
to policy rate and liquidity changes.
But the feeling among individuals, borrowing under
flexible rates that they face an opaque system which is
changed or not solely according to the needs of banks,
is likely to go away. Things look more effulgent now, as
all floating rate loans will be clearly linked to the Base
Rate (e.g., 1.5 percentage point more) and, more
importantly, the rate will automatically and mandatorily
28
changed in response to Base Rate changes. Currently
individual existing borrowers witness a very estranged
behavior from Banks, whereby interest rates revisions on
their loans mostly witness upward movements, seldom
are they revised downwards. Moreover, New Customers
are offered loans at very lower rates relative to their
existing counterparts who are majorly handicapped by
the lesser negotiating avenues available to them. But now
with every loan linked to the same Benchmark Rate,
existing borrowers are likely to see themselves paying
Interest rates in tandem with the industry (rates tend to
float up over time), and once teaser rates are formally
discontinued things will become much clearer. As for
large corporate borrowers negotiating very fine rates for
themselves, that is likely to discontinue as banks no more
oblige them under competitive pressure.
The cost of deposits has the highest weight in calculating
the new benchmark. Banks, however, have the leeway to
take into account the cost of deposits of any tenure while
calculating their BR. For example, SBI took costs of its
6-month deposits into account while calculating its BR,
which it has fixed at 7.5%, and gave sufficient
justification for not taking last quarter or last year
Deposit Rates. But on the other hand, PNB and Bank
of Baroda decided to take average cost of Deposit for the
last quarter as the benchmark Cost of Deposit. Hence,
the issue of Cost of Deposit is very subjective and no
regulations whatsoever on what Cost of Deposits should
be taken for the calculation of BR, can make the whole
exercise redundant. Hence there should be some
guidelines on what cost of deposits to take, which will
make the market more uniform and bring all the Banks
on the same platform.
We therefore believe that it is rather early to arrive at any
conclusion. However the likely benefits of the
changeover to Base Rate system have been stated by RBI
and it is expected that RBI will issues suitable directions
to lead the banking system to ensure that the objectives
are met fully.
Annexure
CRR
Cash reserve Ratio (CRR) is the amount of funds that
the banks have to keep with RBI. If RBI decides to
increase the percent of this, the available amount with
the banks comes down. RBI is using this method
(increase of CRR rate), to drain out the excessive money
from the banks. “Presently, 6.00%”
REPO RATE
Whenever the banks have any shortage of funds they can
borrow it from RBI. Repo rate is the rate at which our
banks borrow rupees from RBI. A reduction in the repo
rate will help banks to get money at a cheaper rate.
When the repo rate increases borrowing from RBI
becomes more expensive. “Presently, 6.00%”
REVERSE REPO
Reverse Repo rate is the rate at which Reserve Bank of
India (RBI) borrows money from banks. Banks are
always happy to lend money to RBI since their money
are in safe hands with a good interest. An increase in
Reverse repo rate can cause the banks to transfer more
funds to RBI due to this attractive interest rates. It can
cause the money to be drawn out of the banking system.
Due to this fine tuning of RBI using its tools of CRR,
Bank Rate, Repo Rate and Reverse Repo rate our banks
adjust their lending or investment rates for common
man. “Presently, 5.00%.”
STATUTORY LIQUIDITY RATIO (SLR)
SLR is Statutory Liquidity Ratio. It’s the percentage of
Demand and Time Maturities that banks need to have
in any or combination of the following forms:
i) Cash ii) Gold valued at a price not exceeding the
current market price, iii) Unencumbered approved
securities (G Secs or Gilts come under this) valued at a
price as specified by the RBI from time to time.
The maximum limit of SLR is 40% and minimum limit
of SLR is 24%. This restriction is imposed by RBI on
banks to make funds available to customers on demand
BDO India
as soon as possible. Gold and G Secs (or Gilts) are
included along with cash because they are highly liquid
and safe assets.
“Presently, 25%”. “364-day, T-Bill: 6.696%”
DRI (Differential Rate of Interest)
This scheme offers need based financial assistance to
those who intend taking up any productive activity and
has been tailored for persons whose income is very low.
This scheme is generally meant for persons belonging to
SC/STs, Adivasis, Village and Cottage Industries,
collection of forest products, agricultural operations,
Orphanages & Women's Homes etc. Due to its inherent
nature, Banks cannot be asked to put a floor rate to this
type of Loan, generally it is very low (around 4%).
BASEL II NORMS
Basel II insists on setting up rigorous risk and capital
management requirements designed to ensure that a
bank holds capital reserves appropriate to the risk. The
underlying assumption behind these rules is that the
greater risk to which the bank is exposed, the greater the
amount of capital the bank needs to hold to safeguard
its solvency and overall economic stability. It will also
oblige banks to enhance disclosures.
REFERENCES:
1. RBI Publication Reports
2. CRISIL Reports
3. Business-Standard.com
4. Financialexpress.com
5. Business Today
6. Livemint.com
7. Apnapaisa.com
8. Economictimes.indiatimes.com
9. Thehindubusinessline.com
10.Indian Banking Association
11.Bank Websites
12.Smartinvestor.in
29
 Sumedha Fiscal BDO India

Abbreviations:
1. BPLR Benchmark Prime Lending Rate
2. BR Base Rate
3. Bps Basis Points (1 Basis Point = 100th of 1%)
4. LC Letter Of Credit
5. CP Commercial Papers
6. CD Certificate of Deposit
7. NCD Non Convertible Debenture
8. MF Mutual Fund
9. NPA Non Performing Assets
10. RBI Reserve Bank of India
11. NIM Net Interest Margin
12. HFC Housing Finance Companies
13. NBFC Non Banking Financial Corporation
14. PSB Public Sector Banks

Short form of Various Banks used:

1. SBI State Bank of India
2. HSBC Hong kong and Shanghai Banking Corporation Limited
3. DBS Development Bank of Singapore.
4. HDFC Housing Development Finance Corporation Limited
5.
6.
ING (Vysya)
ICICI
International Netherlands Group
Industrial Credit and Investment Corporation of India
Disclaimer:
7. SBM State Bank of Mysore This publication has been carefully prepared, but it has do not accept or assume any liability or duty of care for
been written in general terms and should be seen as any loss arising from any action taken or not taken by
8. PNB Punjab National Bank
broad guidance only. The publication cannot be relied anyone in reliance on the information in this publication
9. OBC Oriental Bank of Commerce or for any decision based on it.
upon to cover specific situations and you should not act,
10. UCO Bank United Commercial Bank or refrain from acting, upon the information contained BDO Consulting Private Limited, a private limited
11. BOI Bank of India therein without obtaining specific professional advice. company incorporated in India, is a member of BDO
12. IDBI Industrial Development Bank of India Please contact BDO Consulting Pvt. Ltd. or Sumedha International Limited, a UK company limited by
13. IOB Indian Overseas Bank Fiscal Services Limited to discuss these matters in the guarantee, and forms part of the international BDO
context of your particular circumstances. BDO network of independent member firms.
14. DCB Development Credit Bank
Consulting Pvt. Ltd. and Sumedha Fiscal Services BDO is the brand name for the BDO network and for
15. RBS Royal Bank of Scotland
Limited along with its partners, employees and agents each of the BDO Member Firms.

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