Money Changers

• From April 1, 2010, banks will adopt a transparent cost-based system to set a reference rate for all loans
• No loan can be priced below the base rate. Banks will add charges for each loan category.
• This replaces existing BPLR, based on a bank’s perception. Banks’ lending rates were often below BPLR.
• The BPLR is unresponsive to overall interest rate changes and doesn’t reflect actual costs.

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• Consumers will be able to compare a bank’s minimum loan rate with what they are eventually paying
• Allows easier shopping around between different banks, breeds competition and fair pricing of products.
• As a base rate will be responsive to monetary policy, existing loan consumers will benefit from changes
• The devil lies in the detail. Will banks implement the spirit behind the changes?

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The move to establish a base rate below which banks cannot lend is big news for those tired of living with opaque pricing, a surfeit of devils in the fine print, and discrimination against existing customers, who are left to fend for themselves while banks lay out the red carpet to woo new ones. Of course, we will reach the Promised Land only if the banks play ball. Will they?

It’s clear the system needed an overhaul. Launched in 2003, the existing benchmark prime lending rate (BPLR) has failed to act as a reference rate around which banks lend to consumers and companies. Here’s how: a bank typically establishes a list of best borrowers and not-so-good ones based on internal and external ratings. But the bank would subjectively arrive at a BPLR based on the rate at which it could lend to a not-so-good borrower. To use an analogy, the BPLR would be on the fifth floor of a building rather than at the lobby level.

So, companies which had the best credit ratings would be given loans at rates far below the fifth-floor level (sub-PLR lending) while other borrowers who were in a higher credit risk category would pay far higher rates, maybe the eighth or ninth floor. What this draft guideline does, in effect, is that it brings the floor or base rate to the lobby level. Banks will find it unviable to lend below that. “The current BPLR system has been made redundant due to misapplication. The new system will bring in a lot more transparency,” avers Rana Kapoor, CEO of Yes Bank.

That’s desperately needed. As things stand, banks routinely offer a better rate to new customers of floating home loans while existing customers continue to pay old, higher rates since the BPLR is kept unchanged. Worse, banks would not pass on benefits of lower interest rates to consumers—but would raise the BPLR with alacrity when rates went up. A former public sector bank chairman explains, “Many banks started the practice of reducing home loan rates to unrealistic levels due to market competition, even though the cost of funds was high...however, existing customers bore the brunt of older, higher rates.”

With over 65 per cent of loans being given out at sub-PLR rates, customers with no bargaining capacity have lost out in getting fair rates. “The pricing for each product will be transparent and the element of cross-subsidisation will go. Pricing will reflect actual costs of the bank,” says Indian Banks Association (IBA) and Union Bank of India chairman M.V. Nair.

How will the new system work? The RBI’s draft guideline, based on the recommendations of the Deepak Mohanty committee, establishes a methodology for banks to compute a base rate derived from costs that are common to all customers. This base rate will be calculated after adding aspects like cost of deposits, the negative carry on CRR and SLR balances (the capital difference of what the money parked aside for statutory requirements can earn), administrative or operational expenses and a profit margin. Over and above this, the bank will add the product, credit risk and tenor pricing for each different loan product.

The banks are being very careful about what they say. “There is ambiguity regarding how this system will be implemented for existing customers,” says Renu Sud Karnad, who heads HDFC, India’s leading home loan provider. “It would be difficult for banks and housing finance companies to move their loan books to the new rate. It’s easy to make the change from here on,” she adds.

There’s another issue: given that a bulk of the lending is sub-PLR, bankers say that with the current interest rate environment—rates are expected to go up—the base rate plus the product pricing might translate into a hike for consumers. The impact on banks’ margins and bottomlines is also unclear since banks claim they are yet to calculate and quantify the values of each of the components to arrive at the base rate.

Given that there are so many details that are yet to be ironed out, it’s too early to say whether the shift to the new system will lead to an increase (or decrease) in loan rates. But this move is beneficial for banks. The BPLR system needs to be changed to offer better reporting standards to bank boards. “This change is vital to the disclosure pillar of Basel II norms and governance issues,” says Ashvin Parekh of Ernst & Young.

Personal finance experts say that although the principle of having a clearer system makes sense, the proof of the pudding will be in how well it is applied. “It’s hard to say what the net effect is going be especially in the current interest rate scenario. Whether it actually brings in transparency depends entirely on how banks translate this into reality,” says Apnapaisa.com’s Harsh Roongta.

There’s still some time before the draft becomes reality. But it’s a matter of months. In an era of confusing jargon and differential rates, it’s clear the regulator has done the right thing by stepping in to make things clearer for the consumer. Now, it has to ensure that the new system actually works on the ground. Anything else would be a mockery.