A working group set up by the Reserve Bank of India (RBI) on pricing of credit has said that floating interest rates on existing loans charged by banks need not change with every change in the Base Rate of banks. Instead, it has said the covenant of floating rate loans may have mandatory reset dates which could be monthly, quarterly or half-yearly and existing loans may be reset on the date agreed upon.
The group, headed by former deputy governor, Anand Sinha, has said that this will improve transparency with respect to the customer, who will know upfront when the rates are due for change. It will also aid in better risk management by banks.
The group has recommended that banks should not increase interest rate on loan to an existing customer except in instances where there has been deterioration in the credit risk profile of the customer. The customer should be informed of this at the time of signing the contract.
The working group has said that banks with lower cost of funds aided by higher Current Account-Saving Account (CASA) may not necessarily increase lending rates when the policy rate is increased as long as their margin expectations are fulfilled. It said that these banks can leverage this advantage to maximise their respective market shares. On the other hand, such banks can reduce the Base Rate as soon as the policy rate is moderated (as they already enjoy lower cost of funds) to maximize their market share before waiting for the full impact of reduction in policy rate to be fully felt on their cost of funds.
The Base Rate system replaced the Benchmark Prime Lending Rate (BPLR) system with effect from July 1, 2010, and is applicable for all new loans and for those old loans that come up for renewal. Some existing loans based on the BPLR system continue to be in the system and may run till their maturity. The group has recommended that there may be a sunset clause for BPLR contracts so that all the contracts thereafter are linked to the Base Rate. Banks may ensure that customers who shift from BPLR linked loans to Base Rate loans are not charged any additional interest rate or any processing fee for the switch-over.
To improve transparency in the pricing of floating rate loans, the working group has proposed a new benchmark - Indian Banks Base Rate (IBBR) Index - which will be a Benchmark derived from the Base Rates of some large banks. The use of IBBR would facilitate all floating rate loan pricing to move in tandem and an individual bank's specific funding advantages/disadvantages and changes in funding profile may not affect the customers. Further, as the IBBR will be based on major banks across the system, changes in base rate of few banks will have limited impact on the index. Being an industry-wide index, it is likely to find better acceptance than market benchmarks like MIBOR and T-bill, the group feels.
The RBI group has also suggested that banks should move towards a new system of computing of Base Rate on the basis of marginal cost of funds, instead of the present system of using the weighted average cost of funds. It has said that moving towards the suggested new system of computing the Base Rate will reduce customer complaints, improved asset liability management and result in better transmission of changes in the policy rate.
The group has suggested that if banks continue to use the weighted average cost of funds because of their deposits profile or any other methodology that may result in differentiation between old and new customers, the Boards of banks should ensure that this differentiation does not lead to any discrimination between borrowers. Discrimination will occur if a bank offers different prices on loans to customers with identical credit profile, every other factor being the same.
The groups said that under the present system of using the average cost of funds, the Base Rate does not move in tandem with the policy rate. Using the marginal cost of funds method would make it more responsive to the policy rate and help Base Rate to quickly align with changes in policy rates. However, the working group has said that it would not be proper to make the new system of computing mandatory given the difficulties involved in migrating to marginal cost of funds for computing Base Rate for a majority of banks.
Ananda Bhoumik, senior director, banks, India Ratings, says, "The recommendation that banks compute their lending rate based on marginal cost of fund and not on weighted average cost could increase the volatility of the base rate, particularly for banks with higher dependence on bulk short-term deposits. Consumers may benefit when interest rates are falling as retail loan rates would come down more frequently than it is done now. However, when the rates go up, the retail loan rates would also go up more sharply."
The group pointed out that apart from factors like specific operating cost, credit risk premium and tenor premium, broad factors like competition, business strategy and customer relationship are also used to determine the spread (the difference between interest earned on loans and interest paid on deposits). It said that banks should have a Board-approved policy delineating these components and that banks should be able to demonstrate to the Reserve Bank of India the rationale of the pricing policy. It said that the Board of a bank would be in the best position to assess the optimal bouquet of such factors that it determines should be clubbed under these parameters to price the spread.
The group has suggested that banks should publish their interest rates, fees and charges on their websites for transparency, comparability across banks and informed decision-making by customers. Moreover, banks should disclose the interest rate range of contracted loans for the past quarter for different categories of loans along with the mean and median interest rates charged, it said.
Reacting to the working group's report, Edelweiss has said, "These recommendations, if implemented in the current form, will usher in transparency, fairness and discipline to the credit pricing framework, benefitting customers to a great extent. Limited/reduced flexibility will enhance competition and directionally impact spreads in the long run (although difficult to quantify)."