Lending rates in India
Steps to liberalize interest rates started in the late 1980s. However, the reforms did not gain momentum until mid-1992 when rates of interest in India were gradually decontrolled in a variety of ways. As on date, Indian banks are free to decide the lending rates which they charge to their borrowers, except DRI (Differential Rate of Interest). And like in any free market, the price is determined by the interplay of demand and supply. In modeling a particular rate of interest, the objective is to explain the behavior of the designated rate on a given financial appliance. Analytically, the rate is taken as the equilibrium yield on the given appliance determined by equilibrating its demand and supply.
Interest rates play a very crucial role in economy. It acts like a throttle on economic expansion. Interest rates veering too high or dipping too low can spell trouble and can become a cause for concern for credit quality and financial stability. Interest rates directly affect the credit market because higher interest rates make borrowing more costly. To avert any possibility of such a disaster, Reserve Bank of India (RBI) introduced BASE RATE system to replacing the Benchmark Prime Lending Rate (BPLR) system to reduce the multiplicity and complexity of interest rates.
Banks set different lending rates on loans to different categories of borrowers and on loans for different purposes in light of instructions given by the Reserve Bank of India. The regulation of interest rates was mostly undertaken with a view to maintain them at a low level which, in turn, was regarded necessary for certain purposes. In a planned economy, the priorities and objectives of development are determined by the authorities. If the course of development is to be in keeping with these priorities, the provision of credit with certainty and at low cost in the desired direction becomes necessary. Like we see that the RBI require banks to lend to certain sectors of the economy. Such directed lending comprises priority sector lending, export credit and housing finance. In the Indian context, there has been striking efficacy with which policy rates have impacted money and government securities markets. The effective control over lending rates of banks is also necessary; (a) To avoid unhealthy competition for borrowing, (b) To maintain a kind of uniformity of interest rates, (c) To enable the authorities to avoid frequent changes in the Bank Rate. According to business and industry, high cost of credit has pushed up cost of production of business units, which was injured their profit prospects and reduced their competitive strength in the international markets. Similarly, if the interest rates continue to rule high, it would be difficult to fight industrial recession successfully.
So the Administration system of interest rates had been adopted with a view to maintain interest rates stable and at optimum levels. The system was also expected to enhance the predictability and efficiency of monetary policy.
Stance of Policy
Reserve Bank of India began prescribing the minimum rate of interest on advances granted by Scheduled Commercial Banks with effect from October 1, 1960. In March 2, 1968, in place of minimum lending rate, the maximum lending rate to be charged by banks was introduced, which was rescinded with effect from January 21, 1970, when the prescription of minimum lending rate was reintroduced. The ceiling rate on advances to be charged by banks was again introduced effective March 15, 1976, and banks were also advised, for the first time, to charge interest on advances at periodic intervals, that is, at quarterly rests.
Given the prevailing structure of lending rates of Scheduled Commercial Banks, as it had evolved over time, characterized by an excessive proliferation of rates, in September, 1990, anew structure of lending rates linking interest rates to the size of loan was prescribed which significantly reduced the multiplicity and complexity of interest rates.
An objective of financial sector reform has been to ensure that the financial repression inherent in administered interest rates is removed. Accordingly, in the context of granting greater functional autonomy to banks, with effect from October 18, 1994, RBI has deregulated the interest rates on advances above Rs.2 lakh and the rates of interest on such advances are determined by the banks themselves subject to BPLR and Spread guidelines. For credit limits up to Rs.2 lakh, banks should charge interest not exceeding their BPLR. Keeping in view the international practice and to provide operational flexibility to commercial banks in deciding their lending rates, banks can offer loans at below BPLR to exporters or other creditworthy borrowers, including public enterprises, on the basis of a transparent and objective policy approved by their respective Boards. Banks will continue to declare the maximum spread of interest rates over BPLR. Following the deepening of the global financial crisis since September 2008, the Reserve Bank took several measures to bring down the policy rates to step up the liquidity in the system.
Banks are now required to obtain the approval of their respective Boards for the Benchmark Prime Lending Rate, which would be the reference rate for credit Iimits of over Rs.2 lakh. Each bank's BPLR has to be declared and be made uniformly applicable at all branches.
Banks are free to determine the rates of interest without reference to BPLR and regardless of the size in respect of loans for purchase of consumer durables, loans to individuals against shares and debentures / bonds, other non-priority sector personal loans, etc.
But the BPLR system has been drawing flak from various quarters since banks have been lending to highly-rated corporate below their benchmark rate, making the system irrelevant. The BPLR system failed to achieve what it was originally intended for – transparency in lending rates charged by banks.
Phases of Interest Rates Policy
The period since 1951 can be divided into the following five phases of interest rates policy (system) in India:
i) 1951 – 52 to 1960 – 61 Flexible interest rates system.
ii) 1961 – 62 to 1985 – 86 The system of administered, regulated, and repressed or suppressed (low) interest rates.
iii) 1986 – 87 to 1990 – 91 The beginning of liberalization or the system with inclination or intend towards liberalization and flexibility, or a semi-administered system with the inching up of interest rates.
iv) 1991 – 92 to 1996 – 97 The system of progressive deregulation and flexibility, and a significant increase in and unprecedentally high interest rates, or the phase of deregulation and dear money.
v) Form 1997 – 98 The system of managed flexibility with nearly complete deregulation, and one of the lowest levels of interest rates in India, or the phase of cheap money.
The Reserve Bank of India committee on reviewing the benchmark prime lending rate has recommended that the nomenclature be scrapped and a new benchmark rate known as BASE RATE should replace it.
Now, the RBI has come up with guideline recommendations for banks to adhere to with effect from July 2010.
Now from July 2010 Banks determine their actual lending rates on loans and advances with reference to the Base Rate. Base Rate shall include all those elements of the lending rates that are common across all categories of borrowers. While each bank may decide its own Base Rate, some of the criteria that could go into the determination of the Base Rate are:
(i) cost of deposits;
(ii) adjustment for the negative carry in respect of CRR and SLR;
(iii) unallocatable overhead cost for banks such as aggregate employee compensation relating to administrative functions in corporate office, directors’ and auditors’ fees, legal and premises expenses, depreciation, cost of printing and stationery, expenses incurred on communication and advertising, IT spending, and cost incurred towards deposit insurance; and
(iv) profit margin.
Base Rate = Cost of Deposits + Negative Carry on CRR and SLR +
Unallocatable Overhead Cost + Average Return on Net Worth.
· Negative carry on CRR and SLR balances arises because the return on CRR balances is nil, while the return on SLR balances (proxies using the 364-day Treasury Bill rate) is lower than the cost of deposits.
· Unallocatable Overhead Cost is calculated by taking the ratio of unallocated overhead cost and deployable deposit.
· Average Return on Net Worth is computed as the product of net profit to net worth ratio and net worth to total liabilities ratio expressed as a percentage.
The actual lending rates charged to borrowers would be the Base Rate plus borrower-specific charges, which will include product-specific operating costs, credit risk premium and tenor premium.
Impact of BASE RATE System
All categories of loans should henceforth be priced only with reference to the Base Rate. The Base Rate could also serve as the reference benchmark rate for floating rate loan products, apart from the other 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 sanction or renewal. By changing the structure of interest rates RBI tries to achieve maximum employment, stable prices, and a good level of growth.
The base rate will be applicable to all new loans as well as existing loans which come up for renewal. Accordingly, the current requirement that BPLR will be the ceiling rate for loans up to Rs 2 lakh will stand withdrawn. 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.
Interest rates on loans under the DRI scheme will continue to be fixed without reference to the Base Rate. The Reserve Bank will also separately announce the stipulation for export credit.
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 charged to major categories of borrowers to the Reserve Bank on a quarterly basis. Apart from transparency, banks should ensure that interest rates charged to customers in the above arrangement are non-discriminatory in nature.
It is expected that introduction of the BASE RATE system of lending rates will leads to increase the credit flow to small borrowers at reasonable rate. Thus, direct bank finance will provide effective competition to other forms of high cost credit as well as escort for smooth operation of business and this is in turn stimulate economic growth.