New lending benchmark

THE CHANGE
Replacement of the benchmark prime lending rate (BPLR) for banks with base rate, on 1 July 2010. It is the rate below which the banks cannot lend.

THE INTENT
The RBI's initiative was inspired by the customer's interests and need for greater transparency. As banks had been free to lend at sub-BPLR rates, nearly two-thirds of lending was taking place at these rates, especially to bigger, institutional clients, at the expense of the individual customer. The aim was also to have the benefits of policy rate changes filter down to the customers as the banks were not adjusting their BPLRs in tandem with the rate changes.

THE IMPACT
Why does the EMI of a home loan taken on a floating rate rise when market rates go up, but don't decrease when banks are offering new loans at lower rates? If you are grappling with the answer to this question, your home loan was probably taken during the benchmark prime lending rate (BPLR) regime and you haven't switched to the new base rate system.

"(When) interest rates were indexed to the BPLR, banks were reluctant to adjust their BPLRs in response to the policy rate changes." D Subbarao RBI Governor

Though the Indian banking system is largely deregulated, banks were mandated to lend at rates lower than the BPLR to farmers and exporters. To avoid losing money on such loans, banks preferred to keep their benchmark rates artificially inflated. Moreover, they charged preferred borrowers below the BPLR and other customers paid higher interest rates.

With the introduction of the base rate from 1 July 2010, banks are required to price all categories of loans with reference to the base rate. The rate includes the cost of funds, overheads such as employee salary, and other factors such as the portion of money on which banks don't earn any interest. Banks are free to use any method to calculate the minimum lending rate, but it will be open to scrutiny by the central bank.

However, they are also allowed to levy charges or premium for product- and customer-specific risks. Of course, the banks will have to justify the premium charged.

The biggest gain for customers in the base rate regime is transparency. Lenders are mandated to publish their base rates at their branches and on their Websites.

Since banks will not be able to lend below the base rate, this will check cross-subsidisation among borrowers. All customers, retail or corporate, will be charged a uniform rate.

Mobile Wallet The RBI has granted Bharti Airtel and Essel Group the licence to use semi-closed wallets. They can now offer cell phone subscribers the facility of carrying out monetary transactions via their mobile phones.

Further, banks are required to review the base rate at least once in a quarter. This means lending and deposit rates will move in tandem with the general interest rates. If interest rates fall, these will be passed on to the customer, which was not happening in the BPLR regime.

Consider the period between October 2008 and April 2009. When the repo rates went down by about 400 bps, the BPLR changed by only 225bps. Now, banks are also offering floatingrate products benchmarked to the base rate so that changes are instantly transferred to borrowers.

However, this is just a benchmark and not all banks will have the same rate. The base rates for most banks range from 7.25 per cent to 8 per cent. This is likely to see an upward revision due to the rising interest rates in the system. Also, the existing loans based on the BPLR system will remain unchanged till maturity.