Basics of the base rate

In a move that could increase transparency and efficiency in loan pricing, the Reserve Bank of India (RBI) has proposed that all loans be priced off a base rate as against the current practice of linking them to the so-called benchmark prime lending rate (BPLR). How will this change the world of banking as we know it?

What's proposed: Base rate to replace BPLR from April 1, 2010. While each bank will work out its own base rate, the key determinants would be cost of deposits, cost of keeping to mandatory RBI regulations (liquidity and reserve ratios, for instance) and the cost of running the bank (such as salaries). The central bank is clear that it does not want banks to lend below the base rate to any client, no matter how big and lucrative. In effect, the RBI is pushing for transparent and sustainable pricing of loans.

What will be the impact: Lending at rates below PLR to large and blue-chip borrowers will stop. Determining pricing of loans will be a more disciplined process with focus on reining in costs, and spreads determined more efficiently by a competitive market.

Who will benefit:The new rates should increase credit flow to small borrowers at lower rates than earlier, while it will increase the cost of funds to big corporates who use their bargaining power to negotiate at sharply below the BPLR. In effect, small borrowers were almost cross-subsidising the lending to the big boys of India Inc. earlier which will now end. Banks with higher low-cost current and savings account, or CASA, deposits and overall lower operating costs, too, will gain. They will be able to place their base rates at least a few basis points below the industry average—and so get higher spreads.

What next: Banks will now have to display information on their base rates at all branches and their websites. RBI wants base rate changes to be made public regularly and has asked banks to ensure that interest rates charged are non-discriminatory.