base rate

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T.Y.B.Com (Banking & Insurance) Base RateVth Semester

C HAPTER 1

R ESERVE B ANK OF I NDIA

____________________________________________________1.1 OBJECTIVES OF THE RESERVE BANK OF INDIA

1.2 ORGANIZATION AND MANAGEMENT OF RBI

1.3 FUNCTIONS OF THE RESERVE BANK OF INDIA

1.4 MONETARY POLICY OF INDIA

K.E.S College of Arts & Commerce

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C HAPTER 1

R ESERVE B ANK OF I NDIA

he Reserve Bank of India (RBI) is the apex financial institution of

the country’s financial system entrusted with the task of control,

supervision, promotion, development and planning. RBI is the queen bee of

the Indian financial system which influences the commercial banks’

management in more than one way. The RBI influences the management of

commercial banks through its various policies, directions and regulations. Its

role in bank management is quite unique. In fact, the RBI performs the four

basic functions of management, viz., planning, organizing, directing and

controlling in laying a strong foundation for the functioning of commercial

banks.

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http://www.mbaknol.com/wp-content/uploads/2010/05/rbi-mbaknol.jpg

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1.1 O bjectives of the Reserve Bank of India

a. The Preamble to the Reserve Bank of India Act, 1934 spells out the

objectives of the Reserve Bank as: “to regulate the issue of Bank notes and

the keeping of reserves with a view to securing monetary stability in India

and generally to operate the currency and credit system of the country to its

advantage.”

b. Prior to the establishment of the Reserve Bank, the Indian financial system

was totally inadequate on account of the inherent weakness of the dual

control of currency by the Central Government and of credit by the Imperial

Bank of India.

c. The Hilton-Young Commission, therefore, recommended that the dichotomy

of functions and division of responsibility for control of currency and credit

and the divergent policies in this respect must be ended by setting-up of a

central bank – called the Reserve Bank of India – which would regulate the

financial policy and develop banking facilities throughout the country.

Hence, the Bank was established with this primary object in view.

d. Another objective of the Reserve Bank has been to remain free from

political influence and be in successful operation for maintaining financial

stability and credit. The fundamental object of the Reserve Bank of India is

to discharge purely central banking functions in the Indian money market,

i.e., to act as the note- issuing authority, bankers’ bank and banker to

government, and to promote the growth of the economy within the


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framework of the general economic policy of the Government, consistent

with the need of maintenance of price stability.

e. A significant object of the Reserve Bank of India has also been to assist the

planned process of development of the Indian economy. Besides the

traditional central banking functions, with the launching of the five-year

plans in the country, the Reserve Bank of India has been moving ahead in

performing a host of developmental and promotional functions, which are

normally beyond the purview of a traditional Central Bank.

1.2 O rganization and Management of RBI

a. The RBI is managed by the Central Board of Directors, four Local Board of

Directors and the Committee of the Central Board of Directors. The Local

Boards advise the Central Board on such matters as are referred to them.

They are also required to perform the duties which are delegated to them.

The final control of the RBI vests in the Central Board which comprises the

Governor, four Deputy Governors and fifteen Directors nominated by the

Central Government. The Committee of the Central Board consists of the

Governor, the Deputy Governors and other Directors as may be required to

be present in the meeting.

b. The Reserve Bank of India has local Boards with headquarters at Mumbai,

Kolkata, Chennai and New Delhi. Local Boards consisting of five members

and these members are appointed by the central government as far as


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possible to represent territorial and economic interest, the interest of

cooperatives and indigenous banks.

c. The Chairman of the Central Board of Directors of the RBI is called the

Chief Executive Authority of the Bank and he is known as the Governor.

The Governor has the powers of general superintendence and direction of

the affairs and business of the bank. He is authorized to exercise all powers,

which may be exercised or done by the bank. In the absence of the

Governor, the Deputy Governor nominated by him in this behalf exercises

his powers.

d. A new Department of Banking Supervision was set up in 1994 to give

operational support to the Board of Financial Supervision. The Board

undertakes supervision of commercial banks and in due course its

supervising functions are extended to financial institutions and non-banking

finance companies. The department of banking supervision has been set up

with its central office at Mumbai and 16 regional offices at various centres in

the country.


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1.3 F unctions of the Reserve Bank of India

The Reserve Bank of India performs all the typical functions of a good Central

Bank. In addition, it carries out a variety of developmental and promotional

functions attuned to the course of economic planning in the country. The RBI

performs almost all traditional central banking functions. It functions within the

framework of mixed economic planning. The legal, economic and institutional

factors have rendered the issue of the independence of the central bank almost

irrelevant. It has to maintain close and continuous collaboration with the

government while framing various policies. The following functions are carried

out by the RBI.

Issuing currency notes:

As RBI is the apex institution, it has sole authority to issue currency notes. It

not only issue currency notes but also monitors the money supply in India.

The bank can issues notes against the security of gold coins and gold

bullion, foreign securities, rupee coins, Government of India Securities and

bills of exchange and promissory notes eligible for purchase by the bank.

The RBI has issued notes in the denominations of Rs.2, 5, 10, 20, 50, 100,

500 and 1000.

Serving as banker to the Government.

The Reserve Bank of India acts as a banker to the Central and State

Governments. It is obligatory for the bank to transact government business

including the management of the public debt of the Central Government.


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The Central Government has to entrust the bank all its money, remittance,

exchange and banking transactions in India and deposit all its cash balances

with the Reserve Bank. Reserve Bank also performs similar functions on

behalf of the State Governments. The RBI has entered into agreements with

the central and state governments for carrying on these functions. Thus, the

RBI accepts money on account of the governments, makes payment on their

behalf and carries out other banking transactions such as exchange and

remittances.

Acting as bankers’ bank and supervisor.

The RBI has been vested with extensive powers to control commercial

banking system under the Reserve Bank of India Act, 1934 and the Banking

Regulation Act, 1949. Thus, Reserve Bank is the banker to the banks- i.e.

commercial, cooperative and Regional Rural Banks. This relationship is

established when the name of the bank is included in the second schedule to

the Reserve Bank of India Act, 1934. All banks having paid up capital and

reserves of Rs.5 Lakhs or more are included in the second schedule of the

RBI. These banks are called Schedule banks. All Scheduled banks are under

a statutory obligation to maintain a certain minimum of cash reserve with the

RBI against their demand and time liabilities.

Exchange management and control.

The RBI is required to stabilize the external value of rupee achieves this

objective through the domestic policies and the regulation of the foreign

exchange market. RBI functions as the custodian of the country’s foreign

exchange reserves. It is obligatory for the RBI to buy and sell currencies of


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all the members of the IMF. The RBI administers the exchange control in

terms of the Foreign Exchange Regulation Act, 1973.

Agricultural Finance.

The Agricultural Credit Department of the Reserve Bank is an unique

example of central banks of developed countries. When the integrated

Scheme of agricultural credit was implemented, the RBI assumed certain

new responsibilities and with it there was a clear transformation in the role

of RBI from that of a lender of last resort to that of an active agency for the

promotion of appropriate specialized agencies of agriculture finance. Major

functions of the Agriculture Credit Department of the Reserve Bank were

taken over by the National Bank for Agriculture and Rural Development

(NABARD) from July, 12, 1982.

Credit Control:

The Principal function of a central bank is credit control. Reserve Bank of

India exercises control over the credit granted by the commercial banks in

the following manner:

o Changing the statutory requirements regarding maintenance of liquid

assets i.e. statutory liquidity ratio.

o Issuing directions under Section 21 of the Banking Regulation Act,

1949. These directions are related to the purpose of advances, margin

to be maintained, maximum amount of advance, etc.

o Changing the Statutory Reserve Ratio maintained by scheduled banks

with the RBI i.e. Cash Reserve Ratio.


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o Changing the bank rate and its policy of granting accommodation to

the commercial banks.

o Exercising moral influence on the banks.

Industrial Finance

Export Finance.

Institutional promotion.

1.4 M onetary Policy of India:-

a. The Monetary and Credit Policy is the policy statement, through which the

Reserve Bank of India seeks to ensure price stability for the economy. These

factors include - money supply, interest rates and the inflation. In banking

and economic terms money supply is referred to as M3 - which indicates the

level (stock) of legal currency in the economy.

b. Besides, the RBI also announces norms for the banking and financial sector

and the institutions which are governed by it. These would be banks,

financial institutions, non-banking financial institutions and primary dealers

(money markets) and dealers in the foreign exchange (forex) market. The

Monetary Policy has become dynamic in nature as RBI reserves its right to

alter it from time to time, depending on the state of the economy.

c. However, with the share of credit to agriculture coming down and credit

towards the industry being granted whole year around, the RBI since 1998-

99 has moved in for just one policy in April-end. However a review of the


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policy does take place later in the year. The Monetary Policy regulates the

supply of money and the cost and availability of credit in the economy. It

deals with both the lending and borrowing rates of interest for commercial

banks.

d. The Monetary Policy aims to maintain price stability, full employment and

economic growth. The Reserve Bank of India is responsible for formulating

and implementing Monetary Policy. It can increase or decrease the supply of

currency as well as interest rate, carry out open market operations, control

credit and vary the reserve requirements. The Monetary Policy is different

from Fiscal Policy as the former brings about a change in the economy by

changing money supply and interest rate, whereas fiscal policy is a broader

tool with the government.


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e. The Fiscal Policy can be used to overcome recession and control inflation. It

may be defined as a deliberate change in government revenue and

expenditure to influence the level of national output and prices. For instance,

at the time of recession the government can increase expenditures or cut

taxes in order to generate demand. On the other hand, the government can

reduce its expenditures or raise taxes during inflationary times. Fiscal policy

aims at changing aggregate demand by suitable changes in government

spending and taxes. The annual Union Budget showcases the government's

Fiscal Policy.

Talking about the uses of Monetary Policy:-

1. Monetary policy cannot change long-term trend growth.

2. There is no long-term tradeoff between growth and inflation. (High

inflation can only hurt growth).

3. What monetary policy – at its best – can deliver is low and stable

inflation, and thereby reduce the volatility of the business cycle.

4. When inflationary pressures build up: raise the short-term interest rate

(the policy rate) which raises real rates across the economy which squeezes

consumption and investment.

Prior to recent liberalisation, the RBI resorted to direct instruments like

interest rates regulation, selective credit control and CRR (cash reserve ratio)

as monetary instruments. One of the risks emerging in the past 5-7 years

(through the capital flows and liberalisation of the financial sector) is that

potential risk has increased for institutions. Thus, financial stability has


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become crucial and there are concerns relating to credit flows to the

agricultural sector and small-scale industries. Instruments of Monetary

Policy in India:-

1. Net loans to central government (i.e. open market operations)

2. Net purchase of foreign currency assets

3. Change in cash reserve ratio

4. Changes in repo rate and reverse repo rate

5. Bank rate


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C HAPTER 2

B ASE R ATE AND ITS C ALCULATIONS

____________________________________________________2.1 INTRODUCTION

2.2 WHAT IS BASE RATE?

2.3 APPLICABILITY OF BASE RATE2.4 IMPACT

2.5 IMPACT ON HOME LOAN CUSTOMERS2.6 COMPUTATION OF THE BASE RATE

2.7 GUIDELINES ON THE BASE RATE


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C HAPTER 2

B ASE R ATE AND ITS C ALCULATIONS

2.1 I NTRODUCTION

A. Reserve Bank of India began prescribing the minimum rate of interest on

advances granted by Scheduled Commercial Banks with effect from

October 1, 1960. Effective 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.

B. 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.

In the following period, various sector-specific, programmed-specific and

purpose-specific interest rates were introduced.

C. 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, a new structure of lending rates

linking interest rates to the size of loan was prescribed which significantly

reduced the multiplicity and complexity of interest rates. In the case of the

Differential Rate of Interest Scheme under which credit was provided at a


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rate of 4.0 per cent per annum, and Export Credit, which was subject to an

entirely different regime of lending rates supplemented by interest rate

subsidies, the existing lending rate structure was continued.

D. 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, effective

October 18, 1994, it was decided to free the lending rates of scheduled

commercial banks for credit limits of over Rs. 2 lakhs for loans up to Rs. 2

lakhs it was decided that it was necessary to continue to protect these

borrowers by prescribing the lending rates and accordingly it was

prescribed that for loans up to and inclusive of Rs.2 lakh, the lending rates

of banks should not exceed the BPLR of the respective banks. For credit

limits of over Rs.2 lakh, the prescription of minimum lending rate was

abolished and banks were given the freedom to fix the lending rates for

such credit limits subject to BPLR and spread guidelines. Banks were

required to obtain the approval of their respective Boards for the

Benchmark Prime Lending Rate (BPLR), which would be the reference

rate for credit limits of over Rs.2 lakh. Each bank's BPLR has to be

declared and be made uniformly applicable at all branches.

E. The BPLR system, introduced in 2003, fell short of its original objective of

bringing transparency to lending rates. This was mainly because under the

BPLR system, banks could lend below BPLR. For the same reason, it was

also difficult to assess the transmission of policy rates of the Reserve Bank


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to lending rates of banks. Accordingly, based on the recommendations of

the Working Group on Benchmark Prime Lending Rate which submitted its

report in October 2009, banks have been advised to switch over to the

system of Base Rate with effect from July 1, 2010. The Base Rate system is

aimed at enhancing transparency in lending rates of banks and enabling

better assessment of transmission of monetary policy.

F. The introduction of base rate will ensure that if they are linked to it, they

will see automatic rise and fall in their existing rates. The Reserve Bank of

India has asked banks not to charge any fee for shifting from prime lending

rate to base rate. Importantly, even though banks are going to charge a fee

— in excess of 1.5 per cent in most cases — for renegotiating the loan, it

could still make sense in doing so. Once you have shifted to the latest rate,

this along with the linkage with base rate will ensure that future costs are

saved. “The PLR regime was stickier. Banks took a longer time to align

PLR with the interest rate movements. However, only home loan rates will

be impacted by this. All other retail loans, like auto and personal, are given

at fixed interest rate.

G. From July 1, banks will move to a new, more transparent regime of loan

pricing. They will jettison the Benchmark Prime Lending Rate (BPLR) and

price loans off a base rate.

H. Unlike the BPLR that was set somewhat arbitrarily by banks, the base rate

will follow an explicit formula that factors in a bank’s cost of deposits,


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operating costs (expenses of running its branches, for instance), the cost of

statutory drafts on bank funds imposed by the Reserve Bank of India (the

Cash Reserve Ratio and Statutory Liquidity Ratio) and the profit margin.

I. The base rate will help borrowers to compare interest rates offered by

various banks and make the process of how banks arrive at interest rates for

loans more transparent.

J. RBI has stipulated that banks cannot charge below the base rate for most

loans. (There are a couple of exceptions like agricultural loans and export

credit.) While the new model will ensure greater transparency, it need not

mean lower lending rates for borrowers.

K. In fact, banks’ blue-chip corporate borrowers could see some increase in

their cost of borrowing. The reason is somewhat simple. RBI allowed

banks to lend below their prime lending rates and the majority of banks did

the bulk of their corporate lending at ’sub-PLR rates’.

L. The new reference rate for country’s largest bank is 7.5 per cent. Most of

the other public sector banks have the base rate at 8 per cent. These

include, IDBI Bank, Indian Bank, Bank of Baroda, Allahabad Bank and

Punjab National bank. HDFC Bank has set the rate at 7.25 per cent.

M. The best ‘credits’ for a bank could drive the hardest bargains. This led to

peculiar situations in which a bank whose official BPLR was in the range


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of 14-16 per cent was found lending to its best customers way below its

costs at 5-6 per cent.

N. The incentive for this ‘irrational’ pricing was to keep the ratio of non-

performing assets low, particularly in the wake of the global financial crisis

when banks’ risk appetite waned and safety got precedence over margins.

The base rate regime does away with this.

2.2 W hat is Base Rate?

A. The Base Rate system, replace the BPLR system with effect from July 1,

2010. For loans sanctioned up to June 30, 2010, BPLR will be applicable as

given in Annex2. However, for those loans sanctioned up to June 30, 2010

which comes up for renewal from July 1, 2010 onwards, Base Rate would be

applicable. Base Rate shall include all those elements of the lending rates

that are common across all categories of borrowers. Banks may choose any

benchmark to arrive at the Base Rate for a specific tenor that may be

disclosed transparently. Banks are free to use any other methodology, as

considered appropriate, provided it is consistent and are made available for

supervisory review/scrutiny, as and when required.

B. Banks may determine their actual lending rates on loans and advances with

reference to the Base Rate and by including such other customer specific

charges as considered appropriate.


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C. In order to give banks some time to stabilize the system of Base Rate

calculation, banks are permitted to change the benchmark and methodology

any time during the initial six month period, i.e. end-December 2010.

D. The actual lending rates charged should be transparent and consistent and be

made available for supervisory review/scrutiny, as and when required. There

can be only one Base Rate for each bank. Banks have the freedom to choose

any benchmark to arrive at a single Base Rate which should be disclosed

transparently.

E. Even after introduction of the Base Rate system, banks would have the

freedom to offer all categories of loans on fixed or floating rates. Where

loans are offered on fixed rate basis, notwithstanding the quarterly review of

the Base Rate, the rate of interest on fixed rate loans will continue to remain

the same subject to the condition that such fixed rate should not be below the

Base Rate.

2.3 A pplicability of Base Rate

A. With effect from July 1, 2010, all categories of loans should be priced only

with reference to the Base Rate.

However, the following categories of loans could be priced without

reference to the Base Rate: (a) DRI advances (b) loans to banks’ own

employees (c) loans to banks’ depositors against their own deposits.


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In those cases where subvention is available to borrowers, it is clarified as

under:

(i) Interest Rate Subvention on Crop Loans a) In case of crop loans up to Rupees three lakh, for which subvention is

available, banks should charge farmers the interest rates as stipulated by the

Government. If the yield to the bank (after including subvention) is lower

than the Base Rate, such lending will not be construed to be volatile of the

Base Rate guidelines.

b) As regards the rebate provided for prompt repayment, since it does not

change the yield to the banks [mentioned at (a) above] on such loans, it

would not be a factor in reckoning compliance with the Base Rate

guidelines.

(ii) Interest Rate Subvention on Export Credit It has already been clarified, vide our circular DBOD.Dir.

(Exp).BC.No.102/04.02.001/ 2009-10 dated May 6, 2010 that interest rates

applicable for all tenors of rupee export credit advances will be at or above

the Base Rate. In cases where subvention is available in terms of our

Circular DBOD.Dir. (Exp.).BC.No.94/04.02.001/2009-10 dated April 23,

2010; banks will have to reduce the interest rate chargeable to exporters as

per Base Rate system by the amount of subvention available. If, as a

consequence, the interest rate charged to exporters goes below the Base

Rate, such lending will not be construed to be volatile of the Base Rate

guidelines.


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B. Restructured Loans

a. In case of Restructured loans if some of the WCTL, FITL, etc. need to be

granted below the Base Rate for the purposes of viability and there are

recompense etc. clauses, such lending will not be construed to be volatile of

the Base Rate guidelines.

b. The Base Rate could also serve as the reference benchmark rate for floating

rate loan products, apart from 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.

c. Changes in the Base Rate shall be applicable in respect of all existing loans

linked to the Base Rate, in a transparent and non-discriminatory manner.

d. Since the Base Rate will be the minimum rate for all loans, banks are not

permitted to resort to any lending below the Base Rate. Accordingly, the

current stipulation of BPLR as the ceiling rate for loans up to Rs. 2 lakh

stands withdrawn. It is expected that the above deregulation of lending rate

will increase the credit flow to small borrowers at reasonable rate and direct

bank finance will provide effective competition to other forms of high cost

credit.

e. Banks are required to review the Base Rate at least once in a quarter with the

approval of the Board or the Asset Liability Management Committees

(ALCOs) as per the bank’s practice. Since transparency in the pricing of


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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 to

the Reserve Bank on a quarterly basis, as hitherto.

f. The Base Rate system would be applicable for all new loans and for those

old loans that come up for renewal. Existing loans based on the BPLR

system may run till their maturity. In case existing borrowers want to switch

to the new system, before expiry of the existing contracts, an option may be

given to them, on mutually agreed terms. Banks, however, should not charge

any fee for such switch-over.

g. Interest rates under the BPLR system are applicable to all existing loans

sanctioned up to June 30, 2010. However, wherever loans sanctioned up to

June 30, 2010 come up for renewal from July 1, 2010, the Base Rate system

would be applicable. The guidelines on Benchmark Prime Lending Rate

(BPLR) and Spreads and its determination for existing loans sanctioned up

to June 30, 2010 are given in Annex 3 and Annex 4.


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2.4 I mpact:

A. Short-term rates for large corporates might inch up:

Ample liquidity and relatively subdued credit demand over FY10 had led to

many large corporates borrowing at significantly low rates. Application of

the illustrative formula (as provided by the RBI) to most banks reveals that

base rates could vary between 8% to 9.5% (see Annexure). With most banks

setting their base rates around these levels, we believe that short-term rates

for large corporates could inch up.

B. Teaser rates would come under pressure

RBI has taken a negative view of the recent “teaser rate” schemes launched

by major banks. RBI expects banks to be more prudent in pricing the risk

and do not lose sight of asset quality while chasing market share (in wake of

subdued credit demand). We believe that such “teaser rate” schemes would

come under pressure as base rates are expected to higher than the rates

offered on such schemes.

C. Increased transparency on lending rates

Over Oct-08 to Dec-09, while banks’ cost of deposits declined significantly,

the movement in BPLR’s was relatively less and did not adequately reflect

the effective lending rates in the economy. Moreover, ample liquidity in the

system and the subdued demand for bank credit had increased the

competitive pressure on banks to lend at sub-BPLR rates. As a consequence,


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the BPLRs of banks have turned out to be the maximum lending rates in

most cases, distorting the information content.

D. Faster transmission of policy rate changes

We believe the base rate system has directly linked headline lending rates in

the economy to banks’ cost of deposits. The RBI, over the past 3-4 quarters,

had repeatedly sounded concern that while transmission of policy rate

changes (over Sep-08 to Apr-09) had been faster in the money and

government securities markets, it had been slow to the banks’ lending rates.

The RBI’s present action is to encourage faster transmission of policy rate

changes to banks’ lending rates as the base rate would be directly linked to

banks’ cost of deposits.

E. Home and auto loans

It is unlikely that the home and auto loan rates will be cheaper under the new

system. Under the BPLR system banks had different rates for home and auto

loans and the same may continue in the future. Since such retail loans are

given to individuals based on their creditworthiness and valuation of

mortgage, banks will factor in credit risk and charge a rate above the base

rate.

F. Big borrowers:

As per the earlier system big and high creditworthy borrowers were the

kings. Chased by banks, they bargained hard to extract maximum possible

discount on BPLR. Now also they will continue to get money close to the

base rate. To collect funds below the base rate, corporates will also float of


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commercial papers for short term money and debentures for medium term

borrowings with low interest rates. Since buying such instruments will be

treated as investments, they will not come under the base rate stipulation.

Banks, however, will have limited exposures in such securities because their

prices will vary in the market requiring provisions for loss of value under

‘mark to market’ accounting norms.

G. Small borrowers:

Companies with lower credit ratings and small & medium businesses may

get marginal benefit under the new system. All these days they were fleeced

by banks by way of higher interest rates in the garb of high credit risk.

Under the new system banks will charge risk premium to the relatively

weaker borrowers, however, if the interest rate is too high from the base rate

they will find it hard to justify. Transparency in base rate calculation may

arm weaker borrowers to question unrealistic high rates.

2.5 I mpact on Home loan Customers :-

But not all home loan customers would benefit linking their loans to the new

benchmarking system. For example, if you have taken a teaser loan just few

months back, it would still make sense to stick to it.

And with SBI planning to continue its teaser rate of 8 per cent for the next

three months, borrowers would continue to benefit.

“In dual rate (or teaser) loans, a borrower gets fixed rates for the initial

years. This means, there is predictability of monthly outgo for this period


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and the borrower, in turn can plan his finance accordingly without bothering

about interest rate fluctuation,” said a certified financial planner.

For an existing borrower, there are some situations in which they will benefit

by shifting. In other cases, it may not make much difference.

A. Less than one year: If you have taken the loan just a year back, around 90

per cent of the equated monthly installment (EMI) goes towards repayment

of interest and the rest towards principle.

If serving a floating rate loan for less than two years, financial planner said it

makes sense to shift the loan – even if the lender is charging you an interest

of 9-9.5 per cent.

When a person shifts to base rate, the interest is likely to remain the same. In

addition, shifting is free. Shifting early to the new benchmark would only

help to get the benefits earlier. And if the existing loan rate is around 1-2 per

cent lower than your existing rate, it makes sense to renegotiate as well.

Of course, there will be a charge. But you can easily get into a new regime

which is completely new and more sensitive to changes.

B. 2 to 5 years: There is a strong possibility that such borrowers are stuck at

higher floating rates of 12-13 per cent. It certainly makes sense for them to

shift from their existing rates to new ones. And by paying the renegotiating

charges as well.

Other customers should shift to the base rate as even in the fifth year, the

interest portion is as over 40 per cent if the tenure is 15 years and more for

loans with longer tenure.


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There are customers who fixed their loan rate at 7.5-8 per cent in 2003-04

periods; it makes less sense for them to shift. Especially, if their loan rate is

fixed for the entire tenure.

C. 5 to 10 years: This is a crucial period to decide whether to shift or not. For a

15-year loan, two-third of the loan is repaid. For 20-year loan, the interest

portion in the tenth year is still more than principle.

“There are chances that a person has brought the tenure further down by

prepaying a portion of the loan as and when possible,” said a certified

financial planner. A person can stick to the BPLR who has 15-year tenure.

For loans over 15 years, base rate would make sense as there are still many

years left to service the loan.

D. Over 10 years: If your loan tenure is of 20 years, almost 50 per cent of the

time period is remaining. But the good part is that most of the interest

payout has taken place.

1. During these years, the principle portion in the EMI accounts for 60 per cent

or more, as you get closer to repaying the loan. Shifting to base rate is a

tough call in such a situation.

2. Do your math and compare the advantages of BPLR vis-a-vis base rate. If

you have more than three years to repay the loan and you still saving money

on the EMI, go for it.


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3. Shift to base rate anyway. Because it will ensure that you get the advantage

of loan rate fluctuations.

4. As far as renegotiations go, it would be a decision based on the tenure that is

remaining, and your finances.

5. If the blue-chips stand to lose in the new regime, who stands to gain? Some

would argue that banks ’subsidized’ the low-cost loans to their prime

borrowers by charging hefty rates from smaller, riskier borrowers — small

and medium enterprises and households, for example.

6. Those who argue this claim that once banks are forced to price loans in line

with their costs, these ’subsidies’ are likely to disappear and the segments

that arguably need the money the most are likely to get fairer rates.

7. The other thing that the base rate could prevent to a degree is what

regulators term ‘predation’ — the phenomenon of large banks dropping loan

rates way below costs to grab market share.

8. There have been recent instances of predation in retail credit markets

breeding the risk of credit bubbles building up on the back of these

exceptionally cheap loans.

9. From a monetary policy perspective, a transparent basis for credit pricing

should make the transmission of policy impulses to actual lending rates

more efficient.


29


10. It would at least provide a better gauge of whether monetary policy changes

are making a difference to borrowing and lending rates on the ground. There

is a case to be made for some structural changes in the policy rates as well.

11. As the current liquidity crunch in the banking system has shown, the wide

gap of one-and-half percentage points between the reverse repo and the repo

rates drives a large swing in short-term interest rates as the banking system

goes from surplus to deficit and vice versa.

12. This volatility is perhaps undesirable and can be ironed out by reducing this

gap. A hike in the reverse repo rate, keeping the repo rate unchanged in the

RBI’s July 27 Monetary Policy could do the trick.


30


2.6 C OMPUTATION OF THE BASE RATE:-

Base Rate=𝒂+𝒃+𝒄+𝒅

a - Cost of Deposits=𝐷𝑐𝑜𝑠𝑡

b - Negative Carry on CRR and SLR= 𝐷𝑐𝑜𝑠𝑡− 𝑆𝐿𝑅∗𝑇𝑟 1− 𝐶𝑅𝑅+𝑆𝐿𝑅 ∗100 −𝐷𝑐𝑜𝑠𝑡

c - Unallocatable Overhead Cost= 𝑈𝑐𝐷𝑝𝑙𝑦 100 ∗d - Average Return on Net Worth= 𝑁𝑃𝑁𝑊 ∗ 𝑁𝑊𝑇𝐿 ∗100

Where: 𝐷𝑐𝑜𝑠𝑡∶Cost of Deposits

𝐷∶Total Deposits= Time Deposits + Current Deposits + Saving Deposits

𝐷𝑝𝑙𝑦∶ Deployable Deposits

=Total deposits less share of deposits locked as CRR and SLR balances,.

=𝐷 1− ∗ 𝐶𝑅𝑅+𝑆𝐿𝑅

CRR : Cash Reserve Ratio

SLR : Statutory Liquidity Ratio 𝑇𝑟∶ 364 T-Bill Rate

𝑈𝑐∶Unallocatable Overhead Cost


31


NP : Net Profit

NW : Net Worth = Capital + Free Reserves

TL : Total Liabilities

Negative Carry on CRR and SLR

Negative Carry on CRR and SLR =

Negative carry on CRR and SLR balances arises because the return on CRR

balances is nil, while the return on SLR balances (proxied using the 364-day

Treasury Bill rate) is lower than the cost of deposits. Negative carry on CRR

and SLR is arrived at in three steps. In the first step, return on SLR

investment was calculated using 364-day Treasury Bills. In the second step,

effective cost was calculated by taking the ratio (expressed as a percentage)

of cost of deposits (adjusted for return on SLR investment) and deployable

deposits (total deposits less the deposits locked as CRR and SLR balances).

In the third step, negative carry cost on SLR and CRR was arrived at by

taking the difference between the effective cost and the cost of deposits.

Unallocatable Overhead Cost

Unallocatable Overhead Cost=


32


Unallocatable Overhead Cost is calculated by taking the ratio (expressed as a

percentage) of unallocated overhead cost and deployable deposit.

Average Return on Net Worth

Average Return on Net Worth=

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.

a. Since no bank will be permitted to give loans below the base rate, large

companies, which had been getting loans lower than the benchmark prime

lending rate, will now have to pay as much as 200 basis points more as per

the Bankers. The most important thing to keep in mind is that the cost of

money is not changing, i.e., if my car loan cost about 12% or home loan cost

9%, this rate of interest charged to me will be no different going forward.

It’s just that the method used to arrive at this will be clearer. So, interest

rates aren’t coming down as a result of this base rate implementation.

b. Following on from this, EMI on an existing loan is also not going to change.

We will continue to pay whatever we were paying up to last month in future

months as well. The most common question that has been arising in the

minds of the people is that should they shift to the Bank with the lower base

rate? But shifting to the Bank with lower base rate will not be able to do

major difference.


33


c. Banks will now be more precise in selecting the premium for risk and

tenure, resulting in an increase in the loan rates to the corporate sector, Cost

of borrowing will slightly increase, and to the extent money is borrowed

from the banks. Once a base rate is determined, bank will not be able to give

a loan to any corporate below the base rate. At this moment, there are some

AAA companies who are enjoying a 7–7.5 per cent rate according to the

bankers.

d. At least six other public sector banks, including Punjab National Bank and

Bank of Baroda, announced their base rate—all pegging it at 8%. Private

Banks, including ICICI Bank Ltd, India’s second largest lender. For every

bank, the base rate is lower than the BPLR which it replaces, but that does

not necessarily mean that the cost of money will decline for borrowers. This

is because no bank will be allowed to price loans cheaper than the base rate.

The new regime has been put in place by the Reserve Bank of India to

ensure that small businesses don’t end up subsidizing below-BPLR

borrowings by top-rated firms that have been able to raise funds at much

lower rates.

e. Until now, around 70% of borrowers have been raising money at below

BPLR. Although the BPLR of most public sector banks ranges between

11.5% and 12.5%, triple A-rated corporate borrowers were raising short-

term loans at a rate as low as 6.75-7%. Private Banks are expected to set

their base rate lower, but their public sector counterparts are not worried

about losing customers to the competition.


34


2.7 G UIDELINES ON THE BASE RATE

Following the announcement in the Annual Policy Statement for the year

2009-10, Reserve Bank of India constituted a Working Group on

Benchmark Prime Lending Rate (Chairman: Shri Deepak Mohanty) to

review the present benchmark prime lending rate (BPLR) system and

suggest changes to make credit pricing more transparent. The Working

Group submitted its report in October 2009 and the same was placed on the

Reserve Bank’s website for public comments. Based on the

recommendations of the Group and the suggestions from various

stakeholders, the draft guidelines on Base Rate were placed on the Reserve

Bank’s website in February 2010.

In the light of the comments/suggestions received, it has been decided that

banks switch over to the system of Base Rate. The BPLR system, introduced

in 2003, fell short of its original objective of bringing transparency to

lending rates. This was mainly because under the BPLR system, banks could

lend below BPLR. For the same reason, it was also difficult to assess the

transmission of policy rates of the Reserve Bank to lending rates of banks.

The Base Rate system is aimed at enhancing transparency in lending rates of

banks and enabling better assessment of transmission of monetary policy.

Accordingly, the following guidelines are issued for implementation by

banks.


35


i. The Base Rate system will replace the BPLR system with effect from July

1, 2010. Base Rate shall include all those elements of the lending rates that

are common across all categories of borrowers. Banks may choose any

benchmark to arrive at the Base Rate for a specific tenor that may be

disclosed transparently. Banks are free to use any other methodology, as

considered appropriate, provided it is consistent and are made available for

supervisory review/scrutiny, as and when required.

ii. Banks may determine their actual lending rates on loans and advances

with reference to the Base Rate and by including such other customer

specific charges as considered appropriate.

iii. In order to give banks some time to stabilize the system of Base Rate

calculation, banks are permitted to change the benchmark and methodology

any time during the initial six month period i.e. end-December 2010.

iv. The actual lending rates charged may be transparent and consistent and

be made available for supervisory review/scrutiny, as and when required.

v. All categories of loans should henceforth be priced only with reference to

the Base Rate. However, the following categories of loans could be priced

without reference to the Base Rate: (a) DRI advances (b) loans to banks’

own employees (c) loans to banks’ depositors against their own deposits.


36


vi. The Base Rate could also serve as the reference benchmark rate for

floating rate loan products, apart from 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.

vii. Changes in the Base Rate shall be applicable in respect of all existing

loans linked to the Base Rate, in a transparent and non-discriminatory

manner.

viii. Since the Base Rate will be the minimum rate for all loans, banks are

not permitted to resort to any lending below the Base Rate. Accordingly, the

current stipulation of BPLR as the ceiling rate for loans up to Rs. 2 lakh

stands withdrawn. It is expected that the above deregulation of lending rate

will increase the credit flow to small borrowers at reasonable rate and direct


credit.

ix. Reserve Bank of India will separately announce the stipulation for

export credit.

x. Banks are required to review the Base Rate at least once in a quarter with

the approval of the Board or the Asset Liability Management Committees

(ALCOs) as per the bank’s practice. 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


37


from time to time through appropriate channels. Banks are required to

provide information on the actual minimum and maximum lending rates to

the Reserve Bank on a quarterly basis, as hitherto.

xi. The Base Rate system would be applicable for all new loans and for those

old loans that come up for renewal. Existing loans based on the BPLR

system may run till their maturity. In case existing borrowers want to switch

to the new system, before expiry of the existing contracts, an option may be

given to them, on mutually agreed terms. Banks, however, should not charge

any fee for such switch-over.

xii. In line with the above Guidelines, banks may announce their Base Rates

after seeking approval from their respective ALCOs/ Boards.

xiii. The above guidelines on the Base Rate system will become effective on

July 1, 2010.


38


C HAPTER 3

C ASH R ESERVE R ATIO & S TATUTORY R ESERVE

R ATIO

__________________________________________________3.1 CASH RESERVE RATIO

3.2 STATUTORY LIQUIDITY RATIO (SLR)3.3 REPO RATE

3.4 REVERSE REPO

3.5 BANK RATE


39


C HAPTER 3

C ASH RESERVE R ATIO & S TATUTORY R ESERVE

R ATIO

3.1 C ASH RESERVE RATIO

With a view to monitoring compliance with statutory reserve requirements

viz. Cash Reserve Ratio and Statutory Liquidity Ratio by the Scheduled

Commercial Banks, Reserve Bank of India has prescribed statutory returns

i.e. Form A return (for CRR) under Section 42 (2) of the RBI, Act, 1934 and

Form VIII return (for SLR) under Section 24 of the Banking Regulation Act,

1949. The broad details of the reserve requirements are summarized below.

A. Maintenance of CRR

In terms of Section 42(1) of the RBI Act 1934, Scheduled Commercial

Banks are required to maintain with RBI an average cash balance, the


40


amount of which shall not be less than three per cent of the total of the Net

Demand and Time Liabilities (NDTL) in India, on a fortnightly basis and

RBI is empowered to increase the said rate of CRR to such higher rate not

exceeding twenty percent of the Net Demand and Time Liabilities (NDTL)

under the RBI Act, 1934. At present, effective from the fortnight beginning

June 14, 2003, the rate of CRR is 4.50 per cent of the NDTL.

B. Maintenance of incremental CRR

In terms of Section 42(1A) of RBI Act, 1934, the Scheduled Commercial

Banks are required to maintain, in addition to the balances prescribed under

Section 42(1) of the Act, an additional average daily balance, the amount of

which shall not be less than the rate specified by the RBI in the notification

published in the Gazette of India, such additional balance being calculated

with reference to the excess of the total of the NDTL of the bank as shown

in the return referred to in section 42(2) of the RBI Act, 1934 over the total

of its NDTL at the close of the business on the date specified in the

notification. At present no incremental CRR is required to be maintained by

the Scheduled Commercial Banks.

C. Computation of Demand and Time Liabilities

Liabilities of a bank may be in the form of demand or time deposits or

borrowings or other miscellaneous items of liabilities. Liabilities of the

banks may be towards banking system (as defined under Section 42 of RBI

Act, 1934) or towards others in the form of Demand and Time deposits or


41


borrowings or other miscellaneous items of liabilities. Reserve Bank of India

has been authorized in terms of Section 42 (1C) of the RBI Act, 1934 to

classify any particular liability and hence for any doubt regarding

classification of a particular liability, the banks are advised to approach RBI

for necessary clarification.

D. Demand Liabilities

'Demand Liabilities' include all liabilities which are payable on demand and

they include current deposits, demand liabilities portion of savings bank

deposits, margins held against letters of credit/guarantees, balances in

overdue fixed deposits, cash certificates and cumulative/recurring deposits,

outstanding Telegraphic Transfers (TTs), Mail Transfer (MTs), Demand

Drafts (DDs), unclaimed deposits, credit balances in the Cash Credit account

and deposits held as security for advances which are payable on demand.

Money at Call and Short Notice from outside the Banking System should be

shown against liability to others.

E. Time Liabilities

Time Liabilities are those which are payable otherwise than on demand and

they include fixed deposits, cash certificates, cumulative and recurring

deposits, time liabilities portion of savings bank deposits, staff security

deposits, margin held against letters of credit if not payable on demand,

deposits held as securities for advances which are not payable on demand,

India Millennium Deposits and Gold Deposits.


42


F. Borrowings from banks abroad

Loans/borrowings from abroad by banks in India will be considered as

'liabilities to others' and will be subject to reserve requirements.

G. Arrangements with correspondent banks for remittance facilities

When a bank accepts funds from a client under its remittance facilities

scheme, it becomes a liability (liability to others) in its books. The liability

of the bank accepting funds will extinguish only when the correspondent

bank honours the drafts issued by the accepting bank to its customers. As

such, the balance amount in respect of the drafts issued by the accepting

bank on its correspondent bank under the remittance facilities scheme and

remaining unpaid should be reflected in the accepting bank's books as an

outside liability and the same should also be taken into account for

computation of NDTL for CRR/SLR purpose. The amount received by

correspondent banks has to be shown as 'Liability to the Banking System' by

them and not as 'Liability to others' and this liability could be netted off by

the correspondent banks against the inter-bank assets. Likewise sums placed

by banks issuing drafts/interest/dividend warrants are to be treated as 'Assets

with Banking System' in their books and can be netted off from their inter-

bank liabilities.


43


H. Other Demand and Time Liabilities (ODTL)

Other Demand and Time Liabilities (ODTL) include interest accrued on

deposits, bills payable, unpaid dividends, suspense account balances

representing amounts due to other banks or public, net credit balances in

branch adjustment account, any amounts due to the "Banking System" which

are not in the nature of deposits or borrowing. Such liabilities may arise due

to items, like (i) collection of bills on behalf of other banks, (ii) interest due

to other banks and so on. If a bank cannot segregate from the total of "Other

Demand and Time Liabilities" (ODTL) the liabilities to the banking system,

the entire 'Other Demand and Time Liabilities' may be shown against item II

( c ) 'Other Demand and Time Liabilities' of the return in Form 'A' and

average CRR is required to be maintained on it by all Scheduled

Commercial Banks; Participation Certificate issued to other banks, the

balances outstanding in the blocked account pertaining to segregated

outstanding credit entries for more than 5 years in inter branch adjustment

account, the margin money on bills purchased / discounted and gold

borrowed by banks from abroad, also should be included in ODTL.

I. Procedure for calculation of CRR

In order to improve the cash management by banks, as a measure of

simplification, a lag of one fortnight in the maintenance of stipulated CRR

by banks has been introduced with effect from the fortnight beginning 6th

November 1999. Thus, all Scheduled Commercial Banks are required to


44


maintain the prescribed Cash Reserve Ratio (@ 4.50 per cent with effect

from the fortnight beginning June 14, 2003).

J. Maintenance of CRR on daily basis

With a view to providing flexibility to banks in choosing an optimum

strategy of holding reserves depending upon their intra period cash flows, all

Scheduled Commercial Banks, are required to maintain minimum CRR

balances upto 70 per cent of the total CRR requirement on all days of the

fortnight with effect from the fortnight beginning December 28, 2002. If any

Scheduled Commercial Bank fails to observe the minimum level of CRR on

any day/s during the relevant fortnight, the bank will not be paid interest to

the extent of one fourteenth of the eligible amount of interest, even if there is

no shortfall in the CRR on average basis.

K. Penalties

Shortfall, if any, observed in the maintenance of the CRR is reckoned

against the eligible cash balances required to be maintained on the NDTL.

The total amount of interest payable so arrived at is being reduced by an

amount calculated at the rate of 25 per cent per annum on the amount of

shortfall. In a situation where shortfall exceeds the level at which no interest

becomes payable on eligible balances held by a bank on net basis i.e. (after

interest deduction on the amount of CRR shortfall) the penal interest under

sub-section (3) of Section 42 of the RBI Act, 1934 is made applicable.


45


3.2 S TATUTORY LIQUIDITY RATIO (SLR)

LR, or Statutory Liquidity Ratio is the amount of liquid assets, such

as cash, precious metals or other short-term securities, that a financial

institution must maintain in its reserves. The objectives of SLR are:

S1. To restrict the expansion of bank credit.

2. To augment the investment of the banks in Government securities.

3. To ensure solvency of banks. A reduction of SLR rates looks

eminent to support the credit growth in India.

In terms of Section 24 (2-A) of the B.R. Act, 1949 all Scheduled

Commercial Banks, in addition to the average daily balance which they are

required to maintain under Section 42 of the RBI Act, 1934, are required to

maintain in India,

a) in cash, or

b) in gold valued at a price not exceeding the current market price, or

c) in unencumbered approved securities valued at a price as specified by the

RBI from time to time. an amount of which shall not, at the close of the

business on any day, be less than 25 per cent or such other percentage not

exceeding 40 per cent as the RBI may from time to time, by notification in

gazette of India, specify, of the total of its demand and time liabilities in

India as on the last Friday of the second preceding fortnight, At present, all

Scheduled Commercial Banks are required to maintain a uniform SLR of 25

per cent of the total of their demand and time liabilities in India as on the last


46


Friday of the second preceding fortnight which is stipulated under section 24

of the B.R. Act, 1949.

A. Procedure for computation of demand and time liabilities for SLR

The procedure to compute total net demand and time liabilities for the

purpose of SLR under Section 24 (2) (B) of B.R. Act 1949 is similar to the

procedure followed for CRR purpose. However, it is clarified that Scheduled

Commercial Banks are required to include inter-bank term deposits / term

borrowing liabilities of original maturities of 15 days and above and up to

one year in ‘Liabilities to the Banking System'. Similarly banks should

include their inter-bank assets of term deposits and term lending of original

maturity of 15 days and above and up to one year in 'Assets with the

Banking System' for the purpose of maintenance of SLR. However, both the

above liabilities and assets are not to be included in liabilities/assets to the

banking system for computation of DTL/NDTL for the purpose of CRR as

mentioned in paragraph 2.3.7 above.

B. Valuation of approved securities for SLR

The entire investment portfolio of the banks (including SLR Securities) will

be classified under three categories viz.' Held to Maturity', 'Available for

sale' and 'Held for Trading'. Investment classified under Held to Maturity

category need not be marked to market and will be carried at acquisition cost

unless it is more than the face value. In such a case, the premium should be

amortized over a period remaining to maturity. Individual scrips in the


47


Available for Sale category will be marked to market at the year-end or at

more frequent intervals. The net depreciation under each classification

should be recognized and fully provided for and any appreciation should be

ignored. The book value of the individual securities would not undergo any

change after the revaluation. The individual scrips in the Held for Trading

category will be revalued at monthly or at more frequent intervals and net

appreciation/depreciation under each classification will be recognized in

income account. The book value of the individual scrip will be changed with

revaluation.

C. Penalties

If a banking company fails to maintain the required amount of SLR, it shall

be liable to pay to RBI in respect of that default, the penal interest for that

day at the rate of 3 per cent per annum above the bank rate on the shortfall

and if the default continues on the next succeeding working day, the penal

interest may be increased to a rate of 5 percent per annum above the Bank

Rate for the concerned days of default on the shortfall.

3.3 R EPO RATE

Repo rate is the rate at which our banks borrow rupees from RBI. This

facility is for short term measure and to fill gaps between demand and

supply of money in a bank .when a bank is short of funds they borrow from

RBI at repo rate .A reduction in the repo rate will help banks to get money at


48


a cheaper rate. When the repo rate increases borrowing from RBI becomes

more expensive. To borrow from RBI bank have to submit liquid bonds

/Govt Bonds as collateral security ,so this facility is a short term gap filling

facility and bank does not use this facility to Lend more to their customers.

3.4 R EVERSE REPO

Reverse Repo rate is the rate which is paid by RBI to banks on Deposit of

funds with RBI. ( present rate is 3.75 as on 02.07.2010)and if bank has a

surplus fund then they deposit the funds with RBI and earn interest at

Reverse repo rate.


49


3.5 B ANK RATE

Bank rate is the minimum rate at which the central bank provides loans to

the commercial banks. It is also called the discount rate. Usually, an increase

in bank rate results in commercial banks increasing their lending rates.

Changes in bank rate affect credit creation by banks through altering the cost

of credit. The bank rate signals the central bank's long-term outlook on

interest rates. If the bank rate moves up, long-term interest rates also tend to

move up, and vice-versa. Banks make a profit by borrowing at a lower rate

and lending the same funds at a higher rate of interest. If the RBI hikes the

bank rate, the interest that a bank pays for borrowing money (banks borrow

money either from each other or from the RBI) increases. It, in turn, hikes its

own lending rates to ensure it continues to make a profit. Currently the bank

rate is 6% (As on August 2010).


50


C HAPTER 4

B ENCHMARK P RIME L ENDING R ATE (BPLR)

____________________________________________________4.1 INTRODUCTION

4.2 BENCHMARK PRIME LENDING RATE (BPLR) AND SPREADS

4.3 DETERMINATION OF BENCHMARK PRIME LENDING RATE

(BPLR)

4.4 FREEDOM TO FIX LENDING RATES


51


C HAPTER 4

B ENCHMARK P RIME L ENDING R ATE ( BPLR )

4.1 I NTRODUCTION

a. Reserve Bank of India began prescribing the minimum rate of interest on

advances granted by Scheduled Commercial Banks with effect from

October 1, 1960. Effective 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. In the following

period, various sector-specific, programme-specific and purpose-specific

interest rates were introduced.

b. 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, a new structure of lending rates

linking interest rates to the size of loan was prescribed which significantly

reduced the multiplicity and complexity of interest rates. In the case of the

Differential Rate of Interest Scheme under which credit was provided at a

rate of 4.0 per cent per annum, and Export Credit, which was subject to an


52


c. entirely different regime of lending rates supplemented by interest rate

subsidies, the existing lending rate structure was continued.

d. 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, effective

October 18, 1994, it was decided to free the lending rates of scheduled

commercial banks for credit limits of over Rs. 2 lakh; for loans up to Rs. 2

lakh, it was decided that it was necessary to continue to protect these

borrowers by prescribing the lending rates. For credit limits of over Rs.2

lakh, the prescription of minimum lending rate was abolished and banks

were given the freedom to fix the lending rates for such credit limits. Banks

are now required to obtain the approval of their respective Boards for the

Benchmark Prime Lending Rate (BPLR), which would be the reference

rate for credit limits of over Rs.2 lakh. Each bank's BPLR has to be

declared and be made uniformly applicable at all branches.

4.2 B ENCHMARK PRIME LENDING RATE (BPLR) AND

SPREADS

a. 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


53


operational flexibility to commercial banks in deciding their lending rates,

1banks 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.

b. Given the prevailing credit market in India and the need to continue with

concessionality for small borrowers, the practice of treating BPLR as the

ceiling for loans up to Rs. 2 lakh will continue.

c. 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. BPLR will be made uniformly

applicable at all branches of a bank.

4.3 D etermination of Benchmark Prime Lending Rate (BPLR)

In order to enhance transparency in banks’ pricing of their loan products as

also to ensure that the BPLR truly reflects the actual costs, banks should be

guided by the following considerations while determining their Benchmark

PLR:

a) Banks should take into account their (i) actual cost of funds, (ii) operating

expenses and (iii) a minimum margin to cover regulatory requirement of

provisioning / capital charge and profit margin, while arriving at the


54


benchmark PLR. Banks should announce a Benchmark PLR with the

approval of their Boards.

b) The Benchmark PLR will be the ceiling rate for credit limit up to Rs.2

lakh.

c) All other lending rates can be determined with reference to the

Benchmark PLR arrived at as above by taking into account term premia

and / or risk premia.

Detailed guidelines on operational aspects of Benchmark PLR have been

issued by IBA on November 25, 2003.

In the interest of customer protection and to have greater degree of

transparency in regard to actual interest rates charged to borrowers, banks

should continue to provide information on maximum and minimum interest

rates charged together with the Benchmark PLR.

4.4 F reedom to fix Lending Rates

Banks are free to determine the rates of interest without reference to BPLR

and regardless of the size in respect of the following loans:

i. Loans for purchase of consumer durables;

ii. Loans to individuals against shares and debentures / bonds;

iii. Other non-priority sector personal loans including credit card dues;

iv. Advances / overdrafts against domestic / NRE / FCNR (B) deposits

with the bank, provided that the deposit/s stands / stand either in the


55


name(s) of the borrower himself / borrowers themselves, or in the

names of the borrower jointly with another person;

v. Finance granted to intermediary agencies including housing finance

intermediary agencies (list at Annex 2) for on-lending to ultimate

beneficiaries and agencies providing input support.;

vi. Discounting of Bills;

vii. Loans / Advances / Cash Credit / Overdrafts against commodities

subject to Selective Credit Control;

viii. To a co-operative bank or to any other banking institution;

ix. To its own employees;

x. Loans covered by refinance schemes of term lending institutions.


56


C HAPTER 5

B ASE R ATE V/S. B PLR R ATE

____________________________________________________5.1 BASE RATE OF BPLR RATE WHICH IS BETTER

5.2 WORKING GROUP ON BPLR

5.3 WHAT ARE THE MAIN RECOMMENDATIONS OF THE BPLR

GROUP?


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CHAPTER 5

BASE RATE V/S. BPLR RATE

5.1 B ASE RATE OF BPLR RATE WHICH IS BETTER

A. BPLR or Benchmark Prime Lending Rate is the rate charged by commercial

banks to their most credit worthy customers. According to the Reserve Bank

of India, banks are free to fix their BPLRs but the interest rates charged by

them have to bear relevance to the BPLR. Banks are free to fix BPLRs for

credit limit beyond Rs.2 lakhs. Lending rates for the agricultural sector was

set by the RBI.

B. Questions about the BPLR system being out of sync with market conditions

have been arising since quite some time. Customers were dissatisfied with

this system of lending as they felt banks lent money to strong and rich

corporate at sub BPLR rate. Lending operations in a bank act as a major aid

in the growth of the economy of a nation. It is through reasonable and just

lending rates that banks can direct fund flow in the economy for productive

purposes. Also the variation in BPLR was so wide amongst banks that it

stretched to over 4% sometimes.

C. Thus in order to come over all these delinquencies, the RBI appointed a

working group headed by Shri Deepak Mohanty to study the ongoing

activities pertaining to BPLR and hence present a report. The report was


58


submitted in October 2009. The working group in it report clearly mentioned

that it strongly felt that "The BPLR has tended to be out of sync with market

conditions and does not adequately respond to changes in monetary policy.

In addition, the tendency of banks to lend at sub-BPLR rates on a large scale

raises concerns of transparency.....On account of competitive pressures,

banks were lending at rates which did not make much commercial sense."

D. Thus the RBI, in a drive to initiate the replacement of the BPLR system of

lending came up with the base rate system. The base rate would include all

cost elements which can be clearly defined and are common to all

borrowers. The base rate is directed to come into effect from 1st April 2010.

The banks have been given the liberty to choose their own base rate.

E. The base rate would be calculated by banks based on four major factors:

a. cost of deposits

b. cost of adjustment for negative carry in respect of CRR and SLR

c. unallocatable overhead costs

d. profit margin

F. The actual rate charged to borrowers would be base rate plus borrower

specific charges depending on the credit risk premium and creditworthiness

of the borrower.

G. With the base rate system coming into play, the banks will no longer be

lending below the base rate as used to be the case with BPLR. This step is in


59


line with RBI's expectation that with deregulation in lending rates there will

be an increase in the credit flow to small borrowers.

H. Since lack of transparency in deciding the lending rates was one of the major

factors which led RBI to opt in for a new benchmark, so banks are needed to

exhibit information on their base rate to all their branches and also on their

website. Changes in the base rate will also have to be conveyed to the

general public using appropriate channels.

I. The base rate system will be applicable to all fresh loan applications and also

for old loans that have been demanded for renewal. If an existing borrower

wants to change to the new lending system then it can be done by the mutual

consent of both the customer and the respective bank.

J. Initially the base rate system was welcome by many criticisms arising from

the banks. Since this system allowed every bank to price its loan

individually so each bank would price its loan according to the cost of funds

and operating efficiencies. This implies that a bank with a higher CASA

ratio will benefit more than the one with a lower ratio.

K. CASA stands for current and savings account. The CASA ratio shows out of

the total deposits available with a bank, how much is attributable to current

and savings deposits.


60


L. An increased CASA ratio therefore would infer an increased source of funds

from current and savings account deposits. CASA provides more liquidity as

compared to term and demand deposits.

M. This infers that banks with high CASA ratios will benefit themselves and

banks with base rates at the higher end are sure to have a tuff time

competing in this highly competitive business. But in this race the customer

seems to be in a win-win scenario. As the banks fight for the best lending

rate, the customer gets to have the cherry of the cake.

N. Base rate as the name suggest, will be the base interest rate applicable to the

borrowers. It does not change the interest outgo on your existing or new

loans however it's pegged against a new base for all future calculations.

Borrowers continue to pay same interest rate and some banks might provide

an option of switching to base rate for its customers (even though the actual

money does not change). Even though banks are restricted from lending

below the Base rate, in certain situations they can do so, but only for short

term loans.


61


5.2 W ORKING GROUP ON BPLR

A. Why RBI wanted to replace the existing system of BPLR? What

prompted RBI to set up Working Group for review of BPLR?

While initiating the move to replace the existing system of BPLR, RBI felt

that the existing lending rate system had lost relevance and hindered

effective transmission of monetary policy signals. For example, RBI

reduced its benchmark lending rate by 425 basis points in the last one year,

but banks reduced their BPLR by about 200 basis point cut. This was

mainly because bulk of their lending was below their BPLR. Although,

prime rates (read BPLR) of Indian banks ranged between 11 percent and

15.75 percent, yet three-fourths of their total loans are made below these

levels because of competitive pressures in the fragmented banking sector.

The panel said while market conditions may necessitate lending below the

base rate, the need may be only for a short term. Besides, to ensure that such

lending does not proliferate, it should not exceed 15 percent.

B. Working Group on BPLR

The Reserve Bank announced the constitution of the Working Group on

Benchmark Prime Lending Rate (BPLR) in the Annual Policy Statement of

2009-10 (Chairman: Shri Deepak Mohanty) to review the BPLR system and

suggest changes to make credit pricing more transparent.

The Working Group was assigned the following terms of reference


62


(i) to review the concept of BPLR and the manner of its computation;

(ii) to examine the extent of sub-BPLR lending and the reasons thereof;

(iii) to examine the wide divergence in BPLRs of major banks;

(iv) to suggest an appropriate loan pricing system for banks based on

international best practices;

(v) to review the administered lending rates for small loans up to Rs 2

lakh and for exporters;

(vi) to suggest suitable benchmarks for floating rate loans in the retail

segment; and

(vii) Consider any other issue relating to lending rates of banks.

5.3 W hat are the main recommendations of the BPLR group? The main recommendations of the Group are as follows:

After carefully examining the various possible options, views of various

stakeholders from industry associations and those received from the public,

and international best practices, the Group is of the view that there is merit

in introducing a system of Base Rate to replace the existing BPLR system.

The proposed Base Rate will include all those cost elements which can be

clearly identified and are common across borrowers. The constituents of the

Base Rate would include (i) the card interest rate on retail deposit (deposits

below Rs. 15 lakh) with one year maturity (adjusted for CASA deposits);


63


(ii) adjustment for the negative carry in respect of CRR and SLR; (iii)

unallocatable overhead cost for banks which would comprise a minimum set

of overhead cost elements; and (iv) average return on net worth.

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.

The Working Group has worked out an illustrative methodology for

computing the base rate for the banks. According to this methodology with

representative data for the year 2008-09, the illustrative Base Rate works out

to 8.55 per cent.

With the proposed system of Base Rate, there will not be a need for banks to

lend below the Base Rate as the Base Rate represents the bare minimum rate

below which it will not be viable for the banks to lend. The Group, however,

also recognizes certain situations when lending below the Base Rate may be

necessitated by market conditions. This may occur when there is a large

surplus liquidity in the system and banks instead of deploying funds in the

LAF window of the Reserve Bank may prefer to lend at rates lower than

their respective Base Rates. The Group is of the view that the need for such

lending may arise as an exception only for very short-term periods.

Accordingly, the Base Rate system recommended by the Group will be

applicable for loans with maturity of one year and above (including all

working capital loans).


64


Banks may give loans below one year at fixed or floating rates without

reference to the Base Rate. However, in order to ensure that sub-Base Rate

lending does not proliferate, the Group recommends that such sub-Base Rate

lending in both the priority and non-priority sectors in any financial year

should not exceed 15 per cent of the incremental lending during the financial

year. Of this, non-priority sector sub-Base Rate lending should not exceed 5

per cent. That is, the overall sub-Base Rate lending during a financial year

should not exceed 15 per cent of their incremental lending, and banks will be

free to extend entire sub-Base Rate lending of up to 15 per cent to the

priority sector.

At present, at least ten categories of loans can be priced without reference to

BPLR. The Group recommends that such categories of loans may be linked

to the Base Rate except interest rates on (a) loans relating to selective credit

control, (b) credit card receivables (c) loans to banks’ own employees; and

(d) loans under DRI scheme.

The Base Rate could also serve as the reference benchmark rate for floating

rate loan products, apart from the other external market benchmark rates.

In order to increase the flow of credit to small borrowers, administered

lending rate for loans up to Rs. 2 lakh may be deregulated as the experience

reveals that lending rate regulation has dampened the flow of credit to small

borrowers and has imparted downward inflexibility to the BPLRs. Banks

should be free to lend to small borrowers at fixed or floating rates, which

would include the Base Rate and sector-specific operating cost, credit risk


65


premium and tenor premium as in the case of other borrowers.

The interest rate on rupee export credit should not exceed the Base Rate of

individual banks. As export credit is of short-term in nature and exporters

are generally wholesale borrowers, there is need to incentivize export credit

for exporters to be globally competitive. By this change in stipulation of

pricing of export credit, exporters can still access rupee export credit at

lower rates as the Base Rate envisaged is expected to be significantly lower

than the BPLRs. The Base Rate based on the methodology suggested by the

Group is comparable with the present lending rate of 9.5 per cent charged by

the banks to most exporters. The proposed system will also be more flexible

and competitive.

At present the interest rates on education loans are linked to ceilings with

reference to the BPLR. In view of the critical role played by education loans

in developing human resource skills, the interest rate on these loans may

continue be administered. However, in view of the fact that the Base Rate is

expected to be significantly lower than BPLR; the Group recommends that

there is a need to change the mark up. Accordingly, the Group recommends

that the interest rates on all education loans may not exceed.


66


C HAPTER 6

D ATA A NALYSIS AND I NTERPRETATION


67


C HAPTER 6

D ATA A NALYSIS AND I NTERPRETATION

D ifferent Base Rate of Banks and their fixed load

Allah

abad

Ban

k

Axis

Bank

Bank o

f Bar

oda

HDFC B

ank

HSBC B

ank

ICIC

I Ban

k

IDBI B

ank

Kotak M

ahind

ra B

ank

State

Ban

k of I

ndia

Union B

ank o

f Ind

ia0

2

4

6

8

10

12

Current base rate and load upto Rs.30 lakhs

In fixing base their these two things to be followed one is the fixed and other is

fixed load the base rate is variable but fixed load remains fixed for longer period of

time. The base can be changed but fixed load remains the same. In the above

diagram it shows base rate its fixed loads of different banks. We have taken data

from 10 banks to see how each bank loads its home loan. Remember that all other

loans will be prices in a similar fashion.


68


While most base rate announced till now are in a range of 7.2% - 8%, the

load for each bank varies from as low as 0.5% to as high as 6%.

For example, the base rate of IDBI Bank ltd is 8%. With a load of 0.75% for

loans between Rs.20 lakh and Rs.30 lakh over 15 years, the final interest rates

comes to 8.75% (base rate plus load). Similarly, for loans between Rs.30 lakh and

Rs.50 lakh for the same period, the load is 1% and, thus the final interest rate goes

up to 9%. Kotak Mahindra Bank Ltd, on the other hand, has a lower base rate of

7.25% and a higher load 1.25% for loans for salaried customers, irrespective of the

amount and tenor.

Allah

abad

Ban

k

Axis

Bank

Bank o

f Bar

oda

HDFC B

ank

HSBC B

ank

ICIC

i Ban

k

IDBI B

ank

Kotak M

ahind

ra

State

Ban

k of I

ndia

Union B

ank o

f Ind

ia0

2

4

6

8

10

12

Current Base and load above Rs.30 lakh


69


B ase Rate of Different Bank

P ublic Sector Bank

Bank Base Rate (p.a.)

State Bank of India7.50%

Federal Bank of India7.75%

State Bank of Mysore 7.75%

Corporation Bank7.75%

Bank of India 8.00%

Punjab Bank of India8.00%

Bank of Baroda 8.00%

Union Bank 8.00%

Central Bank of India 8.00%

Indian Bank 8.00%

UCO Bank 8.00%

IDBI Bank 8.00%

Canara Bank 8.00%

Vijaya Bank 8.25%

Indian Overseas Bank 8.25%

Most of the public sector banks have fixed their base between 8% and some fixed

to 7.50% - 7.75%


70


State

Ban

k of I

ndia

Fede

ral B

ank o

f Ind

ia

State

Ban

k of M

ysor

e

Corpo

ratio

n Ban

k

Bank o

f Ind

ia

Punja

b Ban

k of I

ndia

Bank o

f Bar

oda

Union B

ank

Centra

l Ban

k of I

ndia

Indian

Ban

k

UCO Ban

k

IDBI B

ank

Canar

a Ban

k

Vijay

a Ban

k

Indian

Ove

rseas

Ban

k7.00%

7.20%

7.40%

7.60%

7.80%

8.00%

8.20%

8.40%

Base Rate

Base Rate

Private Sector Bank

Bank Base Rate (p.a.)

HDFC Bank 7.25%

ICICI Bank 7.50%

Dhanlaxmi Bank 7.75%

Bank of Rajasthan 8.00%

Karur Vysya Bank 8.50%

HSBC Bank 7.00%


71


HDFC Bank

ICICI Bank Dhanlaxmi Bank

Bank of Rajasthan

Karur Vysya Bank

HSBC Bank

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%

Base Rate


72


Appendix -ICIRCULAR FROM RBI

Draft Circular

RBI/2009-10/ February , 2010

Ref.No.MPD.BC. /10.14.01/2009-10 Magha , 1931(S)

To,

All Scheduled Commercial Banks

Guidelines on the Base Rate

1. Following the announcement in the Annual Policy Statement for the year

2009-10, the Reserve Bank constituted a Working Group on Benchmark Prime

Lending Rate (Chairman: Shri Deepak Mohanty) to review the present

benchmark prime lending rate (BPLR) system and suggest changes to make

credit pricing more transparent. The Working Group submitted its report on

October 20, 2009 and it was placed on the Reserve Bank’s website for public

comments. After considering the recommendations of the Group and the

suggestions from various stakeholders, the Reserve Bank has decided as

follows:

2. The Base Rate system will replace the BPLR system with effect from April

1, 2010. Banks may 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


73


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. An illustration for computing the Base Rate is

set out in the Annex.

3. 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.

4. 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.

5. 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.

Accordingly, the current stipulation of BPLR as the ceiling rate for loans up to

Rs. 2 lakh stands withdrawn. It is expected that deregulation of lending rates

will increase the credit flow to small borrowers at reasonable rate. Thus, direct


credit.


74


6. Interest rates on loans under the DRI scheme will continue to be fixed

without reference to the Base Rate.

7. The Reserve Bank will separately announce the stipulation for export credit.

8. 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.

9. The Base Rate system would be applicable for all new loans and for those old

loans that come up for renewal. However, if the existing borrowers want to

switch to the new system before the expiry of the existing contracts, in such

cases the new/revised rate structure should be mutually agreed upon by the

bank and the borrower.


75


10. In line with the above Guidelines, banks may announce their Base Rates

after seeking approval from their respective Boards.

Kindly acknowledge receipt.

Yours faithfully,

(Janak Raj)

Adviser-in-Charge

Encl: As above.


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Annexure 2


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Annexure- 3


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base rate

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