RBI has decided to curb the current practice of banks using different benchmark rates for different customers. From April 1, 2010 all banks will have to use a single base rate that will be the reference rate for all customers:
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 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.
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.
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.
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.
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.
This is significant – many banks have had this kind of funda:
- Lure a customer using a fundoofied low interest rate like 7.25% floating
- Make the paperwork such that the loan adjusts with respect to a benchmark rate called “Home Loan Benchmark”, say 200 basis points below it. Set this benchmark rate at 9.25%.
- When the customer’s signed up and paid for a few months, INCREASE this Home Loan Benchmark rate slowly – to 10%, then 11% etc.. The customer now has to pay 200bps lower.
- Most customers won’t care because you will increase the tenure of the loan rather than the EMI. They are too busy or ignorant to realize that they are paying 10% more interest to the bank over the term of the loan if the loan tenure is extended, for each 0.25% increase!
- Example: 30 lakh loan for 20 years at 7.25% is 23,711 a month, and you pay Rs. 27 lakhs in interest over 20 years. If they bump up the rate to 7.5%, and keep the EMI the same, you’ll pay it for 20 years 11 months; the amount of interest you pay, though, goes up to 29.4 lakhs, or 9.36% more. Screw that – you pay 3% interest in the first year.
- But this means you can’t snare the new suckers – who want low interest loans. So instead of losing that juicy extra income from the already trapped customer, you create a different benchmark called “NEW Home Loan Benchmark” and offer loans at 7.25% only to new customers. That way you can milk the older customers who have no choice but to pay, and get new customers at lower rates.
- Your older customers can’t run off easily; you set up a pre-payment penalty.
This is at the retail end. At the corporate end banks were killing each other by offering rates way below the BPLR benchmarks (one of the many numbers) and since there is no “bottom” banks could simply lowball each other to whatever end.
A fixed base rate will solve some of these problems – all loans, corporate or retail, must benchmark themselves to the base rate. (Note: Floating rate products can take on external benchmarks also – but that’s good enough if the bank doesn’t control the external benchmark. )
What this will do though, is show you the huge spread between what is offered to corporates and what you and I get. Where corporates can get loans at 7%, we can only get them at 10% or more; once they put in the base rate at 7% we get some negotiating room to eke out a better rate. But honestly most borrowers will be too ignorant to even check a bank website for it’s current base rate, so who am I kidding. All it will do right now is create a more competitive environment for certain banks.
Public sector banks are most certainly going to benefit – they didn’t indulge in these kinds of practices. Private banks are going to see margin erosion. I hope they make pre-payment penalties illegal too – then private banks are hosed. But there are ways to make money – not as much as before but still, good money – for banks, and I hope they come around and offer better products instead of trying to squeeze the last naya paisa from customers.