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NAME-GURPREET KAUR

SECTION-R1813

ROLL NO.-B27

BANKING AND INSURANCE TERM PAPER

TOPIC-IMAPCT OF BASE RATE ON BANKS

BANK?FUNCTIONS?TYPES OF LOAN’S?INTEREST RATE?

WHAT IS BASE RATE?

The rate of interest used as a basis by banks for the rates they charge their customers. In practice most customers will pay a premium over base rate on loans andwill receive below the base rate on deposits with banks. Previously, banks used to pricethe loans they offered us on a complicated system called benchmark prime lending rate(BPLR). Each bank has its own BPLR methodology which made it difficult for borrowers

to compare rates across banks.Now, with the base rate in place, it will be easier for allof us to compare across banks and to get a more transparent sense of how the interestrate for the loan is being arrived at.for example- When you borrow money to buy ahouse or car or electrical appliance, there is an interest rate that you have to pay to thelender. The base rate is the minimum rate that a bank will lend money at. Think of it asa floor below which RBI will not allow banks to lend to you.

INTRODUCTION-

BPLR->

The Benchmark Prime Lending Rate was introduced by the Reserve Bank of India inthe year 2003 with the aim of introducing transparency and ensuring appropriate pricingof loans, wherein the lending rates truly reflect the actual costs. It was envisaged as areference rate and was to be computed taking into consideration (i) cost of funds; (ii)operational expenses; and (ii) a minimum margin to cover regulatory requirements of provisioning and capital charge, and profit margin.

The evolution of the BPLR can be traced back to September 1990 when the first



attempt to rationalise the administered lending rate structure was made by removingmultiplicity and complexity of interest rates. According to this structure, the advances of scheduled commercial banks were divided into six slabs and progressively higher interest rates were prescribed for larger advances (subject to a floor rate). While for thelowest slab consisting of advances amounting up to Rs. 7,500, a minimum interest rate

of 10 per cent per annum was prescribed, advances of above Rs. 2 lakh, which fellunder the highest slab, were prescribed a minimum rate of interest of 16 per cent per annum. While the above structure was applied to both working capital and term loans,concessional rates were offered on term loans to agriculture, small-scale industry andspecific transport operators.

HOW BANKS WORK BEFORE ADOPTING BASE RATE?

The PLR was introduces in 2003 to ensure that banks publish their lending rates basedon their true cost of funds. All lending was expected to be at or above the BPLR. Thiswas a fair expectation, as you can't expect a bank to lend below its cost of funds!However, over time, competition forced banks to do exactly the opposite.Banks stoppedadjusting the BPLR when the interest rates went down – therefore, the BPLR lost itsrelevance as a rate reflecting the cost of funds for banks.And when the RBI allowedlending at below BPLR rates, the banks started giving out most of their loans below thePLR / BPLR (also known as sub-PLR or sub-BPLR loans). In fact, the loans were pricedas “BPLR minus 200 basis points”! For example, banks made home loans at 8% whenthe BPLR was 12%!Thus, the PLR / BPLR system became totally meaningless.

Due to these limitations, a new “base rate” system is being implemented from 1st July2010. This new framework would have two major benefits:

* Banks would be required to revise the base rate every quarter

* Banks would not be allowed to lend below the base rate

This would bring the much needed transparency to the loan market in India.TheReserve bank of India (RBI) has given out guidelines which say that customers of existing loans (based on BPLR) should be given an option to switch to the new baserate system without any fee.

IMAPACT OF BASE RATE ON BANKS IN INDIA?The Reserve Bank of India (RBI) is likely to come out with clarification over the impactof base rate on loans where the government is providing subsidies. Currently, thegovernment provides interest rate subvention on farm loan, loans given in rupee termsto the exporters and above all, for the corporate loans, which are governed by corporatedebt restructuring (CDR). The bankers had pleaded with RBI that the competitiveness of subsidised sectors should not get affected after the base rate regime begins on July 1.



In base rate system, which would replace the existing BPLR (benchmark primelending rate) system of lending, no lending can be done below the base rate.The deputychairman of IBA, MD Mallya, who is also the chairman & managing director of Bank of Baroda said that while the government gives 2% interest rate subvention on farm loans,the subsidy varies between 2% and 2.5% in case of rupee loans for exporters from bank

to bank. Even the commerce ministry has advocated for keeping the export credit at7.5-8% in the base rate regime.The bankers want a clear-cut classification over theapplication of the base rate and the subsidised loans for farmers and exporters.Thebankers also discussed with RBI what should be the way out to publicise the theimplementation of base rate. The base rate replaces the opaque benchmark primelending rate (BPLR). This base rate will have under it, the bank's cost of funds and costof running the bank.

HOME LOAN GET BENEFIT BY SHIFTING TO BASE RATE->

Base Rate is one of the reforms on banking system by RBI to reduce the lending risk for

banks. Before setting the base rate system, banks used Prime Lending Rate (PLR) toset their lending rates. RBI come up with the new Base Rate system where banks canlend the loans based on the new rating system. Banks have given their existingcustomers the options to shift their benchmark rate to the base rate. Base Rate Systemhas many advantages over the older method of Prime Lending Rate (PLR).

Advantage of Base Rate->

Normally the banks can not lend the money below the PLR but to lure the customers,banks started offering the loans cheaper than the PLR which put the extra burden onthe borrowers. RBI come up with the new base rate system where every bank has todeclare to the public how they have calculated the base rates. This provides moretransparency to compare interest rates offered by various banks.

Banks have given their existing customers the options to shift to the base rate from theexisting system of benchmarking against the PLR. The RBI has asked banks not tocharge any fee for shifting from prime lending rate to base rate. Once we have shifted tothe latest rate, this along with the linkage with base rate will ensure that future costs aresaved.

SHOULD WE CHANGE TO A BANK WITH LOWER BASE RATE-

Most banks will continue to charge us a very similar rate of interest as they did before.Just because one bank has a base rate of 7.5% and another has a rate of 8% does notmean you should switch to the bank with the lower rate.On top of this base rate will be



added an additional amount of interest that they bank will charge us to cover its cost of doing business with us, and some compensation for the risk its taking in lending tous.So, after all these additions, its unlikely that the lending rate that a bank will becharging to you will be any different to the rate being charged by your current bank.

The Indian banking scene last week transited from a benchmark prime lending rate(BPLR) regime to a base rate system of lending. The base rate is the minimum rate atwhich banks can lend after meeting all their costs. So the base rate includes the cost of deposits, the cost of running the bank and a bit of profit margin. More importantly, bankscannot lend below the base rate. In contrast the BPLR was a more opaque system withbanks calculating their BPLR differently and most of the lending occurred below theBPLR.

The base rate has been now advised to the customers and others and the public atlarge through various newspapers and television and other things and the public isaware. As far as the credit outstanding up to June 30, 2010 is concerned, the linkage of the credit to the benchmark remains the same until both the borrower and lender

mutually agree to shift to a new benchmark that is a base rate. So we arecommunicating to only those people who are willing to or who are coming to us for resetting the rate of interest as of July 1, 2010.

Benefit by Shifting to base rate from BPLR->

The borrowers can shift to the base rate from the existing system of PLR.In Base rate system as the banks are supposed to visit their base rates

every three months, they will have to cut their base rates if interest rates inthe market fall. As all the variable rates of interest are pegged against thebase rate, the existing borrowers will also be benefited by any cut in thebase rate. The base rate is fixed on the basis of various costs that a bankincurs in mobilizing funds and is a more transparent system.

When a person shifts to base rate, the interest is likely to remain the same.Shifting early to the new benchmark would only help to get the benefitsearlier. And if the existing loan rate is around 1-2 per cent lower than your existing rate, it makes sense to renegotiate as well. The bank says the

margin would be adjusted accordingly to maintain the effective currentinterest rate. Assume you have a home loan of Rs 20 lakhs and the currenteffective rate of interest of 12 percent, now, with migration to base rate asthe benchmark, your rate of interest will continue to be 12 percent (7.5percent the base rate plus 4.5 percent margin). The bank has fixed its baserate at 7.5 percent.



* Corporation Bank – 7.75%* Vijaya Bank – 8.25%* Punjab and Sind Bank – 8.2%* Karnataka Bank – 8.75%* Indian Overseas Bank (IOB) – 8.25%

* Syndicate Bank – 8.25%* Dena Bank – 8.25%* Oriental Bank of Commerce (OBC) – 8%* Canara Bank – 8%* State Bank of Mysore – 7.75%* Dhanalakshmi Bank – 7%* IndusInd Bank – 7%* DBS Bank – 7%* Andhra Bank – 8.25%

ARTICLES->

1).Article: Company Of The Week/ICICI Bank: Breaking ground in productsand technology->

ICICI Bank, India's second largest private sector bank has grown at aphenomenal rate in the past three years. Its operating income up more than81 percent. It is at the forefront of new technology initiatives and wasthe first in India to launch Internet banking and Web-based stock broking.

The bank is in an advantageous position compared to other private sector banks, as it is promoted by ICICI (with a 62.2 percent stake), the

second-largest financial institution in India. The parent's strong equitywith corporations and its brand have helped the peoples.

2).Article: QUARTERLY REVIEW OF RBI'S MONETARY POLICY.February 17 (PTI FEATURE): The Indian Economy is booming at over 9 per cent andmany in the North Block are rejoicing but Reserve Bank Governor Y.V. Reddy is in anun-envious position as he has to do a tight-ropewalk to ensure that high growth is notimpeded while taking measures to contain inflation in the monetary policy. The mainemphasis of the monetary policy is to ensure that credit is not choked maintain the highgrowth momentum. At the same time Reddy has to ensure that Inflation remain close tothe projected level of 5-5.5 per cent. In this balancing act, Reddy in his third quarter

review of the annual monetary policy on January 31, hiked the repo rate by 0.25 per cent to 7.5 per cent while keeping other key rates-reverse repo rate, bank rate andcash reserve ratio untouched.

3).Banks raise deposit and base rates->

A few public and private banks have raised their base rates to accommodate theincreasing borrowing costs. Though the liquidity situation with the banks is comfortable



at this point in time, it might not remain the same going ahead, considering some topbanks have also raised deposit rates to garner liquidity.

4).Base rates hiked->

The new benchmarking of loans through - base rate, which replaced BPLR in July 2010,has also been upped by ‘some banks' so as to match the deposit rates and to havesome breathing space as borrowing costs eat into their NIMs. Public sector banks like,Allahabad bank and Punjab National Bank as well as private sector banks like KotakMahindra and Axis Bank have raised base rates.

The reason why some banks have refrained from hiking base rate is the upcomingfestive season and the demand for loans, which comes with it. On the whole bankshave remained somewhat ‘patient' this time around in hiking rates, but once the festive

season is over the situation might not remain the same.

5).INDIAN Bank Base Rate: An Overview->

The paper deals about the issues arising out of implementing base rate for Indianbanks. With effect from July 1st, 2010, all banks are supposed to lend at base rate or minimum level of interest rate to customers. The net impact of this for retail customer will not be much as cost of funds for banks are not going to change much and cost of funds determine base rate. Big corporate will be biggest losers as they had advantage

of getting loans at sub-base rates. Biggest gainers will be small and medium firms whowere getting raw deal earlier from banks. Banks may lose market share in short termbut there is going to be greater transparency and trickling down of policies made by RBIacross banks due to base-rate system. Game theory has been applied to explain thebase rate transition scenario in the paper.

CONCLUSION->

In the new base rate system, if the interest rates fall, banks will have to lower the base

rate, which is a function of cost of funds in the market. As all the variable rates of interest are pegged against the base rate, the existing borrowers will also be benefitedby any cut in the base rate. But when interest rates go down banks was not able todecrease the BPLR. Therefore, it is advisable for the existing borrowers to opt for thebase rate as their benchmark rate.

REFERENCES->http://ideas.repec.org/p/pra/mprapa/25666.html

http://ideas.repec.org/p/pra/mprapa/25666.html

http://ideas.repec.org/p/pra/mprapa/25666.html

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