<div><em>The idea behind a new BR based on marginal cost of funds is that it will be more sensitive to policy rate changes, writes <strong>Raghu Mohan</strong></em><br><br><br>Every time, the Reserve Bank of India (RBI) cut its key rates, you continued to crib that bank lending rates still held firm. On its part, Mint Road grew tired of banks who peddled the view that their cost of funds had not fallen; it led Governor Raghuram Rajan to quip (6th April 2015) that it was "nonsense" to assume that the cost of funds had not fallen”.</div><div> </div><div>In this fiscal’s first bi-monthly policy review, RBI prodded banks to use a modified Base Rate (BR) – the floor rate below which they can’t lend. The new BR “based on the marginal cost of funds should be more sensitive to changes in policy rates. To improve the efficiency of monetary policy transmission, (we) will encourage banks to move in a time-bound manner to marginal cost of funds-based determination of their BR,” RBI had said. The idea behind a new BR based on marginal cost of funds is that it will be more sensitive to policy rate changes. Sure, only the new BR draft guidelines are out, what’s in store?</div><div> </div><div><strong>Grin And Bear</strong></div><div>The first hit will be taken by banks. Says Pawan Agrawal, Chief Analytical Officer-CRISIL Ratings: “Our base-case is that profitability of banks will have a one-time impact of around Rs 20,000 crore in fiscal 2017, which would be equal to 15 per cent of the total estimated profit of the banking system for that year. The actual impact will depend on whether the banks will be given a leeway to make this shift over a longer timeframe in the final guidelines.”<br> </div><div>Says Parag Jariwala of Religare Institutional Research: “We think this methodology would lead to frequent BR changes. It may not go down well with borrowers, particularly when interest rates are rising. In a declining interest rate scenario too, frequent BR cuts would hurt banks as deposits would be re-priced with a lag”.</div><div> </div><div><table align="right" border="1" cellpadding="2" cellspacing="2" style="width: 300px"><tbody><tr><td style="text-align: center;"><span style="color:#ff0000;"><strong>How The New BR Works</strong></span></td></tr><tr><td><div><span style="color:#0000cd;"><strong>Cost of deposits:</strong></span> To be calculated using the latest interest rate payable on CASA (current and saving accounts) deposits and term-deposits. The cost of borrowings is to be arrived at using the average rates at which funds were raised in last one month preceding the date of review</div><div><br><span style="color:#0000cd;"><strong>Negative carry on reserves (CRR and SLR):</strong> </span>This would be based on the marginal cost of funds calculated above, implying negative carry will increase or decrease with an increase or decrease in cost of funds (negative carry will decline when deposit rates are cut)<br><br><span style="color:#0000cd;"><strong>Un-allocable Overhead Costs: </strong></span>It is to remain fixed for three years<br> </div><div><strong><span style="color:#0000cd;">Average Return on Net Worth: </span></strong>This is the hurdle rate of ROE determined by the Board or management of the bank. RBI expects banks to keep this component fairly constant and any change be made only in case of a major shift in business strategy<br> </div><div><em>Source: Religare Institutional Research</em></div><div> </div></td></tr></tbody></table></div><div>It was from 1st April 2010 that the BR concept kicked in. Until then, it was the benchmark prime-lending rate (BLPR). A large universe of borrowers had their loan priced below it. At that point in time, the RBI pointed that the share of sub-BPLR lending by banks (excluding export credit and small loans) increased to 70.4 per cent in September 2009 from 66.9 per cent in March 2009. Strangely enough, the whole idea underlying the BPLR was that it was to act as a BR — with top-most rated borrowers getting funds at the rate. But it had created confusion – what is the BPLR to signal if the world borrowers both below and above it. Folks who borrowed below the BPLR had little reason to complain if it (the BPLR) continued to hold firm despite repeated policy rates cuts; ones who borrowed above it thought the world was unfair to them!</div><div> </div><div>The BR had just one consequence – the practice of lending below it came to end. But banks continued to say that their BR could not be reduced despite policy rate cuts as their cost of funds (on deposits and borrowings contracted earlier) remained high.</div><div> </div><div>It’s this stand of banks which prompted Rajan to say “we are not looking for a specific number (on the BR cuts) and saying unless this happens, nothing more will happen. But we want to facilitate the process of transmission. I do not see an environment where credit growth is tepid, banks are sitting on money and their marginal cost of funding (has) fallen, the notion that it hasn't fallen is nonsense, it has fallen”.</div><div> </div><div>Agrawal observes that yields of banks that lend mostly on a floating rate basis will be significantly impacted in an environment of falling interest rates – that floating rate is pitched over the BR. As the BR falls (and along with it the floating rate), so will the interest income of banks. And that banks with low levels of current and saving accounts, or relatively longer tenure-term deposits, will also be majorly affected. That’s becaus, their cost of funds will not come down soon enough -- as they will continue to payment interest to depositors at the old rate before a policy rate cut.</div><div> </div><div>The good news for banks (not for you and I) says Agrawal is that “in an increasing interest rate scenario, banks will tend to benefit as they will be able to immediately pass on any hike in deposit rate to the BR”.</div><div> </div><div>What about a cut in the BR next time Mint Road cuts policy rates? Adds Agrawal: “Given the impact on profitability, banks may shy away from cutting deposit rates, especially in times of low profitability, which will defeat the objective of quick transmission of cuts in the RBI’s policy rates”.</div><div> </div><div>You as customer will not win anytime soon.</div><div> </div>
BW Reporters
Raghu Mohan is an award-winning senior journalist with 22 years of experience. He has worked for BW Businessworld since December 2006, and is currently its Deputy Editor. His area of expertise is banking – commercial, investment, and the regulatory. Previous stints include those at The Financial Express and Business India.
