Creditable switch

Banks will now move from the prime lending rate system to the base rate model based on a directive from the Reserve Bank. The shift is expected to be operational on July 1. The objective of the base rate system is to bring in transparency as many banks were giving loans to corporates below the prime lending rate,thus rendering the rate irrelevant. It seems the RBI was troubled at the fact that customers had to pay higher rates. The base rate system would ensure that banks report to the RBI the minimum rate they are charging from customers. All loans would be then made at interest rates in reference to this rate.

While transparency is a noble cause,the new system should not reduce the flexibility of banks to charge different rates on loans depending on borrower creditworthiness and the maturity of the loan. For example,a short-term loan to a large corporation offers an investment avenue with low risk. If the base rate system makes such loans more expensive,and corporates turn to other sources of borrowing such as commercial paper where banks are dis-intermediated,this would mean banks lose that business. Similarly,if the new model allows risky lending by charging higher interest rates to small enterprises,there is merit in it. However,if the model does not allow for banks to earn more by charging for the extra risk that they are taking,it could prove to be loss-making for banks.

Conditions in the market are changing all the time,either due to changes in liquidity,demand for credit,business cycle conditions,or taxes and government borrowing and spending. The success of the new framework will depend on whether in it,banks are able to retain the flexibility to change the rate according to these conditions. One reason for the change away from prime lending rate system was that it tended to remain unchanged for months despite changes in these conditions. It was thus difficult for the central bank to assess the impact of monetary policy as the transmission through the banking system was unclear. In addition,the actual rate charged to a customer should correctly reflect borrower-specific costs such as credit risk,tenure risk,operating costs that may be product or industry specific.