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What the RBI Notification on Base Rates means for Banks?


Posted on 09-Sep-2015 Comments  6

The previous week, the RBI issued an innocuous notification on the change in the methodology of calculation of base rates by banks. Base rates, as the name suggests is the basic rate that will be charged by a bank to its customers for a loan. The actual rate charged will always be higher than the base rate based on a variety of criteria. For example a customer with a good credit score will get loans at a smaller spread over the base rate, whereas a customer with a bad credit score will pay a higher spread! Similarly, secured loans may attract a lower spread, while an unsecured loan may attract a higher spread. The end purpose of the loan also matters as loans that carry higher end-use risk will also entail a higher spread over the base rate. But first the notification...

 

Last week the RBI issued a notification proposing a change in the methodology of calculation of base rates by banks. Till now banks were calculating their base rates on the basis of the average cost of funds. Now, the RBI wants banks to shift to the practice of calculating the base rate on the basis of the marginal cost of funds. First let us understand why this distinction is so important.

 

The distinction between average cost of funds and marginal cost of funds...


When banks calculate the base rate on the basis of their average cost, their old cost of funds is also taken into consideration. Effectively, a customer borrowing today has to partly pay the price of the historic cost of funds of the banks. That may appear unfair to a customer who is borrowing today but that is more because there is no standardized methodology that has been prescribed for the calculation of base rates and every bank follows its own formula. Under the Marginal Cost method, the base rates will have to fall along with the fall in the cost of funds. For example if the marginal cost of funds for a bank is 8%, then their base rate must be closer to 8%, even though their actual cost of funds may be closer to 9.5% due to a historical baggage of funding at higher levels. That is why this distinction is important.

 

What the RBI is trying to ensure...


Over the last few months, the RBI has pointed that rate cuts by the RBI were not being passed on to the end customers in entirety. For example since January 2015, the RBI has cut repo rates by a total of 75 basis points but banks have passed on just 30 basis points to the end customer.  PSU banks argue that their base rate is based on their average cost of funds, which is higher. Their logic, therefore, is that once their average cost of funds comes down, they will automatically be able to transmit the rate cuts in entirety.

 

Why banks are worried about this method...


Banks are worried about shifting to the marginal cost basis of funding for a very simple reason. It will take away the spread that banks have been enjoying by not passing on the entire rate cuts to the end customer. For example, in 2015 the RBI has already cut repo rates by 75 basis points but only 30 basis points were passed on to the end customers. The balance 45 basis points actually contribute to the incremental margins of banks. According to preliminary estimates, if the banks shift to a marginal cost approach to pricing their base rates then the banking system will have to incur a one-time loss of Rs.20,000 crore. That is surely a huge loss at a time when Indian banks are already reeling under the pressure of bad loans and poor loan off-take.

 

The sum and substance of the whole story...


To begin with, this notification is not applicable with immediate effect, but only with effect from April 01, 2016. By then the banks and the IBA will have the time to go through the proposed notification and debate the pros and cons. There are two key issues that will arise. Firstly, it will result in greater transparency in pricing of loans because customers will be able to actually experience the benefits of lower rates when repo rates are cut by the RBI. That is the good news. But there is a word of caution, here. Back in the early 2000s when interest rates were cut drastically by the RBI, some of the banks had shifted to marginal cost based pricing on their home loan portfolios. While it helped them to aggressively expand business, it eventually led to asset liability mismatch and eventual losses for banks. That is something the RBI must be cautious about.

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VIkram

Posted on 9/9/2015 12:25:12 PM

Good News for customers as their duration of EMIs will be reduced to some extent but banks has to take effective measure before the implementation date so that their NPA doesn't increase & P/L gets afected

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Thangarasu

Posted on 9/11/2015 5:22:01 PM

Good info-such things will improve customer sentiments to buy House ,Car etc.

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Sukanya

Posted on 9/11/2015 6:01:52 PM

A fair play by RBI. As a Regulator, it has tactically handled banks to pass benefits to common man and at the same time has given a cooling period to the banks.

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Gopal J Walhe

Posted on 9/30/2015 4:08:58 PM

Agreed

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vikram

Posted on 9/24/2015 11:49:13 AM

Good info

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gopalw

Posted on 10/3/2015 5:17:53 PM

Good news from RBIThanks

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