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Battle against the Prime Lending Rate

Battle against the Prime Lending Rate

The prime lending rate and the benchmark PLR, on which banks are expected to base their lending rates, have failed to achieve the desired effect of efficiency in credit allocation and competitive pricing of bank loans. The Reserve Bank of India working group that reviewed the BPLR now recommends a "base rate" that will not in any way deal more effectively with the problem of a lack of transparency nor will it better reflect costs. Unfortunately, the working group did not take up any of the larger issues faced by our banks in their lending strategies. It falls back on a simplistic accounting approach and leaves out the imponderables in estimating banks' costs.

COMMENTARY

Battle against the Prime Lending Rate rates of scheduled commercial banks for credit over Rs 2 lakh were freed with the introduction of the prime lending rate (PLR). It was a radical departure from the decades of “administered” rates and “cred
it rationing”. It shifted the role of credit al-
K Subramanian location and interest determination to the

The prime lending rate and the benchmark PLR, on which banks are expected to base their lending rates, have failed to achieve the desired effect of efficiency in credit allocation and competitive pricing of bank loans. The Reserve Bank of India working group that reviewed the BPLR now recommends a “base rate” that will not in any way deal more effectively with the problem of a lack of transparency nor will it better reflect costs. Unfortunately, the working group did not take up any of the larger issues faced by our banks in their lending strategies. It falls back on a simplistic accounting approach and leaves out the imponderables in estimating banks’ costs.

K Subramanian (subrabhama@gmail.com) retired from the Ministry of Finance and writes frequently on global economic affairs.

Economic & Political Weekly

EPW
november 21, 2009

B
ankers are unloved creatures. In the United States (US), they are under attack for creating the mayhem and running away with bonuses secreted out of bailouts. Barack Obama and the Treasury are battling in Congress to frame laws to regulate them, especially their bonuses.

In India too there is no love lost. Forget that nearly 70% of banks are governmentowned and our bank bosses did not overreach à la their US counterparts. Forget also the chorus of imported economists who criticise them for their conservatism and lack of animal spirits.

The complaint of India Inc. is that banks do not lend, and when they do, they charge high interest rates and do not pass on the benefit of lower rates signalled in successive monetary policy statements of the R eserve Bank India (RBI). Economists are concerned over the lack of transparency in interest rate dispensation and, more importantly, the rigidity and lags in transmission which defeat the efficacy of monetary policy. The gravamen of the charge is that unless the industry gets credit at a lower rate, growth will suffer. Banks have become the whipping boys for our economic stagnation.

PLR: Floor or Ceiling? In recent years the RBI has been adopting a soft interest rate regime in line with global approaches. However, there is the constant refrain that banks do not pass on the benefit even when there is ample liquidity in the system and scope for rate reduction. In its second quarter monetary policy review for 2009-10, the RBI describes the situation as “hysteresis”.

Leaving aside the blame game, this is a serious issue and deserves closer study. However, it is not a new issue and has been with us since the commencement of financial reforms in the early 1990s. By October 1994, the era of “administered” rates was over and there was complete deregulation of lending rates. Lending

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market. One consequence was that term lending institutions such as the Industrial Development Bank of India (IDBI), the Industrial Credit and Investment Corporation of India (ICICI), the Industrial Financial Corporation of India (IFCI), etc, which provided longer term credits to companies were abolished and banks took over that role. Sadly, it was a role for which they were unprepared and untrained.

The new regime was ushered in with the hope, as predicated by neoclassical economics, that it would result in a more efficient allocation of credit, and loan products would be competitively priced.

Very soon, the PLR ran into trouble. It did not work the way the reformers had hoped for. Instead of remaining the floor, it became a ceiling. By April 1998, the PLR was converted into a ceiling rate for loans up to Rs 2 lakh. For loans above that threshold, banks were given operational flexibility. The PLR was a benchmark and banks could lend at sub-PLR rate. These modifications were to repair its working. Notwithstanding such modifications, the system remained creaky.

The Annual Report of the RBI (2003-04) explained the rationale, especially how banks were encouraged to switch to the cost concept of pricing loans by explicitly declaring processing and service charges. “In order to enhance transparency, a benchmark PLR was advocated for banks, taking into account their actual cost of funds, operating expenses, a minimum margin to recover regulatory requirement of provisioning/capita charge and profit margin.”

Moving over to the BPLR

The PLR, as a benchmark, did not result in lower bank rates. The report detailed the circumstances creating “stickiness” in transmission. In part, it is associated with the floor set by the Liquidity Adjustment Facility (LAF) as well as a preference for short-term deposits by banks to gain flexibility in asset-liability management (ALM). There were structural impediments to

COMMENTARY

flexibility in the interest rate structure such as high carrying costs of long-term deposits mobilised in the past on fixed interest rates and non-performing assets (NPAs). Even short-term credit at fixed rates constituted a high proportion (40%) and this was compounded by the reluctance of depositors to opt for variable rate deposits in an environment of low inflation and falling interest rates.

Many economists began to comment on the downward rigidity of Indian interest rates (Jha 2002). Not alluded to in the RBI analysis is the crucial factor that the burden of investing in government bonds was shifted from the RBI to the commercial banks. Given the nature of the yield and guarantees, banks got addicted to government securities. This volume has since r isen to very high levels with ever widening fiscal deficits.

The PLR failed to deliver and turned opaque and arbitrary. There was only one rate and it did not make any distinction between various sectors. The growing commercial clout of some Indian companies led to a lower PLR on a negotiated basis.

Responding to criticism, the RBI modified the PLR in 2003. In its mid-term r eview of November 2003, it requested the Indian Banks’ Association (IBA) to advise member banks to adopt a benchmark prime lending rate (BPLR), keeping in view the operational requirements.

The new method was expected to be more transparent and competitive. In the framework, BPLR takes into account each bank’s actual cost of funds, operating expenses and the minimum margin to cover regulatory requirements such as provisioning/capital charge and profit margin. Banks were allowed to freely price their loan products below or above their BPLR and also offer floating rate products by u sing market benchmarks in a transparent manner. They were encouraged to align the pricing of their credit risk assessment so that both credit delivery and quality improved. Unfortunately, with all the finetuning, the BPLR met with a fate far worse than the PLR.

Inefficient Pricing and Non-Transparency

In less than two years, the RBI was disappointed with the way the BPLR functioned.

In its mid-term review for 2005-06, the RBI dealt with the issues at length. It noted,

Over the period, however, the system of BPLR has evolved in a manner that has not fully met these expectations. Competition has forced the pricing of a significant p roportion of loans far out of alignment with BPLRs and in a non-transparent manner. As a consequence, this has undermined the role of the BPLR as a reference rate. Furthermore, there is a public perception that there is under pricing of credit to corporates while there could be overpricing of lending to agriculture and small and medium enterprises.

The Annual Policy Statement 2009-10 reiterated the same view questioning its relevance as a meaningful reference rate. It announced the constitution of a working group to review the BPLR system and suggest changes to make credit pricing more transparent. The working group submitted its report on 20 October 2009, and the RBI has to consider its recommendations in consultation with banks, etc.

The working group has come out with the conclusion that the BPLR has tended to be out of sync with the conditions (in the market) and does not adequately respond to changes in monetary policy. It raises concerns about transparency. It feels that it fails to transmit policy rates. Significantly, it takes the view that rates at which loans were offered did not make much commercial sense. (It fails to explain how banks could survive if rates were not commercial.) Overall, it is of the view that the BPLR has “fallen short of expectations in its original intent of enhancing t ransparency”, etc.

The group recommends a base rate which “will include all those cost elements which can be clearly identified and are common across borrowers” (emphasis added). It will include (i) the card interest rate on retail deposit (deposit below Rs 15 lakh) with one year deposit (adjusted for current account and savings account (CASA) deposits); (ii) adjustment for the negative carry in respect of CRR and SLR;

(iii) unallocatable overhead cost for banks which would comprise a minimum set of overhead cost elements; and (iv) average return on net worth.

It is interesting that the base rate is not to be set in stone and banks may lend b elow the base rate when necessitated by market conditions, especially when there is excess liquidity. Banks may also give loans at fixed or floating rates without reference to the base rate. But this is within a 15% limit of the incremental lending during a financial year. Certain categories of loans may be given without reference to base rate. To increase the flow of credit to small borrowers, the group suggests abolition of administered rate and banks should be free to lend at fixed or floating rates which would include base rate and sector specific operating cost, credit risk premium and tenor premium as in the case of other borrowers. Education loans are special and should not exceed the average base rate of five largest banks plus 200 b asis points. It is difficult to find any new i ssue or analysis in the group’s report which can enhance the quality of public debate on the subject. Most of them are well known over the last decade and successive attempts by the RBI and the IBA to refine or fine-tune them have met with the same results. The base rate suggested by the group is in no way an improvement over the PLR or the BPLR. In actual practice it will remain as opaque as the BPLR or PLR as it recounts the same elements or semantically rephrases them. Sadly, in a free market, there is no way by which one can arrive at the cost elements of the various components listed by the group. All that will happen is that banks will start lending selectively above the base rate. There

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november 21, 2009 vol xliv no 47

EPW
Economic & Political Weekly

COMMENTARY

is no mechanism to enforce their application if the market is to operate freely unless the idea is to introduce administered rates through the backdoor.

Unjustified Crticism

Some of the criticisms levelled are not fair and do not capture the circumstances u nder which our banks, especially public sector banks, operate. The view that I ndian banks do not transmit policy rates is a partisan view held by the commercial class. The RBI Report on Currency and F inance (December 2005) devoted several pages studying the interest rate passthrough in many countries and leaned on learned studies on the subject. Its crosscountry survey found that the situation varies from country to country and there is no uniform pattern in the pass-through between deposits and loans. For the interest rate channel to work effectively and e fficiently, changes in the short-term policy rate should feed into the bank and other market rates in the economy. It would depend on a number of factors such as the structure of the financial system, extent of regulation, degree of competition between banks, the usage of variable rate products, the response of portfolio substitution to the policy rate and the transparency of monetary policy operations.

Likewise, it studied a number of factors which led to the downward flexibility of commercial rate structure. The RBI r eferred to a number of factors such as the average cost of deposits for major banks which remains high in India. A substantial portion of deposits is in the form of longterm deposits at fixed interest rates which restrict the flexibility to reduce interest rates. Others are the relatively high interest rates on savings schemes and overhang of NPAs; legal constraints and procedural bottlenecks in recovery of dues; and finally the large borrowing programmes of the government over and above the statutory liquidity ratio (SLR) requirements providing opportunities to banks to invest in sovereign paper. Thus one may well argue that deregulation of interest rate was attempted in the absence of necessary institutional infrastructure. Though it is being calibrated, there are hiccups along the way.

The criticism about interest rate passthrough is not correct. It fails to note that

Economic & Political Weekly

EPW
november 21, 2009

it is not peculiar to India. In a very interesting study by Teruyoshi Kobayashi (2008) of the Chukyo University, he explains how cost channel plays an important role in the transmission of monetary policy. A number of studies “have also reported that, especially in the euro area, shifts in monetary rates, including the policy rate, are not completely passed through to retail lending rates.” His study revealed that “a shift in the policy rate has not been fully passed through to lending rates in the UK at least during the past 25 years”.

A recent working paper of the International Monetary Fund (IMF) suggests “that even during the crisis, the core part of ECB’s monetary policy transmission – from policy rates to market rates – has continued to operate, but with a decreased efficiency.” When we consider that these are economies with financial depth and s upport structure to banks, attacks on our banks is unjustified.

In fact, the mid-term review of the A nnual Policy (2009-10) refers to “better transmission from low policy rates to declining lending rates.” It goes on to say, “the movement in the benchmark prime lending rates (BPLR) does not fully and accurately reflect the changes in effective lending rates as nearly two-thirds of banks’ lending takes place at sub-PLR rates.” It goes on to record the true movements of lending rates with reference to weighted average lending rates of banks which declined from 12.3% in March 2008 to 11.1% in March 2009. Weighted average on advances also declined from 10.6% to 10.3% for the same period. Further, data on reduction in BPLR would show that while public sector banks have passed on 125275 basis points, private sector banks passed on 100-125 and five major foreign banks passed on only 125.

Putting Stability before Cost

Much of the cost to banks, especially public sector banks, stems from regulatory r equirements. A very perceptive study done by the Development Research Group of the RBI captures this well. As it puts, “Prudential regulations issued by the Reserve Bank on capital adequacy, asset quality, income recognition and provisioning, single group borrower

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exposure and other such norms influence the credit decisions of the banks, depending on the individual bank’s business profile and its risk appetite.” At a time when the US and European banks circumvented the adoption of Basel guidelines and other prudential norms, the RBI insisted on their adoption by our banks. Due to these measures, the cost of bank operations has gone up. But, it has to be remembered that this was the price we had to pay to ensure the stability of our financial system. The cost is negligible when weighed against the trillions of dollars of bailouts thrown in by the US and elsewhere to save their banks.

Though the working group included e xperienced bankers and economists, the report does not bring to bear any of the larger issues faced by our banks in their lending strategies. It falls back on a simplistic accounting approach and leaves out the imponderables in estimating banks’ costs. The battle with BPLR will not be over if the report is accepted; within a year or two we will have one more working group to replace it with another rate.

References

Jha, Raghbendra (2002): “Downward Rigidity of I ndian Interest Rates”, Economic & Political W eekly, 2-8 February.

Kobayashi, Teruyoshi (2008): “Incomplete Interest Rate Pass-Through and Optimal Monetary Policy”, International Journal of Central Banking, September.

International Monetary Fund (2009): “Euro Area Monetary Policy in Uncharted Waters”, Working Paper, WP/09/85, August.

Reserve Bank of India (2005): Report on Currency and Finance, December.

  • (2006): “Transmission of Monetary Policy and the Bank Lending Channel: Analysis and Evidence from India”, Development Research Group of the RBI, 16 January.
  • (2009): “Annual Policy Statement 2009-10”, RBI, April.
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