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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 and
will receive below the base rate on deposits with banks. Previously, banks used to price
the 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 all
of us to compare across banks and to get a more transparent sense of how the interest
rate for the loan is being arrived at.for example- When you borrow money to buy a
house or car or electrical appliance, there is an interest rate that you have to pay to the
lender. The base rate is the minimum rate that a bank will lend money at. Think of it as
a 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 in
the year 2003 with the aim of introducing transparency and ensuring appropriate pricing
of loans, wherein the lending rates truly reflect the actual costs. It was envisaged as a
reference 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 removing
multiplicity 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 the
lowest 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 fell
under 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 and
specific transport operators.

HOW BANKS WORK BEFORE ADOPTING BASE RATE?


The PLR was introduces in 2003 to ensure that banks publish their lending rates based
on their true cost of funds. All lending was expected to be at or above the BPLR. This
was 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 stopped
adjusting the BPLR when the interest rates went down – therefore, the BPLR lost its
relevance as a rate reflecting the cost of funds for banks.And when the RBI allowed
lending at below BPLR rates, the banks started giving out most of their loans below the
PLR / BPLR (also known as sub-PLR or sub-BPLR loans). In fact, the loans were priced
as “BPLR minus 200 basis points”! For example, banks made home loans at 8% when
the 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 July
2010. 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.The
Reserve 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 base
rate 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 impact
of base rate on loans where the government is providing subsidies. Currently, the
government provides interest rate subvention on farm loan, loans given in rupee terms
to the exporters and above all, for the corporate loans, which are governed by corporate
debt 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 prime
lending rate) system of lending, no lending can be done below the base rate.The deputy
chairman 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 at
7.5-8% in the base rate regime.The bankers want a clear-cut classification over the
application of the base rate and the subsidised loans for farmers and exporters.The
bankers also discussed with RBI what should be the way out to publicise the the
implementation of base rate. The base rate replaces the opaque benchmark prime
lending rate (BPLR). This base rate will have under it, the bank's cost of funds and cost
of 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) to
set their lending rates. RBI come up with the new Base Rate system where banks can
lend the loans based on the new rating system. Banks have given their existing
customers the options to shift their benchmark rate to the base rate. Base Rate System
has 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 on
the borrowers. RBI come up with the new base rate system where every bank has to
declare to the public how they have calculated the base rates. This provides more
transparency to compare interest rates offered by various banks.
Banks have given their existing customers the options to shift to the base rate from the
existing system of benchmarking against the PLR. The RBI has asked banks not to
charge any fee for shifting from prime lending rate to base rate. Once we have shifted to
the latest rate, this along with the linkage with base rate will ensure that future costs are
saved.

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 not
mean 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 to
us.So, after all these additions, its unlikely that the lending rate that a bank will be
charging 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 at
which 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, banks
cannot lend below the base rate. In contrast the BPLR was a more opaque system with
banks calculating their BPLR differently and most of the lending occurred below the
BPLR.
The base rate has been now advised to the customers and others and the public at
large through various newspapers and television and other things and the public is
aware. 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 are
communicating 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 in
the market fall. As all the variable rates of interest are pegged against the
base rate, the existing borrowers will also be benefited by any cut in the
base rate. The base rate is fixed on the basis of various costs that a bank
incurs 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 benefits
earlier. 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 current
interest rate. Assume you have a home loan of Rs 20 lakhs and the current
effective rate of interest of 12 percent, now, with migration to base rate as
the benchmark, your rate of interest will continue to be 12 percent (7.5
percent the base rate plus 4.5 percent margin). The bank has fixed its base
rate at 7.5 percent.
What happens to the existing loans?

The Reserve 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 base
rate system without any fee. Even for banks, maintaining two systems of PLR and base
rate would be administratively difficult – so we can expect the banks to encourage us to
shift to the base rate system. Example->
Let's say you have taken a floating rate home loan which is at BPLR minus 200 basis
points. (2% less than the BPLR). Right now, the BPLR is 12%, so your loan is at 10%.
As you would have observed, if the interest rates go down, the bank does not
necessarily reduce the BPLR. So, even if the overall interest rates go down by 0.5%,
your loan would remain at 10%. Yes, it is unfair, but that’s the reality today. When you
change to the base rate system, the current rate for your loan would remain the same.
So, if the bank's base rate is say 7.5%, your loan would be marked as “base rate plus
250 basis points” (or, 2.5% above the base rate). So, there would be no immediate
change for you. However – and this is important – what would change is how a change
in interest rate is passed on to you. Since banks have to revise the base rate every
quarter, any change in interest rate – either downwards or upwards – would be passed
on to you in a maximum of 3 months.
This is a big leap forward, considering the fact that till now, most floating rate loan
customers have only seen an upward movement in their interest rates.

WHAT ARE THE BASE RATES OF DIFFERENT BANKS?


Here are the base rates announced by some banks -

* State Bank of India (SBI) – 7.5%


* ICICI Bank – 7.5%
* HDFC Bank – 7.25%
* Axis Bank – 7.5%
* Citibank – 7.25%
* Standard Chartered Bank – 7.25%
* HSBC – 7%
* Deutsche Bank – 6.75%
* IDBI Bank – 8%
* Indian Bank – 8%
* Bank of Baroda (BoB) – 8%
* Allahabad Bank – 8%
* Punjab National Bank (PNB) – 8%
* 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 products


and technology->

ICICI Bank, India's second largest private sector bank has grown at a
phenomenal rate in the past three years. Its operating income up more than
81 percent. It is at the forefront of new technology initiatives and was
the 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 equity
with 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 and
many in the North Block are rejoicing but Reserve Bank Governor Y.V. Reddy is in an
un-envious position as he has to do a tight-ropewalk to ensure that high growth is not
impeded while taking measures to contain inflation in the monetary policy. The main
emphasis of the monetary policy is to ensure that credit is not choked maintain the high
growth momentum. At the same time Reddy has to ensure that Inflation remain close to
the 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 and
cash reserve ratio untouched.

3).Banks raise deposit and base rates->

A few public and private banks have raised their base rates to accommodate the
increasing 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 top
banks 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 have
some 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 Kotak
Mahindra and Axis Bank have raised base rates.
The reason why some banks have refrained from hiking base rate is the upcoming
festive season and the demand for loans, which comes with it. On the whole banks
have 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 Indian
banks. 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 who
were getting raw deal earlier from banks. Banks may lose market share in short term
but there is going to be greater transparency and trickling down of policies made by RBI
across banks due to base-rate system. Game theory has been applied to explain the
base 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 benefited
by any cut in the base rate. But when interest rates go down banks was not able to
decrease the BPLR. Therefore, it is advisable for the existing borrowers to opt for the
base rate as their benchmark rate.

REFERENCES->
http://ideas.repec.org/p/pra/mprapa/25666.html
http://www.articlesbase.com/loans-articles/indian-banks-deposit-growth-covering-may-
impact-liquidity-hdfc-3167867.html

http://www.articlesbase.com/banking-articles/banks-raise-deposit-and-base-rates-
3405978.html