New guidelines to calculate base rate this week: Rajan

Mumbai: After goading banks, without much success, to pass on full benefits of policy rate cuts to borrowers, Governor Raghuram Rajan Tuesday said the Reserve Bank will this week issue guidelines to determine base rates on a new methodology based on the marginal cost of funds.

"Since the rate reduction cycle that commenced in January, less than half of the cumulative policy repo rate reduction of 125 bps has been transmitted by banks. The median base lending rate has declined only by 60 bps since then," he said in the 5th bi-monthly monetary policy review in the current fiscal.

Explaining the rationale of the move, Rajan told reporters during the customary post-policy press meet that "there is a particular way to calculate the base rate now. And our worry is that it should not come in the way of banks to pass through lower lending rates to customers.

"That is why we took a relook at the base rate and are coming to the marginal cost pricing which we will be announced later this week."

Stating that the marginal cost of pricing makes the costs flow through into lending rates faster, Rajan said that "the intent is that banks would be able to make incremental loans on the marginal cost pricing while historical or legacy loans will be on the base rate. That's the intent as we go forward."

Rajan further said the marginal cost of fund calculation offers banks flexibility to move more quickly while the base rate calculated under the average cost will not allow them to do so and react to competition from the markets.

As banks held on to higher lending rates even after the central bank had cut the repo rate twice till March this year, RBI in April suggested the marginal cost as the basis for calculating their base rate, much to the chagrin of bankers who said that the domestic market was not mature enough to adopt such a method as deposits are still priced higher.

In a bid to bring in more transparency in credit pricing, RBI under the past governor D Subbarao had in July 2010 asked banks to calculate their lending rates based on base rates, barring lenders from selling credit below the declared base rate. Earlier this year, RBI had again asked banks to review their base rates on a quarterly basis. 

The base rate, the minimum benchmark rate below which a bank cannot lend, has made it impossible for banks to cheaply price corporate loans and charge more from retail borrowers.

Rajan further noted that banks have massively reduced their 1-3 year deposits rates, which is much more than what they have transmitted through the base rate cuts. "In that sense, there is room building up for banks to transmit more. I think it is matter of time."

Partly blaming higher cost of bank funds as a major reason for low credit demand and higher demand in money market instruments like commercial papers and certificates of deposits, Rajan said: "Newspapers are reporting an increase in commercial paper issuances, which essentially means corporations are going there rather than banks.

"At some point, when the banks are thinking of recapturing their market share, the way they calculate their lending rates should not come in the way. Hence, marginal cost of funds based formula. Ideally, we need a market benchmark and we are getting there."

He also said moving on to the marginal cost pricing will also allow banks to pay more attention to asset liability management and the market will become more vibrant."

Clearly, he said, banks have the capability to switch to marginal cost of fund based pricing methods. Besides, the rate reduction on small savings like PPF and post office deposit is also going to bring down cost of fund for banks.

"The government is examining linking small savings interest rates to market interest rates. These moves should further help transmission of policy rates into lending rates," Rajan said, adding there is room for banks to pass on interest rate to customers.