The Reserve Bank of India has proposed that, starting April, the existing mechanism of linking lending rates to the benchmark prime lending rate be replaced with a base rate below which banks will not be permitted to lend.
The move, proposed through a draft circular, seeks to introduce greater transparency in pricing credit.
The ban on lending below the proposed bank base rate will apply to all segments other than export credit and differential rate of interest schemes targeted at certain low-income groups.
The base rate will be applicable to all new loans. For old loans that come up for renewal, borrowers will have the option to switch to the new system provided they agree with the terms the banks offer.
Banks will have to calculate the base rate on the basis of the cost of deposits, adjustment for the negative carry in respect of cash reserve ratio and statutory liquidity ratio, overhead costs and a profit margin.
Banks have been demanding that RBI pay interest on the funds they set aside to meet the cash reserve ratio, or the proportion of deposits they set aside.
The return on statutory liquidity ratio balances is lower than the cost of deposits. At present, banks have to invest a quarter of their net demand and time liabilities in government securities for calculation of SLR.
In moving to the system of base rates, the RBI has relied on the report of committee headed by its executive director Deepak Mohanty.
Based on Mohanty committee's calculations, when the cost of one-year retail deposits was used to calculate base rate, using the data for 2008-09, the RBI panel had computed the base rate at 8.55 per cent.
While bankers were unwilling to comment on how the base rate will change based on the new formula, it is almost certain that the base rate will be in single digits for almost all lenders.
At present, the BPLR of Indian banks is between 11 and 15.75 per cent, with Punjab National Bank at the lower end of the spectrum and lenders such as ICICI Bank and Yes Bank at the other end.
Among other things, the Mohanty committee had recommended a shift to a system of base rate with only 15 per cent lending permitted below the base rate.
The draft circular said the deregulation will include directed lending schemes such as farm credit. "Accordingly, the current stipulation of BPLR as the ceiling rate for loans up to Rs 200,000 stands withdrawn.
"It is expected that deregulation of lending rates will increase the credit flow to small borrowers at reasonable rate. Thus, direct bank finance will provide effective competition to other forms of high cost credit," it said.
At present, nearly three-fourths of the lending takes place below the BPLR and bankers have often blamed priority sector lending and export finance as one of the prime reasons for the practice.
Bankers said the ban on sub-base rate lending will bring about more transparency though it will reduce the bargaining power for companies.
They also said the net interest margin which is the difference between the yield on advances and cost of funds might begin to settle at lowers levels, compared to the present level of 2.5 to 3 per cent for most banks.
"It will be in tune with international trends and push banks to step up fee-based income," said a bank executive.