The Hindu Business Line : A benchmark for interest

The recent increase in interest rates highlights some key features in the pricing of bank loans. It also shows that financial markets development in India has some more distance to go. While a falling rate environment — as was in evidence in the four years up to 2004 — should have ideally thrown up the same issues (from the lenders' side) as seen now, they got sidelined in the euphoria surrounding the bumper profits banks made in that period. This time around home loan borrowers have been affected as their "floating rates" have been marked up with each successive move up in the interest rate structure. Enduring relief for home loan borrowers may come only with the turn of the interest rate cycle, but in spotlight are the structural limitations of the credit market.

A key limitation is the absence of a short-term benchmark interest rate based on which `floating rate loans' can be priced. In advanced markets, there is an active money market among banks for maturities up to one year. This provides the reference for pricing longer-term floating rate loans. The advantage is that no single financial institution has any control over the benchmark that emerges from the matching of short-term liquidity surpluses/deficits of all market players. Against that, the floating rate loans in India are priced off a lending institution's internal rate. Transparency is the biggest casualty here. Also, the borrower runs a double risk. Not only will the overall hardening in rates push up his debt-servicing costs, he would also be affected by how the general increase in rates impacts the cost structure of the bank he has borrowed from.

So, why has a benchmark interest rate not evolved in India? The Mumbai inter-bank overnight offered rate (NSE MIBOR), of course, is an active benchmark. But this has been mainly for the inter-bank market and not the general borrowers/lenders. The most important player to aid the development of a benchmark is the central bank. Even in the developed money markets, central banks actively defend their interest rate stance. While all other rates are market-determined, it is the central bank that decides what the interest rate should be for a particular maturity and this decision is backed by active market operations. Then, the benchmark rates for other maturities automatically fall into place.

While the Reserve Bank in India too has gone some way towards setting an interest rate target (or a corridor), it has not been able to defend this consistently because of the conflicts with its other responsibilities. The money market in India is, therefore, stunted. To provide relief to housing loan borrowers, following the recent sharp run-up in rates, the RBI has lowered the risk weights on loans up to a certain value. This is but a placebo and deeper structural issues need to be addressed.

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