The Hindu Business Line : Benchmark rate

There have been elaborate discussions on different interest rates, giving the impression that they were, in fact, the benchmark. For instance, the auction rate on government bonds, the repo rate, the `corridor', and the prime-lending rate of banks. Yet, the `official' benchmark has been the Bank Rate. But transparency demands that the official rate provides the link between the present and the future and does not allow exploitation of short-term trading opportunities. That would help derive a meaningful yield rate and better understanding of market expectations, says A. Vasudevan.

ONE OFTEN comes across the word `benchmark' in discussions on economic policy and corporate business issues, as critical to assessing certain variables.

However, neither theoretical economics nor economics teachers refer to this word as a concept. One, therefore, suspects that it has emanated from the practitioners of business management.

Benchmark, a point of reference

The dictionary meaning of `benchmark' is that it is a marked point of known or assumed elevation, so relevant in land surveys or construction of irrigation channels.

But in the world of finance, the word has come to denote a number in respect of interest rate or yield rate or overall performance of the company.

It is rarely expressed in terms of ranges or bands. It is not an objective: It is merely a point of reference.

If `benchmark' is a reference point, it could well be used in all the areas of economics — say, in respect of fiscal deficit or inflation rate or the overall fiscal performance of a State, or growth rate of the economy, or order of credit expansion, or the level of the exchange rate.

However, this is rarely the case although potential output could well serve as benchmark despite misgivings about its estimation.

Assume that the central bank, as a regulator, announces a rate that it considers the benchmark and that which is perceived as investment friendly. It cannot prescribe a rate for `prime' borrowers as it is not in full knowledge of such borrowers and their credit record. The rate can neither be a ceiling nor a floor loan rate. Obviously, banks can lend at different interest rates. But banks would consider the announced benchmark as the average of rates. They also have to ensure that the rate spread among the borrowers is not large and adverse selection eliminated. Besides, they would be wary of being questioned by the regulator in case the actual average lending rate exceeds the benchmark. On the other hand if the actual average rate is lower than the benchmark, the regulator may choose not to intervene.

The above case, however, is not realistic. Regulators encourage banks to announce the benchmark rates, but keep a watch on the rate spread. For, when much of the borrowing is at rates that are far in excess of the banks' announced benchmark rate, the regulator would become alert so that credit disbursements are not unsustainably large.

Commercial banks prefer to determine loan rates on certain objective criteria. They would not object to the central bank providing signals about what it considers as the appropriate benchmark.

If such a signal, openly heralded or informally mentioned, were available, then banks would adopt a variety of methods to ensure that their actual loan rates are broadly in line with the signalled rate.

For example, they could ration credit or charge different rates for their borrowers on the basis of their calculations of creditworthiness or announce benchmark loan rates in terms of ranges for each group of borrowers, thereby creating multiple reference points for each bank.

In case the last option is favoured, banks would benefit by colluding with one another in announcing multiple benchmark rates that are near-convergent across banks for each group of borrowers.

Or, the big sized banks would first announce such benchmark rates and let smaller ones follow their lead (the `herd' behaviour!).

In the event, rate competition among banks would be at a discount. At best, banks could be differentiated only on the basis of range of services they offer and the quickness of their delivery.

`Prime' borrowers

Still the question as to how the benchmark rate, be it single or multiple, gets determined remains. In India, when banks announced the prime rates, they were set at levels lower than what was then charged for major or `prime' borrowers.

This became a benchmark and the rates were subsequently fine tuned to be competitive with the rates at which prime borrowers could mobilise resources either through issuance of alternate financial instruments such as commercial paper or from foreign markets (or foreign currency loans).

This, however, is not the way economics students at Indian universities view the determination of interest rates. For the student, the loan rate is uniquely determined on the basis of the supply of and demand for funds. It is an equilibrium rate and is at once the benchmark rate.

However, the student would be willing to consider the existence of different benchmark rates for different borrowers, representing multiple equilibrium rates. An average of multiple equilibrium rates would then give a unique equilibrium rate for the bank as a whole.

Typically, the actual rate deviating from the equilibrium rate can only be temporary as there would be a tendency on the part of lenders and borrowers to move to the equilibrium rate.

Determining benchmark rates

The word, `equilibrium', however, is generally viewed with derision, ever since Kaldor's criticism of it around the 1980s. But if one were to closely examine the processes through which bankers arrive at benchmark rates, there is very little of difference between the bankers' judgments and the students' perceptions.

The only difference between the two processes is that while bankers consider themselves as suppliers of loans subject to structural or exogenous constraints, and view the demand for funds as what `the traffic can bear', the economics students would regard the demand and supply sides as forces that work on objective economic factors.

Viewed differently, for the bankers there would be no forces at work to move towards their pre-determined benchmark rates in the event the actual rates deviate whereas for the economics students, there would be a tendency to move to equilibrium rates.

In reality, there is no knowing where exactly the demand for and supply of funds would be equal simply because the demand for funds is not available as a datum.

Nor are central bankers sure of the effects of changes in interest rates on investments or growth, irrespective of whether the commodity prices are `fixed' or `flexible'.

That is why central banks vary their official rates by typically small percentages. But whether such interest rate smoothening would have the desired effects in a given period is unknown. This is particularly so in the case of India.

There have been many elaborate discussions in India at different times on different interest rates, giving the impression that the discussed rate was in fact the benchmark rate.

As a result, it is difficult to be certain about the rate that the regulator focuses upon. In the mid-1990s, the Bank Rate was a reference one. Subsequently, the discussions surrounded the auction rate on government bills and bonds, the repo rate, the `corridor', and the prime-lending rate of banks in different hues (the short- and the long-term ones).

Yet, the `official' interest rate has continued to be the Bank Rate. But transparency requires that the official rate provides the link between the present and the future and does not permit exploitation of short-term trading opportunities.

That would facilitate derivation of a meaningful yield rate and better understanding of market expectations.

(The author, formerly Executive Director of the Reserve Bank of India, can be accessed at asurivasudevan@hotmail.com)

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