Micromanaging loans

The Reserve Bank of India’s directive demanding banks spell out their rationale for charging differential spreads to borrowers and to display minimum and maximum lending rates on their websites may be intended to improve transparency in loan pricing. But it is undesirable as it robs the discretion of banks to take loan decisions based on their own perceptions of risk. Such micromanagement is unnecessary given that banks are subject to a base rate mechanism, arrived at on the basis of an RBI formula, and which forms the basis for all their rate decisions. If the RBI monitors individual pricing decisions as well, what leeway will banks have in managing their commercial affairs?

The reluctance of banks to pass on rate cuts to borrowers appears to have prompted the RBI’s move. Banks have generally chosen to reduce their spreads (the mark up over the base rate) rather than lop base rates whenever the RBI undertakes rate cuts. This has resulted in new borrowers benefiting from lower rates, while older ones have remained locked in at higher ones. There is a valid reason for this practice. When the RBI cuts rates, banks can trim rates on incremental term deposits; older depositors continue to earn higher rates. Against this backdrop, if banks reduce their base rates and thus lending rates on all loans, their margins will take a severe hit. To avoid this, banks opt to tinker with spreads on a case-to-case basis. Banks will find the directive asking them to charge the same spread to all borrowers with similar risk profiles difficult to implement. It will require banks to operate detailed credit appraisal systems, which some PSBs are still in the process of evolving. Maintaining and updating individual loan accounts is an expensive proposition. With floating rate home loans, for instance, banks rework the tenure or EMI of the loans whenever the base rate changes. Resetting loan rates frequently may also be unsettling to borrowers, who for this very reason, opt for fixed rate loans. Listing the minimum and maximum limits for lending rates may have borrowers demanding the lowest rate available on a particular loan.

The problem of passing on rate cuts is better addressed by measures such as tweaking the norms for base rate calculations, as the RBI has done. Now, it must be measured on the basis of deposits that have the largest share in the banks’ fund base rather than in the arbitrary fashion they were arrived at. All in all, however, instead of micromanaging pricing decisions, the central bank will do better to empower borrowers by ushering in greater competition in the banking sector. At a time when opinion is consolidating in favour of the phase-out of directed lending and the use of credit control tools, imposing restrictive credit pricing mechanisms on banks seems retrograde.

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