Are we bringing back interest rate controls?

Dismantling the regime of financial repression, via directed lending and administered interest rates, has been one of the stated objectives of economic reforms.

Regulatory efforts in recent times have sought to give banks the power to price their loan products based on their own assessment of risk-return considerations. In the process, lending rates have become largely market-determined. The only caveat is that no loans can be extended below the ‘base rate’ declared by each bank — though even this is not applicable for restructured loans, loans against deposits and loans under the Differential Interest Rate scheme targeted at weaker sections.

At the same time, the concept of ‘base rate’ itself has been questioned for setting a ‘floor’ below which banks cannot lend — even when it is commercially expedient to do so for short periods, taking into account their liquidity position and lendable surpluses.

In this context, one needs to examine a recent draft report on ‘Pricing of Credit’ by a Reserve Bank of India (RBI) working group headed by former Deputy Governor Anand Sinha. Its recommendations, if implemented, may well further stifle the breathing space banks now have in loan-pricing.

The panel has, among other things, proposed that no bank can hike interest rates for an existing borrower, except on deterioration of ‘credit risk profile’.

Now, credit risk profiling or ‘rating’ is a backward-looking indicator, even in the best of times. Ratings are largely an annual exercise relying on past audited financials of companies. There is hence an in-built skew heavily weighted in favour of the past and not the future outlook for either the borrower or the industry in which it operates.

If banks have to wait for the next rating report to reset interest rates, it would be tantamount to bringing back controls over loan pricing by proxy. Even if one were to mandate tighter norms on resetting interest rates for, say, home loan or retail borrowers, this principle cannot be applied for industrial and commercial segment borrowers.

Banks should have the flexibility to respond to an ever-changing industrial environment. A bank may want to exit or lend less to a particular industry — say, sugar — based on its assessment of risk of exposure to that sector. One way to do it is to raise lending rates to that industry. This perception may not, however, be shared by other banks, which would continue to lend at existing rates to companies in the same sector.

Foreign and private sector banks are known to take such dynamic positions with respect to loan pricing, unlike their public sector counterparts, who are generally not ‘smart’ in terms of exiting or reducing exposures to certain sectors at the right time. That is probably one reason why the problem of non-performing assets has been more serious for state-owned banks that, till recently, continued to lend to troubled sectors when they ought to have exited.

The RBI panel’s recommendation to link resetting of interest rates to annual credit risk profiling would severely hamstring the efforts of banks to reduce exposure to particular borrowers or industries.

Banks can only wring their hands in despair if they do not have the freedom to react to adverse developments in the interim — including events such as invocation of bank guarantees, devolvement of letters of credit or delays in instalment/interest servicing. True, some of these may eventually get reflected in a formal deterioration in the borrower’s credit quality. But does waiting for adverse developments to crystallise make for smart business sense?

The working group’s main underlying concern, based on a reading of its report, seems to be to ensure transparency, consistency and non-discrimination in lending practices.

This is understandable vis-a-vis retail/small borrowers. But the report’s recommendations are over-arching, covering even borrowers in the commercial and industrial (C&I) segments. The latter, after all, are savvy enough to get the best of bargains and obviously do not need the safeguards suggested by the panel.

Further, the flexibility banks currently have on pricing of credit in the C&I segment — based on factors such as track record of customers, length and value of relationships, competitive offers from other banks, availability of collateral and conduct of account — will be lost through the proposed regimentation. No two borrowers in these segments are alike from a credit-risk/relationship perspective.

The draft report also bristles with other proposals on how banks should compute their base rates. “It would be desirable,” the report says, “that banks, particularly those whose weighted average maturity of deposits is on the lower side, move towards computing the base rate on the basis of marginal cost of funds.” The expectation here probably is such a rate would be more directly linked to the RBI’s repo rates, helping the cause of monetary policy transmission.

The base rate concept is itself regressive, as already pointed out. In none of the 18 jurisdictions profiled in the report — including Canada, Germany, Singapore and Hong Kong — is there anything akin to a base rate. The restrictions, if any, in all these mature developed financial markets are on the maximum interest rates that can be charged, not the minimum. Concerns over usury or Shylockian practices have led to ‘caps’ or ceilings in lending rates of banks in these countries, not ‘floors’.

Quite apart from the need for a serious rethink on having a bank-specific base rate at all, the working group’s draft report has sought to further build on a flawed concept, thereby only muddling the interest rate waters rather than clearing them up. It has even gone to the extent of mooting an ‘Indian Banks Base Rate’, a new benchmark to be collated by the Indian Banks Association.

A better solution, instead, would be for the RBI to help develop a term money market in India and pave the way for the Mumbai Inter-Bank Offered Rate or MIBOR to emerge as a relevant benchmark like London’s LIBOR for foreign currency loans.

One cannot argue against the report’s emphasis on the need for greater transparency and board-approved policy on pricing of loans. These, and the importance of financial education drives, are initiatives that will definitely stand the retail borrower in good stead. But its suggestions on the whole will only make for operational difficulties for Indian banks, especially when it comes to MSME and C&I loan pricing.

The writer is with State Bank of Patiala. The views are personal

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