By allowing banks to choose their own benchmark for setting the base rate, the Reserve Bank of India (RBI) is, in a sense, giving them more credit for their intelligence. The latest guidelines allow banks some more flexibility in the sense that they don?t need to arrive at the base rate by any fixed methodology. All the central bank wants is that banks should have a sound methodology and that it should be applied consistently and in a transparent manner. Obviously, it?s only logical banks will want to cover their cost of funds while figuring out the methodology, so it?s good that RBI doesn?t want to push through a formula and is leaving the math to them. That?s in keeping with the general philosophy that interest rates in the system should be, by and large, free; in the original draft there was a suggestion to the effect that the one-year fixed deposit rate should be taken into consideration while fixing the base rate, but that?s virtually out the window now. Bankers will now take a hard look at the prevailing rates in the market, price in their expectations over the next few months and figure out what they can offer their best borrower. Subsequently, if the elements that go into the rate change, for whatever reason, then the base rate will change accordingly and so will the ultimate rate to the borrower. In effect, the rates will be market-determined. Since the inputs, which go into the calculation of the base rate, will be clearly defined upfront, it should not be difficult for the regulator to monitor changes (or no changes) in base rates across banks. That would make the system transparent and borrowers need not worry that they?re being shortchanged. The best part of the move to the new system is that banks have been given half a year to perfect their methodology. Even the most savvy of banks will be grateful for this trial period between July and December 2010 and if there are any that discover to their dismay that they?re out of line with the rest of the pack, they can course-correct. Clearly, the central bank doesn?t want to upset the market. When the methodology was centred around the cost of funds and other expenses, most banks said it was likely the base rate would be arrived at on the basis of their marginal cost of funds. That could still be the case with the banks opting for a slightly different definition of ?cost of funds.?
It?s unlikely that banks will price themselves relative to the MIBOR (Mumbai Inter Bank Offered Rate) because overnight rates can be volatile. However, they may just use the six-month rate or even a 90-day rate whichever they believe is more stable. While there shouldn?t be too much of a problem for rates for longer maturities, banks need to be careful they don?t export the short-term market of the banking system to the mutual funds. Going by the present rate environment, base rates could range between 5% and 7%. NBFCs who access banks for some of their borrowings were earlier apprehensive that the base rate would be set at higher levels. Even if this is so they could perhaps resort to borrowing from banks for shorter tenures.
