The biggest complaint of loan consumers in India who have taken loans on a floating rate has been that lenders are quick to raise rates for them when interest rates rise in the market but are very reluctant to reduce their interest rates when market interest rates drop. Till June 30, 2010 the floating rate products were priced with reference to their Benchmark Prime Lending Rate (BPLR). Clearly the BPLR system was not functioning in a transparent manner. After setting up a committee to examine the issue and a draft note inviting public suggestions the guidelines relating to the new “Base Rate” system have been made effective for all loans issued or renewed on or after July 1, 2010. So will this new Base Rate system be effective?

This article examines the difference between BPLR and Base Rate regime and the potential impact of the Base Rate system.

The rate is “to be computed taking into consideration (i) cost of funds; (ii) operational expenses; and (ii) a minimum margin to cover regulatory requirements of provisioning and capital charge, and profit margin”. No this RBI pronouncement is not about the Base Rate but about the Benchmark PLR. If you see the non-binding “illustrative methodology” for the Computation of the Base Rate in the guidelines, it also more or less lays out the same set of parameters but just in greater detail.

So if the calculation method is similar how will Base Rate system make a significant difference?

For starters there are two big differences. Whilst each bank can choose its own benchmark for the cost of funds they will have to document the detailed formula for the calculation of the “Base Rate” and the method of calculation and follow it consistently (except during a brief six month transition period). This formula will need to be disclosed to RBI, which can also scrutinize that it is being followed consistently. This is unlike the BPLR regime where the BPLR was supposed to take into account the same set of parameters but no documentation was required and it was not open to RBI scrutiny. This is a significant difference between the two regimes since this forces the banks to follow a consistent method of calculating the Base Rate unlike the BPLR.

The second big difference is that, unlike the BPLR, banks are not allowed to lend below the Base Rate (again there are a few exceptions but they are not very relevant for this purpose). Now we all know that blue chip corporates are always able to get good rates from the banks. They are likely to be borrowing at interest rates very close to the banks’ current Base Rates. When market interest rates fall they will naturally expect to get better rates and naturally the banks will be forced to drop their Base Rates if they still want to maintain their share of this market. So apart from the point mentioned in the first paragraph, this factor will also exert downward pressure on the Base Rate when market interest rates fall.

If the transparency is so built in then why the doubt on whether the Base Rate system will be effective or not? Clearly the Base rate system is designed to be more transparent than BPLR. But unfortunately there is no requirement that the detailed formula of each bank’s Base Rate be made public (it is only to be available for review and scrutiny by RBI). Clearly RBI will need to set up a machinery to monitor and review these calculations to ensure that they are consistent, which given their focus on ensuring transparency is likely to function as an effective check on the proper implementation of the Base Rate system. It would be very interesting to find out whether the general public under RTI can access a specific bank’s calculation of Base Rate that is available with RBI.

As is likely the effective functioning of the Base Rate regime will significantly change the retail lending industry in India. Firstly as changes in the effective interest rate for the customer will depend on the “average” cost of funds rather than the “marginal” cost of funds any increases in market rates will take time before they are fully passed on to the borrower (see box for difference between “average” and “marginal” cost of funds). Whilst this is beneficial when interest rates increase it is also not so bad when interest rates decrease as, unlike the current situation, the consumer is likely to get some decrease immediately compared to none or very little in the current scenario.

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Difference between average and marginal cost of funds

Assume a bank currently has funds of Rs. 100 crores at an average cost of 10% (total cost of funds is Rs. 10 crores or Rs. 2.50 crores per quarter). Now the cost of funds in the market goes up by 1% pa. On an arithmetic basis the banks cost of funds should go up by Rs. 1 crore per annum or Rs. 25 lacs per quarter. However since a lot of the bank’s funds are in time deposits which are at a fixed cost - where the cost will rise only when the deposit comes up for renewal - immediately its cost may go up by only say 12.50 lacs for this quarter or only 0.50% p.a. Of course over a period of time as all the fixed deposits mature and are renewed at new higher rates the cost of funds will go up to Rs. 11 crore per annum or 2.75 crores per quarter). Thus the average cost -10% in this example changing to 10.50% or a change of 0.50% only - will always change slower than the marginal cost - +1% in this example)

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If you have an existing loan should you shift to the new Base rate regime?

Firstly there is no automatic shift to the new regime. You will have to ask your bank to shift you to the new Base rate regime for which they are not supposed to charge you any fees. If you are on an existing fixed rate loans (or in the teaser period where rates are still fixed) where the rate is lower than the current floating rate of 8.50% - 9% than wait till you are on a floating rate basis for shifting to the new regime. If you are paying interest rate in double digits then shift to the new regime immediately. If your existing lender is not giving you good terms for the shift or is not acting fast enough to shift you to the new regime then you should seriously consider shifting to a new lender altogether)

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The National Housing Bank (NHB) which regulates the housing finance companies – HDFC, LIC Housing Finance, etc.- will also be forced to come out with a similar system for HFCs which will be good for the home loan consumers. Similarly the scheme will have to be extended to NBFCs also by RBI though that is likely to have a smaller impact on the loan consumers.

In any case the impact of this fundamental change will be felt only over a period of time – at least 6-12 months as interest rates change (likely to increase) during that period. Here’s hoping that this change has a fundamental impact on all loan consumers.

The regulator does not like them. The consumers cannot seem to have enough of them. Yes I am talking of the teaser rate home loans that have become so popular in 2009. Whilst most of the banks had withdrawn these schemes in the first quarter of this year, India’s largest bank State Bank of India doggedly kept the scheme on (albeit with increased rates from its earlier scheme). Given the universal expectation that interest rates are bound to go up this year, the customers found the safety of fixed rates even if only for a limited period quite attractive relative to a regular floating rate product. This consumer preference has forced market leader HDFC to come out with its own teaser rate loan scheme and ICICI bank has also joined the party this week. The teaser schemes, Bank of Rajasthan and LIC Housing Finance always had the scheme on and their schemes are continuing. As of now the teaser rate loan schemes of HDFC, ICICI and SBI are scheduled to apply only for sanctions till April 30, 2010. The partial disbursement should be latest by June 30, 2010 in case of HDFC and ICICI. However it is expected that the schemes will be extended at least till the end of this quarter.

Let’s take a quick look at some of these schemes and their salient features for a loan of Rs. 30 lacs for 20 years:

So how should a consumer decide on which schemes to go for?

Firstly if you are in the market for a new home loan, it is advisable to choose from one of the above teaser rate schemes (versus a regular floating rate product from them or other lenders) since it will give you the safety of low fixed rates during the next few years during which interest rates are likely to rise. Between them also the real difference will arise once the fixed rate period is over and the time comes for the floating rates to take over. At that time how accurately the lenders reference rates reflect the changes in the market interest rates will determine what the actual effective cost is for the consumer. (See article on how lenders do not pass on benefit of lower interest rates to their existing loan consumers in the DNA of February 13, 2010) . It is here that the public sector banks have a relatively better record. The Mohanty committee set up to suggest changes to make credit pricing more transparent found that whilst the BPLR of all banks moved up when RBI increased Repo rate the BPLR of public sector banks were impacted (lowered) more significantly than their private or foreign sector counterparts when RBI dropped Repo rates.

In any case this is an area with developing implications as the new Base Rate system scheduled to be operational in the second half of 2010 should improve the transparency on fixation of reference rates for floating rate loans.

However the biggest opportunity is for existing home loan borrowers who are in a regular floating rate loan. Chances are that you are already paying a fairly stiff rate (probably in excess of 9.50%) compared to what is available for new loan consumers today. Get rid of your inertia and shift now to a teaser rate loan and do it now. This is a small window of opportunity, which may not remain open for too long.

A leading pink paper on Tuesday September 22, 2009 broke a story on its front page  about how RBI is planning to ban all sub-PLR loans for tenures beyond a year. The story mentioned, “If RBI bans sub-PLR rates on loans above a year, banks will find it difficult to reduce rates only for new home loan customers”.

Even this move will not end the trouble of existing home loan consumers who watch on enviously as new customers get lower and lower rates while they are stuck with higher rates. To understand this let’s look at how PLR affects home Loan consumers.

So what is this PLR? PLR stands for Prime Lending Rate or in other words the rate at which the banks will lend to their most Prime customers (customers with the best credit parameters). This way PLR should be the lowest rate at which the bank will lend.  In India lot of banks have more than 80% of their loans being lent out on rates below their PLR. This is due to non-transparency in fixing PLR making PLR itself meaningless.

Also PLR is normally supposed to apply across all loans but most Private banks have different PLRs for different products which completely send the whole concept of PLR for a toss. 

You can see the box below to see how banks can continue to charge existing consumers a higher rate than what they offer to new consumers even after SUB-PLR rates are banned.   

In fact the remedy for home loan consumers already exists in  the form of existing RBI regulations that require that all reference rates should be external and objective which is not being followed by banks. (see this link http://www.apnaloan.com/home-loan-india/some-important-regulations.html). 

So if you are an existing  Home loan customer being treated unfairly by your lender you should immeidately complain to the banking ombudsman that the bank is not following existing RBI regulations regarding transparent fixation of reference rates.

How banks will continue to charge more even after banning SUB-PLR lending?

All floating rate are linked to the movement in a reference rate. For banks in India the reference rate for floating rate loans is a particular PLR of that bank.

Let us say you took a home loan from bank A at 3% below their PLR for home loans (say called Retail PLR) when the Retail PLR was 12%. Thus the effective rate applicable to you became 9% (Retail PLR at 12% less 3%).

Now if the lending rates drop in the market to say 8% it may offer loans to new customers at 8% by increasing the spread from the Retail PLR (i.e. Retail PLR 12% less 4% = 8%). Since the Retail PLR itself has not changed, the existing customers continue to pay 9% whereas the new customer gets 8%.

How banks can continue to provide lower rates to new Home loan customers whilst charging higher rates to existing customers even after the ban on Sub-PLR loans

A momentous moment in India’s retail lending history has just been ushered in very quietly. A few days ago Credit Information Bureau of India Limited (CIBIL), which is currently the only fully operational credit bureau in India, quietly introduced a manual system to provide consumers with their own credit history on a test basis. In a written communication from CIBIL to Apnapaisa it has been clarified by CIBIL that “CIBIL has started offering Consumer disclosures through an interim solution. This interim solution is a testing phase and we will be able to operationalize the full-fledged Consumer Relations System basis our learning from this phase. In this interim phase CIBIL will be manually handling consumer requests for a copy of their credit information report.  CIBIL is also developing the infrastructure, systems and processes for an automated solution that would be needed to enable an individual direct access to their Credit Reports from CIBIL on-line.  The full-fledged Consumer Relations System will have world-class features that will allow consumers to access their report on-line and banks to respond to errors via an on-line maintenance tool. The automated phase is expected to be ready by the beginning of next fiscal year “.

So why is this such an important event that I am calling it a momentous occasion for the Indian retail lending history. For those of you who have just tuned in, CIBIL is one among 4 credit bureaus that have been licensed by the RBI under the Credit Information Companies Regulations Act, 2005 (CICRA). CIBIL though is the only one that already been operational for around a decade now and has the credit repayment history of around 13.7 crore loans or credit cards.

Almost all of the major lenders provide details of the credit facilities given by them to their customers as well as the amounts that have fallen due and the repayment made by the customers on a periodical basis (monthly or quarterly). CIBIL collates and aggregates this information. Thus when a customer (say Mr. Desai) approaches any bank (say Bank of Bharat) for a credit facility CIBIL is in a position to go through its own records and provide details of the existing credit facilities enjoyed by Mr. Desai to Bank of Bharat as well as his repayment history on such facilities. This enables Bank of Bharat to take a more informed decision on Mr. Desai’s credit application since it now has access to credible third party information on Mr. Desai’s existing obligations as well as his repayment history. It also benefits Mr. Desai if he has maintained a spotless repayment history since he is able to get the credit facility quickly and cheaper based on such good record. If his earlier repayment history is not so good, off course, he will find it difficult (and more expensive) to get the credit facility.

Up to now Mr. Desai could not access his own credit report. There was a rather convoluted way for Mr. Desai to get a copy of his own credit report but with this step he can get a copy of his own report by paying Rs. 142/- to CIBIL. This will help him in finding out if there are any errors in the report. A large number of consumers today feel helpless about erroneous repayment history being reported by the banks to CIBIL showing the consumer in default even where the so called “outstanding payment” is in dispute. These kinds of errors are the highest in the case of credit cards.

Since now he can have access to his own report the consumer can point out any errors in the report to CIBIL who are, under the CICR Act, required to notify the concerned bank. The erroneous entry will have to be deleted by CIBIL unless the concerned bank reverts to CIBIL within 30 days of the consumer filing his error report with CIBIL. If the consumer is not satisfied with the action of the bank in this regard he can always file a grievance before the banking ombudsman. Thus by having access to their own credit report the good consumers can ensure that they do not fall victim to erroneous reporting by the banks. At the same time consumers who delay payment for any reason will have to pay the price for such delays. Good consumers who pay their instalments will stop subsidising the consumers who delay payments. At a future point of time CIBIL may even share their proprietary credit score with the consumers for an additional fee. This score predicts customer’s likelihood of becoming a defaulter in more than 91 days within the next year. Higher the score less are the chances that the consumer will default. Any score above 700 is considered good. Having access to this score will assist the consumer in getting a rough idea of how banks view his credit standing and he can then take action either improve his credit score or if his score is already very good take care to maintain it at a high level.

So if you want to get a copy of your own credit report download the form available on the apnapaisa website at this link and fill it in and along with the required documents (mentioned in the form) and the payment of Rs. 142/- send it off to CIBIL address mentioned in the form.

This historic step needs to be welcomed with all fervour by consumers who will now no longer be helpless in knowing what banks are reporting about them to CIBIL.

I have already sent in my application to get a copy of my credit report.  I have taken great personal care to keep my credit standing immaculate but am awaiting with bated breath what my credit standing looks like as reported by the banks.

Watch this space for my comments on my own credit report.

What is a teaser loan? A teaser loan is a loan that offers low interest rates during the first two years of the loan tenure. Here the interest rates are artificially kept low in the initial few years to attract the borrowers. The borrowers get tempted to avail the teaser loan as in the initial years the EMI is comparatively low. Thereafter the interest rate soars. It is also known as ‘2/28’.

For example: A loan starts off with an interest rate of 9% for the first two years. Third year onward, the interest rate rises to 11.5%. Thereafter, the interest rate fluctuates based on the Prime Lending Rate.

The teaser loan is a risky product as the borrowers tend to default when the interest rates jump.

It is available only for floating/adjustable/variable rate loans.

The prepayment penalty is relatively high.