The Right Interest

The reforms of the early 1990s were traumatic for some ministries which were in charge of controls, such as ministries of commerce and industry, but they eventually adapted themselves to the new circumstances. The Reserve Bank of India (RBI) did not have such smooth sailing. An instance of its difficulties is interest rate regulation, on which its Working Group on Benchmark Prime Lending Rate has just given in its report. The prime lending rate, for banks in the West, is their minimum rate at which they lend to their most valued customers. When it “deregulated” interest rates in the 1990s, the RBI asked Indian banks to declare their PLRs. But the PLR was meant to be the minimum rate only for loans over Rs 2 lakh; for loans under the limit, it was the maximum. In 1995, it allowed banks to have two PLRs, one for loans and another for cash credit. Then in 1999, it allowed different PLRs for loans of different maturities. So there was nothing like an identifiable PLR left by 2000. Then in 2001, the RBI allowed banks to give loans over Rs 2 lakh at rates below the relevant PLRs. So the PLRs lost all connection with international usage. Under the RBI’s guidance, Indian banks had grown a jungle of PLRs. And none of them had a concrete meaning: a PLR was just the name given by a bank to a rate it had plucked out of the air.

The RBI tried to rediscover the PLR in 2003. It asked banks to specify a Benchmark PLR which would be the sum of the cost of funds, operational expenses, cross-subsidy to governments that were entitled to cheap money from banks, and a profit margin. The connection of the rate with the best customers was forgotten; the RBI was trying to get the banks to specify an interest rate below which they would not lend. There may be any number of customers who borrowed at less; the RBI was trying to define a break-even interest rate.

The banks were pliant; they reported their BPLRs to the RBI, which published them every week and month. Its suspicions should have been awakened by the fact that the PLRs hardly varied, but it was too trusting. It did realise that banks were giving loans below their BPLRs. It deluded itself that such favours were exceptional; but by and by it became obvious that lending below the BPLR was a common practice. The RBI finally appointed this working group to find out what was happening.
What it found was astounding. Banks lent out over two-thirds of their funds at rates below their BPLRs. Their maximum and minimum rates varied more than their BPLRs. In other words, they changed their interest rates according to circumstances, but they hardly touched the BPLRs. The BPLRs were just pendants the RBI had made them hang around their necks; they were purely decorative.

The working group wants to change that, and bring the BPLR back to its pristine glory. But its name has been so badly besmirched that it would continue to be treated as a bauble. So the working group has invented a new name, the base rate. That would be really the minimum rate at which banks would lend, except to holy borrowers such as exporters. This base rate would be precisely what the PLR was originally supposed to be: it would be a sum of what the bank pays on one-year deposits, the cross-subsidy it gives to its investments in one-year treasury bills, the cross-subsidy it gives to the government on the cash reserve ratio and the statutory liquidity ratio, administrative costs and a profit margin. In other words, the RBI wants all banks to do cost-plus pricing of their credit, and to declare their minimum cost.

This raises two questions. First, what is so important about declaring the minimum interest rate? It would seem that the working group is harking back to the prime lending rate as it is understood abroad. Just what is so sacred about the PLR is not at all clear, however. Elsewhere banks have to compete; they try to attract the best customers by offering them the lowest rate. In this country, there is no competition. Foreign banks charge higher interest rates and still attract better customers because of their superior service. The prime lending rate has no meaning in a country where banks with enormously different rates of profit continue to survive forever.

Second, why should the minimum rate cover average cost? Bank borrowings as well as credit are highly differentiated; a bank raises funds at extremely varying costs, and finds a use for them at the highest interest rate it can get. In this welter of interest rates, cost cannot be easily defined, and a cost-plus floor is irrelevant. The RBI is chasing ghosts.