The Hindu : Banks have a tough task

Online edition of India's National Newspaper
Monday, Mar 15, 2004

Business

Business

Banks have a tough task

Benchmark PLR is a welcome move to ensure transparency and removal of the element of cross-subsidisation but will require banks to prepare to meet several challenges, says K. M. Bhattacharya.

A BENCHMARK PLR for banks is now a hot subject of discussion. Banks have been asked to take into account their actual cost of funds, operating expenses, a minimum margin to cover the regulatory requirement of provisioning for NPAs (non-performing assets) and profit margin while arriving at the benchmark PLR.

For about two years the Reserve Bank of India's efforts to make banks pass on the benefits of soft interest rates to their borrowers had failed. In the private sector the gains of the soft interest rates policy were confined to a few large and influential borrowers who could secure loans at sub-PLR.

Home loans, consumer loans and other retail loans were also de-linked from PLR and banks started large scale lending to these sectors at sub-PLR rates. Some players have gone to the extent of making their rate-chart redundant and allowing their front desks to fix loan rates depending upon the profile of the customers. In other words, the lending rates became negotiable depending on the bargaining power of the borrower and the liquidity position of the lender.

Banks contend that they cannot keep their surplus funds idle and have to deploy them to get the best possible yields. They have to either lend or invest in government securities or call money market at much below their cost of funds. With poor demand from borrowers banks find it difficult to lend at or above their PLRs even to non-prime borrowers.

Cross subsidisation

To cover the losses incurred on sub-PLR lending banks charge higher rates wherever possible which results in cross-subsidisation of sub-PLR lending by other borrowers, mainly SSI units, agriculture, small borrowers, trade and other priority sector borrowers, who really need the benefit of the soft interest rate regime most.

To remove the anomaly, as a first step, the RBI asked banks to declare their spread over PLR and insisted that the same should not exceed three percentage points over PLR. Subsequently, it asked them to declare their PLR also, by taking into account the cost of funds, administrative expenses and suitable mark up on account of reserve requirements and profit margin. Banks were, however, reluctant to declare their realistic PLR and continued charging ad hoc PLR plus spread ranging from one per cent to 3 per cent depending upon their risk perception of borrowers. Their PLR continued to be maintained in the range of 11-13 per cent with the interest in the range of 11-15 per cent for the general category of borrowers. Priority sector loans also continued to be charged at PLR in the range of 11-13 per cent whereas they deserved a lower rate of interest.

IBA formula

As a further corrective step, the RBI in its mid-year review of monetary and credit policy for 2003-04, asked the Indian Banks' Association to come out with a formula for fixing a single benchmark PLR and spread. The IBA has since come out with the formula according to which:

Banks may determine the lending rates on loans and advances with limits in excess of Rs. 2 lakhs with reference to the benchmark PLR calculated on the basis of weighted average cost of funds (historical or marginal as may be considered appropriate), average cost of operations and appropriate provisioning/capital charge and profit margin.

Benchmark PLR needs to be seen as a reference rate around which most banks' lending would take place.

The pricing for borrowers can be arrived at by adding time-varying term premia, risk premia depending on risk profile and such other elements of cost as considered necessary.

Banks may also price floating rate products by using market benchmarks in a transparent manner.

Interest on certain categories of loans and advances may be determined without reference to the benchmark PLR: example: housing loans.

Banks will have to develop scientific tools and techniques to ensure a competitive edge by economising in respect of each and every component of benchmark PLR.

Reducing cost of funds

First, they will have to bring down their cost of funds. For this they will have to focus on low cost deposits and other sources. They will have to improve their marketing skills and efficiency of services delivery to attract such sources.

Second, banks will have to bring down their operating costs. For this they will have to curtail avoidable expenses, increase operating efficiency by increasing per employee business and profit and reducing per employee expenditure. They may have to reduce their staff strength and if necessary think of floating VRS schemes for their employees. Simultaneously, they will have to think of increased use of technology to improve service quality with curtailment of costs.

Third, banks will have to improve their credit /NPA management techniques to better manage their provisioning/capital charge requirements. While banks are precluded from booking interest on NPAs, they are required to make provisions for the same having regard to the asset classification and available securities.

As NPAs cause double drainage on profitability improved NPA management will definitely help them in reducing costs and consequently the benchmark PLR.

Fourth, banks need to have in place a good ALM (asset liability management) and market risk management system so as to have in-depth assessment of interest rate and liquidity scenario in the future.

Fifth, banks will have to adopt advanced techniques for measurement of capital charge applicable for the credit. The New Basel Capital Accord being framed by the Basel Committee on Banking Supervision (BCBS) for implementation by banks requires banks to hold capital against the uncertainties of their business and set out a framework to align capital with banking risks.

Finally, banks should religiously price credit based on benchmark PLR in a transparent manner. If they continue their old practice with PLR by allowing sub-PLR rates to their favourites and keeping the PLR cap for others, the concept of benchmark PLR will become a fiction.

From the point of view of profitability also it will be necessary for banks to desist from sub-BPLR lending after determination of benchmark PLR using various parameters outlined by the IBA such as weighted average cost of funds (historical or marginal as may be considered appropriate), average cost of operations and appropriate provisioning/capital charge and profit margin.

It is, therefore, a matter for the RBI to decide whether in the long term interest of the banking industry no bank would be ordinarily permitted to lend below BPLR except in certain exceptional circumstances and for specified sectors. Further, banks should try to avoid deployment of funds in commercial paper at rates below BPLR or at break even rate, that is, BPLR minus profit margin. If banks continue to quote rates with a view to only minimising the loss, their financial position will be weakened in the long run.

The business prospects of any bank in the ultimate analysis will depend on their efficiency in reducing the other components of BPLR, namely, cost of funds and administrative expenses.

Even today, different banks have different levels of cost of funds and administrative expenses and, therefore, BPLR has been different between banks ranging from 10 to 12 per cent and this itself will give a lot of business opportunities to banks that are efficient enough to cut down these expenses. Thus only the efficient banks will be able to reduce their BPLR substantially and remain profitable.

(The author is Managing Director, Bank of Rajasthan Ltd., Jaipur.)

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