Feel at Home with base rate regime
E-paper Times of
Opportunities Beckons but where the funds ?
EPC -June 2010 , Padmalatha Suresh
Opinion -
Interest Rates
Money
& Banking - Insight
Base rate — questioning the basics?
The proposed ‘base rate' neither ensures autonomy in loan pricing, nor in risk-return balancing. This could impact banks' competitiveness.
Issues in methodology.
Padmalatha Suresh
Banks got a short-term breather when the implementation of the ‘base rate' was pushed to July 1. But come July, banks and borrowers may have to contend with more confusion than the clarity or transparency that the new system claims to usher in.
In its October 2009 report, the Working Group reviewing the BPLR system listed the major issues as (a) large sub-BPLR (benchmark prime lending rate) lending by individual banks, (b) lack of transparency, (c) tendency for downward stickiness, and (d) cross-subsidisation in lending. The alternative — the ‘base rate' suggested by the report — professes to be more forward-looking and transparent, while adequately addressing BPLR drawbacks.
The RBI's move to the base rate is to be analysed using two parameters — (a) impact on banks/borrowers in the immediate future, and (b) consistency with long-term objectives of financial stability and prudent risk management.
IMMEDIATE IMPACT
In a deregulated interest rate environment, banks should be free to price their products keeping three factors in focus — maintaining/increasing ‘spreads' (the difference between cost of funds and asset yield), risk-return trade-offs, and ensuring market competitiveness.
However, the base rate proposed by the Working Group and revised by the RBI falls short of addressing BPLR infirmities.
The Working Group's contention that the one-year deposit rate is forward-looking and transparent can be theoretically true, but poses practical problems for banks operating in a deregulated interest rate environment. To ensure asset-liability matching, banks may want to encourage certain tenure of deposits by offering differential interest rates. Such strategic decisions might impact their base rate. An obvious option is to regulate the one year deposit rate, but the catch, however, is that it would defeat the spirit of deregulation.
The RBI's draft guidelines however replace the one-year rate by ‘cost of deposits' — dubbed by the Working Group as ‘backward looking and sticky'. ‘Cost of deposits' signifies a near-return to the BPLR concept. RBI data show that deposit rates for all tenors have been quite volatile over time and bank groups, signifying that the cost will have to be periodically recalculated.
Banks lend for purposes ranging from short-term demand loans to long term infrastructure loans. In such cases, depending on whether average or marginal ‘cost of deposits' is used, the base rate might be over- or understated.
‘CASA (current account and savings account) adjustment' of the Working Group is academically sensible, but practically unsustainable. CASA is prone to sudden large inflows/outflows. If the adjustment is made annually, banks will be ignoring intra-year fluctuations, or influenced by end-period balances. In fact, banks may be tempted to ‘dress' CASA balances for a higher/lower base rate. The RBI's draft guidelines ignore CASA adjustment. Computation of ‘negative carry on CRR/SLR' assumes the 364 day T-Bill rate to represent income earned from SLR investment. However, RBI data show significant volatility in outstanding amounts of these securities and their yields. Further, latest data show that banks do not prefer investing in 364-day T-Bills. Hence, assessing negative carry based on a small portion of volatile, (albeit transparent), movements in T-Bills may be unrealistic.
The RBI draft guidelines include corporate overheads under ‘unallocated overhead cost'. The ratio of this cost to ‘deployable deposits' is added to the base rate. There are two problems with this method — one, by simply increasing overheads (or decreasing cost control) banks can quote a higher base rate; two, the deployable deposits may fluctuate over time, necessitating frequent changes to this rate.
The average return on net worth is computed in two parts — net profit/net worth multiplied by net worth/total liabilities. Algebraically, this yields the ratio of net profit to total liabilities and not the return on net worth. Second, this is not a forward looking estimate of banks' spreads — rather it could limit banks' ability to legitimately look for more profit.
In spite of being the ‘minimum' lending rate, the RBI can ask banks to lend below the base rate in specific cases/sectors, which defeats the purpose of deregulation.
On
The RBI's April guidelines recognise base rate volatility, and ask banks to publish changes, thus leading to more confusion, and probably loss of market presence for some banks.
Hence, the base rate neither ensures autonomy in loan pricing nor risk-return balancing, both of which could impact banks' market competitiveness.
LONG-TERM EFFECTS
The RBI has specified timelines beginning 2009 for banks to adopt more advanced approaches for capital determination.
These approaches rely on banks' own assessment of capital based on all risks impacting business (‘economic capital'), rather than on the current ‘regulatory' capital. ICAAP (Internal Capital Adequacy Assessment Process) is envisioned as an integral part of banks' decision processes, including loan pricing decisions.
When banks price loans based on ‘economic capital', the ‘minimum' interest rate charged to a borrower would have to ensure that shareholder value is increased (or at least maintained).
Depending on the product, internal credit process policy, and value of the customer relationship, banks may override the loan pricing decision. Such exceptions should be left to the banks' discretion, but closely monitored.
A method like the ‘base rate', with several simplifying, and sometimes restrictive assumptions, may not help banks and the RBI upgrade risk assessment and pricing skills.
In the long term, the RBI's role will be pivotal in integrating bond, credit and derivatives market development, through which a single, market-determined benchmark rate like the LIBOR could evolve.
The RBI has chosen to introduce the base rate, refining its limiting assumptions, in which case, the rate tends toward BPLR, with supervisory checks in place.
In effect, the BPLR system continues, with cosmetic changes. Loan pricing has to be viewed as a credit risk mitigating tool, and the RBI has to ensure that it does not jeopardise deregulation or prudent risk management in banks by prescriptive, ad hoc pronouncements .
(The author is a finance consultant, and visiting professor at IIMs.)
PADMALATHA SURESH
Complete list of
published books / book chapters/ research articles/ magazine articles/
interviews
BOOKS
1. 2007, “ Management of Banking and financial services”, Padmalatha Suresh and Justin Paul, Pearson Education, https://www.pearsoned.co.in/paul-suresh
2. 2006, “Project finance – Concepts and Applications”, ed Padmalatha Suresh, Icfai University Press,
http://www.icfaipress.org/books/ProjectFinance_ovw.asp
BOOK CHAPTERS
1. Suresh, Padmalatha., (2007). “An alternative model for infrastructure funding” - article reprint. Infrastructure development: Issues and country experiences.
2. Suresh, Padmalatha., (2007). “Infrastructure Growth in developing countries: role, issues and challenges”- article reprint. Infrastructure development: Issues and country experiences.
3. Suresh,
Padmalatha., (2007). “Airport Privatization and Financing: Experiences from
countries and lessons for
4. Suresh, Padmalatha., (2007). “Is Public Private Participation in Infrastructure losing its sheen?” – article reprint - Infrastructure development: Issues and country experiences.
5. Suresh, Padmaltha., (2007). “Assessing the Economic Impact of infrastructure projects- the ERR” –article reprint - Infrastructure development: Issues and country experiences.
6. Suresh,
Padmalatha., (2007). Airport Privatization and Financing: Experiences from
countries and lessons for
7. Suresh,
Padmalatha., (2007). Airport Privatization and Financing : Experiences from
countries and lessons for
8. Suresh, Padmalatha., (2007). Structure matters in Project finance - article reprint. Structured Finance: An Introduction.
9. Suresh, Padmalatha., (2006). Budget: Overcoming roadblocks to growth- article reprint. Project finance- concepts and cases.
10. Suresh, Padmalatha., (2006). Airport privatization- issues in Lending . Indian aviation industry: Opportunities and challenges.
11. Suresh,
Padmalatha., (2006). Airport Privatization and Financing: Experiences from
countries and lessons for
12. Suresh, Padmalatha., (2006). Project Finance in Developing Countries :The importance of using project finance- article summary. Project finance- concepts and cases.
13. Suresh, Padmalatha., (2006). Assessing the Economic Impact of infrastructure projects- the ERR. Project finance- concepts and cases.
14. Suresh, Padmalatha., (2006). Structure matters in Project finance. Project finance- concepts and cases.
- Suresh, Padmalatha., (2006). The need to treat large projects differently. Project finance- concepts and cases.
16. 2006 - Web Publications: Article titled 'Can Banks Ensure Eco-Friendly Economic Development?' published in Business line [ May 2006] republished on the web by www.ran.org , an international website for environmental protection
REFEREED ARTICLES
1. Suresh, Padmalatha. (2006). Assessing the Economic Impact of Infrastructure Projects - The ERR. Projects & Profits.
Assessing the
Economic Impact of Infrastructure Projects: The Economic Rate of Return
Padmalatha Suresh
Abstract
Governments would be interested in supporting an infrastructure project
only if the ‘social benefits’ exceed the ‘social costs’. This article explains
why social returns are different from private returns, and outlines the
difficulties in assessing the economic impact of very large projects. The focus
of the article is on the Economic Rate of Return (ERR) used by Multilateral
Institutions such as the International Finance Corporation (IFC) to evaluate
the developmental impact of large projects. The stakeholder analysis for
calculating the ERR has been elaborated, and the related issues dwelt upon. The
article concludes that ERR can be evolved to be a useful tool for assessing the
development impact of large infrastructure projects in the country.
2. Suresh, Padmalatha. (2006). Infrastructure Growth in developing countries-role, issues and chalenges. Icfai Journal of Urban Policy.
Infrastructure
Growth in the Developing Countries: Role, Issues and Challenges
Padmalatha Suresh
Abstract
According to the World Bank estimation, the
next 30 years will witness a growth that is double the size of the existing
urban population in the developing countries. The phenomenon of increasing urbanization
presents unique challenges to the developing countries grappling with multiple
issues of population growth, economic development, and poverty reduction. The
strong link between adequate provision of infrastructure services and economic
productivity and growth has been emphasized time and again, by development
economists and policymakers. It has been discovered that, while the
state-spending on infrastructure has been curtailed due to fiscal and other
pressures, the resulting deficiency in providing infrastructure services has
had major adverse effects on growth, unless offset by an increase in private
sector participation. However, the access rates to basic infrastructure are
quite low and differ among the developing countries. This paper analyzes the
reasons and concludes that low levels of private participation in
infrastructure and huge funding needs are the main challenges for adequate
infrastructure growth in developing countries; and that
3. Suresh, Padmalatha. (2006). Airport Privatization and Financing: Experiences from countries and lessons for India. ICFAI Journal of Infrastructure.
Airport Privatization and Financing – Country
Experiences and Lessons for
Padmalatha Suresh
Abstract
Since the privatization of the British Airport
Authority (BAA) in 1987, private sector participation in airport infrastructure
has expanded and evolved by leaps and bounds. A well functioning air transport
sector offers significant economic development benefits, contributing to
poverty alleviation. When this sector starts making a positive contribution to
the expanded economy, the respective governments could restrict their focus to
safety and security regulation, along with competition policy and economic and
environmental regulation. The commercial viability of operating airport
infrastructure for the private sector arises from being able to price its
services effectively, and the customers being able and willing to pay for these
services. Airport Infrastructure privatization is promising to be a global mega
trend, with more and more governments and private players being pushed in that
direction. Most mature airports remain profitable through the vagaries of the
airline industry, due to the fact that
they earn a high proportion of their income from non-aeronautical revenues!
Airport Ltd is the first PPP Greenfield
project in
4. Suresh, Padmalatha. (2005). Operational Risk Management in Banks: More Capital or Control? Professional Banker
Operational
Risk Management in Banks More Capital or Control?
Padmalatha Suresh
Abstract
Operational Risk (OR) management has got its due attention recently. The
management of operational risk requires more intuitive power because there are
several instances which cause higher losses even though their frequency is too
low. While capital is important for any unexpected operational shocks,
extremely vital for operational risk is avoidance management..
5. Suresh, Padmalatha. (2005). Project Finance: The Need to Treat Large Projects Differently. Projects & Profits.
Project Finance:
The Need to Treat Large Projects Differently
Padmalatha Suresh
Abstract
Large infrastructure projects are unique. Usually they take 5 to 7 years
to structure, require huge upfront capital, comprise of mostly large and
tangible assets, and have a very long life. The risks of such projects are
different from those of capital investments for shorter time frames.
Traditionally, the government was financing infrastructure projects. However,
increasing under pressure, government finances are necessitating greater
private participation in financing such projects. The article outlines the
evolution of modern project finance and the global project finance market, contrasts
it with conventional corporate financing, and concludes that project finance is
relevant for
6. Suresh, Padmalatha. (2005). Structure Matters in Project Finance. Projects & Profits.
Structure Matters in Project Finance
-Padmalatha Suresh
Abstract
What are the structural attributes of project companies that enable them
to find the financial and other resources for very large projects? Having found
the resources, how do the project companies structure the project organization
to take care of its long-term needs? How do project companies take care of the
risks involved in constructing, financing and operating very large projects?
What are the structural features of project companies that enable lenders and
equity holders to invest substantial funds? This article summarizes the
rationale for and various types of contracts and models that form the backbone
of project financing transactions.
7. Suresh, Padmalatha. (2005). Airport Privatization: Look Before You Lend. Professional Banker
Airport
Privatization: Look Before You Lend
Padmalatha Suresh
Abstract
Lending to
ARTICLES IN BUSINESS
DAILIES
1. Suresh,
Padmalatha (2007) “Deriving new ways to finance infrastructure” The Hindu
Businessline,
http://www.thehindubusinessline.com/2007/05/10/stories/2007051000580800.htm
2. Suresh,
Padmalatha (2007) “How to bridge funding gap for infrastructure?” The Hindu
Businessline,
http://www.thehindubusinessline.com/2007/03/26/stories/2007032600150900.htm
3. Suresh,
Padmalatha. (2006). Can banks ensure eco-friendly economic development?
The Hindu Businessline,
http://www.thehindubusinessline.com/2006/05/10/stories/2006051002301100.htm
4. Suresh,
Padmalatha (2006). An
alternative model for infrastructure funding Transferring loan assets
from banks by pooling securities that can be sold to investors . The
Hindu Businessline.,
http://www.thehindubusinessline.com/2006/02/24/stories/2006022401881100.htm
5. Suresh,
Padmalatha. (2005). Greenfield
airport projects - Time for private-public partnerships to take off . The
Hindu Businessline. ,
http://www.thehindubusinessline.com/2005/07/29/stories/2005072900130800.htm
5. Suresh, Padmalatha. (2005). Monetary
Policy 2005-06 -Lending priority to infrastructure . The Hindu
Businessline. ,
http://www.thehindubusinessline.com/2005/05/12/stories/2005051200020800.htm
6. Suresh, Padmalatha. (2005). Budget:
Overcoming Roadblocks to Growth. The Hindu Businessline.,
http://www.thehindubusinessline.com/2005/03/22/stories/2005032200810800.htm
7. Suresh, Padmalatha. (2004). IIM
imbroglio -A social cost-benefit perspective . The Hindu Businessline.
,
http://www.thehindubusinessline.com/2004/05/25/stories/2004052500421000.htm
8. Suresh, Padmalatha. (2004). Beyond
institutional marriages - Real issues in infrastructure financing . The
Hindu Businessline.,
http://www.thehindubusinessline.com/2004/04/02/stories/2004040200010800.htm
9. Suresh, Padmalatha. (2004). SC
verdict on Securitisation Act - More bark than bite? . The Hindu
Businessline. ,
http://www.thehindubusinessline.com/2004/04/15/stories/2004041500120800.htm
10. Suresh, Padmalatha. (2006). Project Finance in Developing Countries: The Importance of Using Project Finance [Article summary – Article by IFC]. Projects & Profits.
INVITED ARTICLES/
INTERVIEWS
1. Suresh, Padmalatha (2007), “Managing
and measuring the
2. Siresh, Padmalatha (2007),
“Credit risk models”, Chartered financial analyst, February 2007 [Interview]
3. Suresh, Padmalathaa, (2006) –“Veteran’s recipe for cracking
the CAT”, Interview by 'the Hindu' –
http://www.hindu.com/2006/10/25/stories/2006102504870200.htm
4. Suresh, Padmalatha. (2006, September). Woman as
entrepreneur. Invited presentation at CII conference on Women
empowerment,
http://www.hindu.com/2006/10/01/stories/2006100109380300.htm
http://www.hindu.com/2006/10/01/stories/2006100120040200.htm
5.. Suresh, Padmalatha. (2006). Is Public Private Participation in Infrastructure losing its sheen? ICFAI Journal of Infrastructure., September 2006
Is Public–Private Participation in Infrastructure
Losing its Sheen?
Padmalatha Suresh
Abstract
Modern infrastructure services play a vital role in economic growth and poverty alleviation. Prior to about two decades, most governments developed and delivered the requisite infrastructure services, or entrusted the responsibility to state-owned enterprises. But in many countries, the results were disappointing, and private sector participation was sought for resource availability and managerial expertise. Private sector investment in developing countries’ infrastructure peaked during the 1990s, and then started declining. The important issue here is to determine whether the apparent slowdown is a short-term phenomenon, or indicative of a major reverse shift from private participation to an entirely public sector-oriented model. This paper concludes that private participation in infrastructure would continue only if governments carry out substantial reforms in the regulatory, legal and financing frameworks of their countries, while de-risking the political environment in the interests of the countries’ economic development.
6. Suresh, Padmalatha. (2006). It's boom time
ahead. Project Monitor, May 2006
http://www.projectsmonitor.com/detailnews.asp?newsid=11193
7. Suresh, Padmalatha, (2005). Interview by 'Project monitor' on SPV for funding infrastructure projects - Dec 2005
http://www.projectsmonitor.com/detailnews.asp?newsid=10023
7. Suresh, Padmalatha (2005). “Lenders have first right
over project cash flows”, Interview by
Projects Monitor,
http://www.projectsmonitor.com/detailnews.asp?newsid=9915
http://www.projectsmonitor.com/detailnews.asp?newsid=9916
8. Suresh,
Padmalatha, (2005): Interview by 'Business World' on infrastructure
financing- Issue dated
9. Suresh, Padmalatha, (2004). Interview by Chartered Financial Analyst on ‘Securitization Act’
SEMINARS/ CONFERENCE
PAPERS
1. Suresh,
Padmalatha (2007), CDS in Infrastructure financing, Invited speaker at
Seminar on Credit Default Swaps, organized by the Indian Institute of Capital
Markets, Mumbai,
2. Suresh,
Padmalatha. (2006). Project finance for infrastructure. Invited
Speaker at National Seminar on infrastructure financing, Chennai, organized by
the
3. Suresh,
P. (2006, February). Transport infrastructure in India and China: Has World
bank made the difference? Presented at IBS National Conference On
Banking & Economics,
4. Suresh,
Padmalatha. (2004). Bank Mergers In