Setting the base right

New regime to compel banks to cut costs and improve profitability.

The country’s largest bank, State Bank of India (SBI), set the ball rolling for the new base rate system coming into effect from July 1. On Tuesday, the bank set a base rate of 7.5 per cent for advances. Since banks will now not be able to lend below their respective base rates, the move will end the proliferation of lending below the benchmark prime lending rates (BPLR), which accounts for 70 per cent of bank loans.

CARE Ratings Head (Industry Research) Revati Kasture says: “This increases transparency levels in the banking sector. It eliminates the ad-hocism regarding setting of the BPLR, which had lost relevance.” Experts say the banking system’s response to RBI’s policy measures will also improve, due to the implementation of the new interest rate regime. More important, it will push banks to improve their efficiency levels in terms of cost of funds as well as operations.

Drivers
Besides SBI, banking majors have looked mainly at their cost of deposits for different tenures to roll out the new rate. However, since banks have a trial period of six months, analysts believe they will monitor at least five-seven different models to arrive at a suitable base rate by December 2010.

Meanwhile, in spite of SBI’s average cost of deposits at 5.8 per cent, which is far from the lowest in the banking space, the bank has been able to come up with a fairly competitive base rate of 7.5 per cent compared to Punjab National Bank (PNB) and Bank of Baroda's (BoB) eight per cent — the cost of deposits for both these banks is about 80-90 basis points lower than that of SBI. Thanks to the large base of ‘current accounts, savings accounts’ (Casa) deposits at 47 per cent, which is second only to HDFC Bank, SBI has the cushion to set a lower base rate.

On the other hand, HDFC Bank, so far, has announced the lowest base rate of 7.25 per cent, thanks to its Casa ratio of about 50 per cent — the highest in the banking industry. The bank has used the cost of one-three months’ deposits to arrive at its base rate, whereas SBI has chosen a tenure of six months for the same.

Apart from the cost of deposits and other borrowings, the opportunity cost of keeping funds in statutory liquidity ratio (SLR) and cash reserve ratio (CRR) investments, as well as administrative costs, are other factors influencing the base rate, according to Kasture.

The effect
With cost efficiencies coming to the fore, the first expectations most have is that of a slight shift in market shares — in favour of private banks. Edelweiss Securities' Analyst Nilesh Parikh says: “Having set a rate lower than public sector banks, we expect private banks to benefit from a shift in business from top-rated companies, specifically for short-term needs. However, limits on borrower-wise exposure could restrict the swing in favour of private sector banks.” On the lower pricing of base rate by peers, SBI Chairman O P Bhatt says: “There may be some impact, but it will not be large.”

The other impact of the sector is that some of the large companies requiring short-term funds could now prefer other instruments like commercial papers (CPs), which are currently available at an interest rate of a little over six per cent. The proportion of CP vis-a-vis total bank credit, which is at 3-3.5 per cent, is expected to inch up

Ambit Capital Analyst Krishnan ASV says: “We expect about 5-15 per cent of the systemic credit to begin looking for alternate instruments, essentially CPs.” The net impact, however, will be far lower as banks themselves may now choose to deploy some of these funds in corporate CPs (as against advances currently). Secondly, with demand for CPs rising, rates too could also inch up and narrow the gap between CPs and base rates.

The way ahead
While the immediate impact is difficult to quantify, the shift to a base rate system is positive. Most banks would witness a shift in the pricing methodology of loans that would help in pricing the risk adequately and support margins. Notably, bankers suggest their net interest margins would not see any major shift. However, in the long run, banks with a healthy deposit franchise and lower operating cost will stand to gain.

Those with a high share of Casa deposits, including HDFC Bank, Axis Bank and SBI, are relatively better placed. Investors could also consider ICICI Bank, which has been successful in cleaning up its balance-sheet, shoring up its Casa ratio to 41 per cent (as of March quarter) and is now aiming to grow robustly. Likewise, PNB – which has a low cost of deposit (less than 5 per cent), helped by a high Casa ratio of about 40 per cent – could be considered on dips.