Will new base rate calculation help borrowers?

In the December 1 monetary policy statement, the Reserve Bank of India (RBI) reiterated the move towards calculating the base rate on a marginal cost basis. This will ensure lending rates reduce quickly when RBI reduces policy rates. There has been a large gap between the rate cuts by RBI and that by lenders in the past year.

The media has been quick to pronounce the move for the new calculation method will lead to lower loan rates. I am not sure that is the case. RBI has clearly indicated it has been unhappy with the reduction in base rates at 0.6 per cent, while it has reduced policy rates by 1.25 per cent. Clearly, they want to move to a system wherein interest rate movements in the future more or less match the changes in policy rates made by them. It does not necessarily mean they are looking to implement a system that will make up the current deficit of 0.6 per cent or so that exists today.

This is borne out by a carefully worded response by the RBI governor, when asked where the additional transmission (referring to this gap of 0.6 per cent) would come from. His answer, according to the transcript of the press conference, was: "If you look at, say, one to three-year deposits, banks have already cut significantly more than what has been transmitted through the base rate. In that sense, there is room for the banks to transmit more. What the marginal cost pricing does is make the cost flow through into lending rates faster. The intent is that banks will be able to make incremental loans on the marginal cost pricing while their historical or the legacy loans will be on the base rate."

This clearly indicates that:

1) There is official acceptance by RBI of the banks' oft-repeated position that they cannot give the same lower rates to old consumers which they give to new ones

2) Existing consumers will have to wait for the transmission gap of 0.6 per cent to flow through to them

3) The trade-off for accepting this discrimination between the two sets of consumers is that for the loans given after the new system is introduced, the rate changes will follow the RBI policy changes much faster.

We should also keep in mind the move by the regulators to allow the re-introduction of pre-payment charges (the move is yet to be confirmed). This can only mean the present discriminatory treatment of existing borrowers might not only continue but worsen.

In fact, it is not clear whether the move to the new method will lead to lower rates even for new borrowers immediately. Banks might have to increase the spreads from the new base rates to meet the additional cost of asset-liability mismatch. Hence, interest rates for even new borrowers might not be significantly lower. The intent really seems to be to move to a system that will quickly transmit RBI rate changes in the future and not necessarily compensate for the transmission gap so far or provide lower rates to new borrowers immediately.

As I write this, the final guidelines for the new methodology is still to be released and I might be proven wrong. However, if you are in the market for taking a loan this month, I would say postpone your decision to become an 'existing' borrower till the dust clears. And, if you are one among the millions of existing borrowers who are paying a higher interest rate compared to new borrowers of the same bank, make your shift now, before prepayment charges make it more expensive. In the end, even If I am proven wrong, it will only benefit borrowers to follow this advice.

The writer is a Sebi-registered investment advisor