Will the deregulation of interest rates destabilise the new base rate system?  

June 21, 2010

 The central bank has mooted the deregulation of interest rates on savings accounts. An upward revision in the same would create pressure on the base rate, which will come into place at the start of next month

The country’s central bank, the Reserve Bank of India (RBI), has made clear its intention to bring about deregulation in interest rates across the banking system, including the fixed rates currently being offered on savings accounts. While this may further cheer depositors who have recently benefited from the revised norms on calculating interest on savings balances, it may have the potential to destabilise the new base rate pricing mechanism that will kick in from the next month.

Banks have been gearing up to implement the base rate structure in place of the benchmark prime lending rate (BPLR) that is being followed today. RBI had mandated banks to adopt the new base rate mechanism from 1st July to introduce greater transparency in loan pricing. All major banks are in the process of finalising their pricing policy based on the new base rate.

 Each bank will have an independent approach towards calculating the base rate, based on historical costs, which could be either the cost of deposits, cost of funds, average quarterly cost etc.

Indications are rife that the banking fraternity would be announcing their base rate anywhere in the range of 7.5%-9%. State Bank of India (SBI), for instance, has indicated that it may fix the base rate at around 8%.

S Rajendran, general manager, Union Bank of India told Moneylife that the calculations for the components are in progress and that the range could be between 8.25%-9%. “We are in the process of finalising the basis for arriving at the base rate and policy for the base rate will be approved by the board,” confirmed Mr Rajendran.

RBI’s proposal to deregulate savings rates will be debated upon by the industry. Last week, RBI deputy governor KC Chakrabarty had told PTI, "We are in favour of deregulating all interest rates, including savings rate. We have initiated a debate in the last policy. The deduction is very clear in favour of deregulating all interest rates, including savings banks. But the decision will be taken, when to do that, after having adequate debate on the issue," Mr Chakrabarty had said.

If deregulation is brought in, it is expected that competitive pricing will lead to a hike in interest rates on savings accounts. If that were to happen, it could create margin pressure on banks with a low base rate. It could disturb all calculations done by banks to determine optimum pricing of loans under the base rate.

Deepak Tiwari, research analyst at KR Choksey, admitted that there could be some margin pressure initially but that it would get transferred on to customers eventually. “Banks have the option to revise the base rate after six months. So, a potential rise in savings rates could be offset by an upward revision in the base rate at that time.”

Nilanjan Karfa of BRICS Securities believes that the RBI will take a call on the deregulation of interest rates only when the base rate system achieves stability. “I don’t think the RBI will take an immediate decision. It (deregulation of rates) is on their long-term agenda. Once the base rate stabilises, they would decide on its workability.”

The proposed move to deregulate rates could hit banks with a higher proportion of CASA deposits hard. Already, these banks are bearing the burden of excess fund outflow after the introduction of revised norms on calculation of interest rates on savings accounts. Now, banks have to offer interest on daily balances in savings accounts instead of on the lowest balance in the account during a month. This has pushed up banks’ cost of deposits significantly.

A senior official from HDFC Bank told Moneylife, “If savings rate is to be changed, it is expected that banks will have to come up with a revised base rate. It will depend on their composition of CASA deposits. For instance, it will not impact banks with greater composition of fixed deposits but will impact those with higher savings and current account deposits.” 

 — Sanket Dhanorkar