As banks trip up on base rate, bond markets may tap the gold finger

Industrialists demanding an interest rate cut need to just look at one thing — the rate at which some of their peers are raising funds from the commercial paper market. It shows that despite Reserve Bank of India governor Raghuram Rajan holding on to policy rates, borrowing costs are falling.

But that also indicates the part failure of the RBI’s egalitarian banking objective of treating customers on par without the poor subsidising the rich. Base rate, a concept that the central bank introduced in 2010, may be on its way to becoming irrelevant.

"Although justifiable to some extent, such sub-BPLR (benchmark prime lending rate) lending on a large scale has created a perception that large borrowers are being cross subsidised by retail and small borrowers," wrote Deepak Mohanty, executive director of the RBI in a working group recommendation in October 2009, after widespread subsidy of the big companies by smaller ones and retail depositors.

Something similar may be emerging five years after the RBI replaced BPLR with the so called base rate, the rate below which the banks cannot lend. But the system is such that it can circumvent many regulations one way or the other.
Check this out: Sale of commercial papers, where interest rates are lower than banks’ base rate, by Indian firms have grown 63% this fiscal till December to Rs 1.27 lakh crore. Outstanding CPs are at Rs 2.34 lakh crore in the market, according to RBI data. Companies pay about 8.5% on CPs and around 10.25% on bank loans.

Banks whose base rate is above 10% are quite active in investing in CPs. So, have they effectively reduced lending rates? Then does it mean that the monetary policy stance, as it was during much of the downward cycle, is ineffective even now? "Corporates are borrowing at 8%," says Rohit Wahi, CEO and country head, FirstRand Bank. "The commercial paper and bond rates have adjusted. Most the corporates are borrowing in the CP market and it seems the base rate is losing its relevance."

The question that arises is whether the base rate, which was supposed to usher in an egalitarian Indian banking sector, is becoming more of a constraint in letting market forces play. Do big and powerful companies continue to get rates far below what smaller companies with a similar financial profile get?

"CPs are mostly available to top-rated corporates. Small and medium enterprises may continue to borrow from banks, whether green field or brown field projects," says B Sriram, managing director and group executive, national banking, State Bank of India.

Companies are now selling two-three months’ commercial papers at about 8.60%, about 150 bps lower than average bank base rates, say market analysts. The tenor of CPs ranges from seven days to 180 days, making it a flexible working capital instrument of different shortterm maturities like less than 90 days, 90-180 days and one year and above.

Unlike loans, the CPs can be traded in the secondary market. The only additional cost that a borrower has to incur is to get the instrument rated from a credible rating agency with pricing linked directly to the rating.

"Even when base rate was introduced there was a wave of CP issuances," says Romesh Sobti, MD and CEO IndusInd Bank. "When rates are going down CP becomes relevant till banks do not reduce the base rate. Basic banking is being done at the base rate. Only in case of top-end corporate clients are we seeing CP issuances," he adds.

Does that mean we are witnessing structural changes in our financial sector? The need for financial sector disintermediation is being recommended by various RBI committees for the past 30 years. A committee headed by the late Sukhmoy Chakravarty in 1985, then economic advisor to the prime minister had suggested it too.

But interest rates were still regulated by the central bank. Only in 1997 was there a step towards deregulated interest rates with the introduction of the prime lending rate or PLR system allowing banks to fix their own lending rates. These rates could be revised by taking cue from the central bank’s policy signals.

"Lending interest rates should also be responsive to changes in the policy rate of the central bank," Mohanty had said. "It is only then that the central bank can achieve the desired objectives through monetary policy actions."

With market rates sliding without any action from the central bank, is a parallel market emerging?

"Bond market yields are lower for AAA companies than bank base rates," says Uday Kotak, executive vice chairman at Kotak Mahindra Bank. "So as the markets develop, there are two parts to intermediation -- saver-borrower and investor-issuer." As of now, the market seems to be restricted to a few companies which have top ratings, or among the top two or three while the rest of the corporate world pays well above the base rate. With the banking system still dominated by the public sector, projects may continue to dominate the system.

"CPs can substitute only a portion of bank finance," says SBI’s Sriram. "It will keep going up and down. It’s a matter of how corporates manage short-term fund requirements. Major bank credit growth comes from project financing."

One thing has remained constant for anyone who has been associated with Indian banking — either as a practitioner or as an observer — for nearly two decades: the need to ‘deepen the Indian bond market.’ Many moons and innumerable tinkerings of regulations later, it may just be emerging even without some noticing it.

It may not yet be like the US markets where bond markets dominate with over 50% of funding. But the signs of change are emerging. "There will be a traditional Indian market because more and more people are coming into financial inclusion and getting included in organised finance, so that is a saver-borrower intermediation," says Kotak.

The second model is also growing and over the next five years, and will probably grow faster than the first, he says, adding, "Now both these models will have legs — the first one will grow more steadily, say two times the nominal GDP — that is real plus inflation — while the second one can grow even faster."