National Law School of India University, Bangalore.

Economics-II Project
DE-REGULATION OF INTEREST RATES IN INDIA

Rudrajit Ghosh 3rd Trimester B.A LLB. (Hons.) Roll No.: 1913

Submitted on: May 9th, 2012.

TABLE OF CONTENTS
INTRODUCTION ........................................................................................................................... 3 RESEARCH QUESTIONS ............................................................................................................... 4 CHANGES IN THE INDIAN BANKING SECTOR TO EFFECT DE-REGULATION OF INTEREST RATES .. 5 Background ......................................................................................................................... 5 A history of de-regulation: ................................................................................................. 6 CHANGES IN THE CREDIT SECTOR INTEREST RATES AND THEIR IMPACT ON THE ECONOMY .......... 9 Determining lending rate and its operation:......................................................................... 10 The Base Rate Mechanism: ................................................................................................. 12 CONCLUSION............................................................................................................................. 14 BIBLIOGRAPHY ......................................................................................................................... 15

INTRODUCTION
The past few decades have seen the Indian economy undergo major structural and regulatory evolution in order to facilitate greater efficiency and competition. The banking sector has not been an outlier in this respect. Along with major structural reforms, the banks have increasingly seen more freedom being granted to them by the Reserve Bank of India in determining the rates at which they provide interests for deposits and extend loans. From a stage where the Reserve Bank prescribed these rates of interests with a sector specific or a maturity period specific discrimination, the commercial banks have now reached a stage where they are virtually free of all controls of the Central Banks but for a very few specific aspects like the degree of flexibility to vary from declared interest rates. This paper intends to look into the chronological development in the field of de-regulation of interest rates offered by the banks in India over time. Given the fact that such de-regulation in the credit market has had a more far-reaching impact and, in general has seen a greater degree of change and innovation, this paper follows closely these changes and also relates such changes to the impact each interest rate regulation mechanism has had, which essentially were also the reasons for their evolution into the next.

RESEARCH QUESTIONS
What were the changes in the form of de-regulation of interest rates that were brought about in the banking sector? What effects were the reforms in the credit sector interest rate control and what effects did it have on the economy?

CHANGES IN THE INDIAN BANKING SECTOR TO EFFECT DE-REGULATION OF INTEREST RATES

Background
Interest rates are a vital variable in determining the flow of investment and the flow of credit for the purposes of such investment. In the days of controlled economic regime, the Reserve Bank of India had the interest rates in the market under strict control. The Bank controlled the rates payable on maturity for deposits for different terms and the rate at which loans of different sizes were extended to various sectors.1 Among other reasons was the need to direct the flow of investment to certain priority sectors as per the needs of the country. 2 Through this method the Reserve Bank of India3 sought to control the growth of various sectors of the economy and also facilitate the small and agricultural credit seekers to have credit available to them. Over time, this method proved to be ineffective. It was found that small credit-holders are benefitted more by the ready availability of credit rather than a low rate of interest. 4 This point was illustrated by the experience of the Grameen Bank in Bangladesh where ensuring the credibility of small credit-holders through ensuring the viability of their enterprises rather that providing them lesser rates of interest on a priority basis led to a surge in investment in small scale industries.5 Therefore, for the mentioned reason and in addition to that to increase the competitiveness in the banking sector in general and going with the trend of liberalisation and de-controlling of

Montek S. Ahluwalia, Reforming Indias Financial Sector: An Overview, July 6, 2000, available at: http://planningcommission.nic.in/reports/articles/msalu/index.php?repts=finreform.htm (last visited on: May 5th, 2012), 4 . 2 Draft Guidelines on Lending to Priority Sector for Feedback, available at http://www.rbi.org.in/scripts/PublicationDraftReports.aspx?ID=493 (last visited on: May 7th, 2012). 3 Hereinafter referred to as the RBI. 4 Arun Ghosh, Monetary Targeting and the Credit Sector, Economic and Political Weekly, Vol. 22, No. , January 3-10, 1987, 13-16. 5 Dharam Ghai, An Evaluation of the Impact of the Grameen Bank Project , March, 1984, (undertaken at the instance of the IFAD, and published by the Grameen Bank) 2g, Shyamoli, Dhaka, 7.

the Indian economy6, interest rates in the banking sector gradually started getting free of control at various levels.7

A history of de-regulation:
A history of the course of de-regulation of interest on credits is provided below: April 1985: Commercial Banks were allowed to set interest rates for deposits maturing between 15 days and up to 1 year, subject to a ceiling of 8 per cent. May 1985: The ceiling mechanism was withdrawn because of a price war between banks to offer the highest possible interest rate under the ceiling and a rush conversion of all deposits to ones maturing between 15 days to 1 year. April 1992: Interest rates for all credits maturing over 46 days was fixed at a uniform level of 13 per cent. November 1994: Ceiling rate brought down to 10 per cent April 1995: Ceiling rate again raised to 12 per cent.

Banks allowed to fix interest rates for deposits over 2 years by October 1995 and over 1 year by July 1996.
April 1997: Ceiling for deposits for 30 days to 1 year was linked to bank rate less 200 basis points. October 1997: Banks were given complete freedom to fix interest rates on all deposits but savings deposits subject to the approval of their Board of Directors/Assets and Liability Management Committee.

October 1998: The restriction that banks should charge same rates for deposits with the same period of maturity irrespective of the amount of the deposit was removed.

Savings bank rates still controlled at 3.5 per cent.

8

Exhibit 1: A chronology of de-regulation of interest rates for deposits.

As mentioned before, the interest rates on credits were also de-regulated gradually. A history of such changes is provided below:

Y. V. Reddy, State and Market: Altering the Boundaries and Emerging New Balances, Economic and Political Weekly, Vol. 34, No. 42/43, October 16-29, 1999, 2990-2996. 7 Supra note 2 at 4. 8 Deregulation of Savings Bank Deposit Interest Rate: A Discussion Paper , available at http://www.rbi.org.in/Scripts/bs_viewcontent.aspx?Id=2344 (last visited on May 6th 2012).

September 1990: The entire lending market was broken down to six slabs. Of these, the banks were free to set interest rates for loans over 2 lakhs with minimum lending rates prescribed by the RBI.

April 1992: Slabs were compressed into four. April 1993: Slabs were compressed into 3. October 1994: Lending rates for loans with credit limits of over 2 lakh were deregulated. Banks were required to declare their Prime Lending Rates(PLR). February 1997: Banks were allowed to declare different PLRs and spreads over PLRs both for loan and cash credits. October 1997: For loans of 3 years and above, separate Prime Term Lending Rates were required to be announced by the banks April 1998: PLR was converted as a ceiling rate on loans up to Rs. 2 lakh.

April 1999: Tenor-linked Prime lending rate introduced. October 1999: Banks were given the freedom of chargiing interest rates without rreferring to PLRs for certain categories of loans/credits. April 2000: Banks given the freedom of charging either fixed or floating rates for credits over Rs. 2 lakh. April 2001: Banks allowed to lend at sub-PLR rates.

April 2003: Benchmark PLR introduced and TPLR was withdrawn.

April 2010: Base Rate system of loan pricing introduced with effect from July 1, 2010.
9

Exhibit 2: A chronology of de-regulation of credit interest rates. The exhibits above explain the chronological de-regulation of interest rates for the deposits and credits in the banking sector that led to increase competitiveness in the sector. This shift has churned out both intended and unintended results for the economy. Over the years, there
9

Deepak Mohanty, Perspectives on Lending Rates in India, Bankers Club, Kolkata, 11th June 2010 available at: http://www.rbi.org.in/scripts/BS_SpeechesView.aspx?Id=508 (last visited on: May 7, 2012).

have been demands for greater de-regulation especially in those left untouched by the initial thrusts such as the agricultural credit sector.10 On the other hand, there was a well-sustained criticism of this process as the Washington Model, a model of economic development that was far-removed from the socio-economic realities of India.11 It was further said that the emphasis of the banking reforms on the three Cs i.e. the Corporate, the Consumer-credit market and the Capital-lending market led to a ignoring of the small and agricultural credit sectors as simultaneous with these changes there was a much less emphasis on the erstwhile priority sectors.12 As we can see form the limited insight into the various strains of criticism against the deregulation of interest rates and other connected reforms, the credit sector reforms have been subjected to a greater scrutiny because of the obvious direct impact it has on the scale of investment on the various sectors in the economy. Therefore, it shall be the focus of this paper hereafter to study the evolution of the mechanism of control of interest rates on credit by the RBI starting with the slab system and evolving to the current system of base rate. The study of this evolution shall be tied to the impact this evolution had on the various sectors in the economy.

10

Anupama Ranade & Ors., Transaction Cost of Lending in Rural Finance , Institute for Financial Management and Research Centre for Micro Finance Working Paper Series, August 2006, 10. 11 S.D Naik, Financial Reform and Development, Financial Daily, Apr 26, 2002, available at: http://www.thehindubusinessline.in/2002/04/26/stories/2002042600060800.htm (last visited on: May 7th, 2012). 12 Id.

CHANGES IN THE CREDIT SECTOR INTEREST

RATES AND THEIR IMPACT ON THE ECONOMY

Exhibit 2 shows the changes in the credit sector interest rates in India and the evolution control of the market by the RBI. From the initial system of slabs, with banks being permitted to determine interest rates for only certain slabs, the system evolved to that of the lending rates and currently that of the base rate. The system of lending rates, starting as that of the Prime Lending Rates, with effect from October 1994, and ultimately evolving to that of the Benchmark Prime Lending Rate saw a great degree of freedom being increasingly granted to the banks by the RBI. Throughout this period, there was a considerable fall in the interest rates in the economy. The trend in the weighted mean of the interest rates in the economy is shown below:

13

Exhibit 3: Nominal Average Weighted Lending Rate of Banks

There was a considerable decline in the rate of interest during the lending rate regime for example, from 1998-99 to 2001-02, the WPI-based inflation fell from 5.9 per cent to 3.6 per

13

Supra note 10.

cent14. Therefore, it is also pertinent to look into the real rate of interest in the credit market, discounting the effect of the interest. The same is portrayed below:

15

Exhibit 4: Measure of real weighted average lending rates of banks.

As can be inferred from Exhibit 4, in spite of fluctuations in the short term, there was a sustained decrease in the interest rates in the economy. However, overtime the system of lending rates proved to be too sticky to react to the flexibility of the real market in India. To understand the problems with the system and the reasons for its subsequent evolution to the system of the base rates, we shall first look into the how the system of lending rates actually worked.

Determining lending rate and its operation:

The basic method used in the system was that of determining the prime lender of the bank and thereafter, taking into consideration the actual cost of the funds extended, operating cost and the minimum margin for, inter alia, profit margin and regulatory purposes, the banks were to declare a prime lending rate with the approval of their boards.16

14

Rakesh Mohan, Transforming Indian banking - in search of a better tomorrow, the Bank Economists Conference 2002, Bangalore, 29 December 2002. 15 Supra note 10. 16 The Reserve Bank of India, Master Circular - Interest Rates on Advances, RBI/2009-10/66 DBOD. No.Dir. BC 10/13.03.00/2009-10, July 1, 2009, paras 2.3 and 2.4.

For the purposes of concessional loan extension to small creditors in the economy, the banks were supposed to provide loans upto 2 lakh rupees at this rate. 17 For export creditors and public enterprises and other trusted borrowers, the banks had an option of lending at subprime rates i.e. at rates that were below these lending rates. For most other categories of loans like, those for consumer durables, buying shares and debentures, personal loans in the nonpriority sectors etc. the banks were allowed to charge interest rates that were completely delinked from the prime lending rate.18 The banks were also allowed the freedom of charging either fixed or floating rates of interests. However, if the banks were charging a floating rate, they had to abide by the Assets and Liabilities Guidelines, which required the banks to base their rates objectively depending on the money market rather than using their own internal benchmarks.19 This was the rough scheme of functioning of the lending rates. Under this system, there were numerous problems that were being faced by the economy. Among others were the problem of the huge range of interest rates absolutely disconnected to the prime rate, the public perception of the corporate, having a higher bargaining power and credibility, being awarded lower, sub-prime interest rates whereas the agricultural sector being taxed with the higher prime rate.20 Moreover, the relative rigidity of the mechanism delayed important monetary signals being transmitted to the market.21 A major concern of these was the ignoring of the small and agricultural credits or the rural sector. It was felt that this issue had been put on a backburner by the banks with the phasing out of the priority sector system by the RBI, where interest rates for various sectors were prescribed by the Central Bank.22 However, as a solution to this, instead of the usual reaction of call for greater control by the RBI and reversal of the de-regulation process, there were demands for de-regulation of interest rates in the agricultural sector as well.23 This was in view of the fact that the higher degree of regulation in these sectors added to the relative lower credit-worthiness of the borrowers made these sectors the bte noire for the banks.24

17 18

Id. Supra note 17 at para 2.5. 19 The Reserve Bank of India, Asset - Liability Management System in banks Guidelines, available at http://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/3204.pdf (last visited on May 7, 2012). 20 Supra note 10. 21 Supra note 10. 22 Supra note 12. 23 Supra note 11. 24 Supra note 11 and supra note 2.

The sought de-regulation would allow the banks to get nearer to these borrowers and allow them to better discriminate between various groups within these sectors.25 Based on these reasons and also to provide greater flexibility to the banking sector in general, the RBI in its Annual Policy Statement of 2009-10 recommended the constitution of a Working Group to review the system in place and to suggest changes therein.26 Subsequently, a Working Group constituted under the chair of Deepak Mohanty suggested the new mechanism of base rate that would replace the existing lending rate mechanism.27

The Base Rate Mechanism:

The Working Group so appointed, in its report28, suggested the substitution of the system of lending rates with a more inclusive, and a more flexible system of base rate. The base rate would be determined by taking into consideration the various expenses of the bank in advancing loans to their borrowers. 29 Base rate would be the minimum rate at which the Scheduled Commercial Banks would be allowed to extend credit and too ensure the reflection of the monetary scenario in the economy the banks would be allowed to revise their base rates at least once every quarter with the approval of their boards.30 In order to address the issue of small credits upto the amount of 2 lakh rupees, the interest rates for these loans were de-regulated and the banks were allowed to charge interests, fixed or floating.31 This was in order to ensure a steady flow of credit in these sectors as it was finally recognised, as was suggested by academic opinions32 and international experiences33 a long time ago, that the small creditors benefit not necessarily from a lower concessional interest rate but from a ready availability of credit.34 Moreover, the report also suggested that sub-base rate lending be allowed whenever there was an excess of liquidity in the market and

25 26

Supra note 11. Dr. D. Subbarao, Governor, The Reserve Bank of India, Annual Policy Statement for the Year 2009-10, April 21, 2009, available at http://rbi.org.in/scripts/NotificationUser.aspx?Mode=0&Id=4936 (last visited on May 7th, 2012), II.1. 27 The Reserve Bank of India, Guidelines on the Base Rate, RBI/2009-10/390 DBOD. No. Dir. BC 88 /13.03.00/2009-10, April 9, 2010 available at http://rbi.org.in/scripts/NotificationUser.aspx?Id=5579&Mode=0 (last visited on May 7th, 2012). 28 Deepak Mohanty, Report of the Working Group on Benchmark Prime Lending Rate (BPLR), October 20, 2009, available at http://rbi.org.in/scripts/PublicationReportDetails.aspx?UrlPage=&ID=571 (last visited on May 7th, 2012). 29 Id. 30 Supra note 29 at para 6.11. 31 Supra note 29 at para 6.18. 32 Supra note 5. 33 Supra note 6. 34 Supra note 32.

the banks were likely to extend more credit rather than use the Liquidity Adjustment Facility of the RBI to invest in short-term government securities.35 However the limit on such subBase Rate lending was limited to 15 percent of the progressive total annual lending of a bank, of which for non-priority sector, it could be only 5 per cent of the total amount.36 One more important aspect of the system was that for fixing floating interest rates based on external benchmarks, like the indicators in the money market, the banks were allowed to fix rates below the Base Rate for loans upto 2 lakh rupees, however, for loans above that, the interest rates had to be either equal to or above the base rate.37 This would allow the banks to take into consideration the various external factors that determine the demand for credit in the small and agricultural sectors providing these sectors with a higher opportunity of landing up with credit in times of need. The recommendation of the Group were accepted and implemented by the RBI with effect from April 9, 2010.38 Impact of the Base rate mechanism: The time is not yet ripe for a full-scale analysis of the impact of the base rate system on the economy. However, there have been various strains of reactions from the banking industry already, which, although not very coherent, might help the RBI to evolve the process on the go. It has been suggested that, while the small credit sectors stands to gain a lot under this system, big corporate portfolios might find it slightly more expensive to raise funds through loans.39 Moreover, the system incorporates a certain degree of bias towards the public sector banks, which, with a higher level of current and savings deposits, would be able to charge more competitive rates than public sector banks.40 It has also been suggested that the RBI should work toward providing a uniform timeline for the revision of base rates by the commercial banks, 41 however, a flip side off such a control would be the system would become less market responsive. It has, however, been accepted in general that the system of base rates makes the credit market more transparent, more flexible to market conditions and more inclusive of all strains of credit-seekers.

35 36

Supra note 29 at para 6.12. Supra note 29 at para 6.12. 37 Supra note 29 at para 6.17. 38 Supra note 28. 39 FICCI Survey on Base Rate Implementation, June 2010, available at http://www.ficci.com/SEDocument/20059/FICCI_SURVEY_ON_BASE_RATE_IMPLEMENTATION.pdf (last visited on: May 8th, 2012). 40 Id. 41 Dr. Suresh Chandra Bihari, BPLR To Base Rate- A New Era In Bank Lending In India, Gurukul Business Review (GBR) Vol. 7, Spring 2011, 119-124.

CONCLUSION
The de-regulation of interest rates offered by banks in India was originally aimed at increasing efficiency, responsiveness and competition in the banking sector. It can be said without doubt that the process, coupled with ancillary measures of qualitative control of the Reserve Bank of India has achieved gone to a great extent in achieving this aim. With specific regard to the credit sector, for due to the relative greater importance of this sector, the main focus of this paper has been on interest rates on credits, it can be said that the reforms brought about by the Central Bank have proved to be definitely responsive to the flaws that have arisen in the previous mechanism. For example the long-standing issue of small creditors being unfairly prejudiced under the lending rate system was duly addressed by the Central Bank while introducing the new system of Base Rate. While it cannot be said without doubt that these reforms have not been in some cases a bit too late, it is beyond doubt that these changes never proved to be too little. In fact, the momentous shift from total control on credit rates by the Reserve bank to the current system of complete freedom subject to certain generally applicable ethical guidelines and the mandate of the Boards of individual banks is a proof of the commitment and efficiency of the Central Bank in addressing long-standing as well as urgent issues in the economy simultaneously.

BIBLIOGRAPHY
Articles: 1. Anupama Ranade & Ors., Transaction Cost of Lending in Rural Finance, Institute for Financial Management and Research Centre for Micro Finance Working Paper Series, August 2006, 10. 2. Arun Ghosh, Monetary Targeting and the Credit Sector, Economic and Political Weekly, Vol. 22, No. , January 3-10, 1987. 3. Deregulation of Savings Bank Deposit Interest Rate: A Discussion Paper, available at http://www.rbi.org.in/Scripts/bs_viewcontent.aspx?Id=2344 (last visited on May 6th 2012). 4. Dharam Ghai, An Evaluation of the Impact of the Grameen Bank Project, March, 1984, (undertaken at the instance of the IFAD, and published by the Grameen Bank) 2g, Shyamoli, Dhaka. 5. Dr. Suresh Chandra Bihari, BPLR To Base Rate- A New Era In Bank Lending In India, Gurukul Business Review (GBR) Vol. 7, Spring 2011, 119-124. 6. Montek S. Ahluwalia, Reforming Indias Financial Sector: An Overview, July 6, 2000, available at:

http://planningcommission.nic.in/reports/articles/msalu/index.php?repts=finreform.ht m (last visited on: May 5th, 2012). 7. S.D Naik, Financial Reform and Development, Financial Daily, Apr 26, 2002, available at:

http://www.thehindubusinessline.in/2002/04/26/stories/2002042600060800.htm (last visited on: May 7th, 2012). 8. Y. V. Reddy, State and Market: Altering the Boundaries and Emerging New Balances, Economic and Political Weekly, Vol. 34, No. 42/43, October 16-29, 1999, 2990-2996. Circulars/Notifications: 1. Draft Guidelines on Lending to Priority Sector for Feedback, available at http://www.rbi.org.in/scripts/PublicationDraftReports.aspx?ID=493 (last visited on: May 7th, 2012).

2. Dr. D. Subbarao, Governor, The Reserve Bank of India, Annual Policy Statement for the Year 2009-10, April 21, 2009, available at

http://rbi.org.in/scripts/NotificationUser.aspx?Mode=0&Id=4936 (last visited on May 7th, 2012), II.1. 3. The Reserve Bank of India, Asset - Liability Management System in banks Guidelines, available at http://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/3204.pdf (last visited on May 7, 2012). 4. The Reserve Bank of India, Guidelines on the Base Rate, RBI/2009-10/390 DBOD. No. Dir. BC 88 /13.03.00/2009-10, April 9, 2010 available at

http://rbi.org.in/scripts/NotificationUser.aspx?Id=5579&Mode=0 (last visited on May 7th, 2012). 5. The Reserve Bank of India, Master Circular - Interest Rates on Advances, RBI/200910/66 DBOD. No.Dir. BC 10/13.03.00/2009-10, July 1, 2009, paras 2.3 and 2.4. Survey/Reports: 1. Deepak Mohanty, Report of the Working Group on Benchmark Prime Lending Rate (BPLR), October 20, 2009, available at

http://rbi.org.in/scripts/PublicationReportDetails.aspx?UrlPage=&ID=571 (last visited on May 7th, 2012). 2. FICCI Survey on Base Rate Implementation, June 2010, available at

http://www.ficci.com/SEDocument/20059/FICCI_SURVEY_ON_BASE_RATE_IM PLEMENTATION.pdf (last visited on: May 8th, 2012). Speeches: 1. Deepak Mohanty, Perspectives on Lending Rates in India, Bankers Club, Kolkata, 11th June 2010 available at:

http://www.rbi.org.in/scripts/BS_SpeechesView.aspx?Id=508 (last visited on: May 7, 2012). 2. Rakesh Mohan, Transforming Indian banking - in search of a better tomorrow, the Bank Economists Conference 2002, Bangalore, 29 December 2002.