The way banks price their interest rates for different types of loans has never been transparent. One of the most common loan in the market is a housing loan where interest rates could be any where from 9.9% to 13% depending upon the bank and amount of loan. We think that it may be a good idea to clarify to our readers on the basics of how a bank sets an interest rate for its product and some of the factors influencing the interest rates.
The basic formula used by a bank to arrive at an interest rate is : Base rate + Interest rate spread.
Base rate shall be discussed in detail below. Interest rate spread is an additional interest rate which a bank would like to charge over its base rate depending upon the riskiness of the loan type and the borrower. For example, home loans will have a very low interest rate spread as they are fully secured loan, while an unsecured personal loan could have a spread of as high as 20- 30% taking the overall interest rate on personal loan to even 40 %.
Reserve Bank of India (RBI) has come up with a requirement for each bank to arrive at a Base Rate which is uniform across all branches of the bank. Putting is simply, it is the minimum interest rate below which a bank will not lend. Another way to look at Base rate is a rate which the bank would lend to its highest credit worthy client. While RBI mandated the banks to have a base rate and price all its products based upon the base rate, it provided flexibility to each of the banks to choose an appropriate methodology to arrive at their individual base rates.
Factors influencing Base Rates
If the Base rate is the minimum rate below which a Bank will not lend, then a corollary is that such a rate should cover the minimum expenses of the bank such as its cost of funding + Operations Cost. For a bank, the following components affect its cost :
1. Interest rates paid on deposit rates
2. Interest rates paid on saving accounts
3. Interest free amount available in Current Account
4. Rate at which the bank can borrow from RBI and other banks
5. Operating costs such as salaries, cost of maintaining infrastructure, branches, etc.
In essence, a bank lends the money which it gets from deposits. So if the deposits are costly, the loans it lend will also be costly. You may have heard the term CASA – it means Current Account & Saving Account. This is the cheapest for of funding for a bank. The more money a bank can source cheaply, the lower is its cost of funding. Again, lesser staff it employs, the lower is its cost of operations.
Based upon the recent July 2013 base rates, the banks and their base rates are (source of data ways2goals.com) :
I am not surprised to SBI having amongst the lowest base rate, followed by largest private sector banks such as ICICI, Kotak, Standard Chartered and HDFC Bank. While SBI is able to get lower base rate owing to its highest market share of CASA, the private sectors would be taking an edge on efficiency combined with CASA.
Linkage of Interest Rates with RBI Rates
This is one of the most Frequently Asked Question by retail customers. If RBI announces that it has cut its interest rates, would it result in lowering of interest rates being paid on loans ? The answer could be a Yes and a No. It all depends upon how much impact does RBI’s interest rate has on the overall cost of funding for the banks and hence impacting their respective Base rates. To understand it better it is important to understand four most important determinant of a bank’s funding cost :
1. Statutory Liquidity Ratio (SLR) – It is an amount which banks need to hold in specific types of high quality investments such as government bonds, golds, etc. As of Aug 2013, banks are required to maintain 23% of their deposits as SLR. If you look closely into it, SLR refrains the banks to take on leverage and instead of lending the funds, it has to invest into safe assets. This impacts a bank’s profitability.
2. Cash Reserve Ratio (CRR) – Similar to SLR, CRR refers to an amount which the bank needs to hold in cash, but it needs to be deposited with RBI. Banks do not get any interest on such deposits and reduces their ability to lend money. As of Aug 2013 CRR is 4%.
3. Repo Rate – It is a rate at which RBI lends money to the banks against the security of government bonds. The higher this rate is, the more expensive it becomes for the banks to borrow from RBI. As of Aug 2013, Repo rate is 7.25%.
4. Bank Rate – is a rate at which RBI provides loan to Banks. Currently the rate is 10.25%.
If you notice all the four points above, it is a combination of all which impacts the funding cost for a bank. RBI may just change one of these factors which may not be directly influencing a bank’s Base rate or may take some time before the banks can start feeling the impact of it. For example, RBI may reduce the SLR from 23 to 20%, it may take several weeks or even months before it may impact a bank’s cost of funding. Further, a bank’s relative position in the Base rate competition would influence its decision to further reduce its Base rate. For example, ICICI Bank’s base rate is 9.75%. It may not be tempted to further reduce its rate as it is already amongst the lowest in the market. It may continue to maintain its base rate and hence enjoy higher margins… this could be naughty of them, but true !
And if you now understand what a Base rate it and your housing loan is Base rate + 1%, then you can understand how it actually impacts your Housing Loan interest rates and how you could read the impact of RBI’ interest rate action on your EMIs.