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Tuesday, April 13, 2010

A more flexible base rate system for banks

The Reserve Bank of India (RBI) seems to have realized that the business of fixing lending rates is best left to the banks themselves. Unlike the February draft, the final guidelines explicitly state: “Banks may choose any benchmark to arrive at the base rate for a specific tenor that may be disclosed transparently.”

While their example of a base rate is linked to the average deposit costs, RBI explicitly says: “Banks are free to use any other methodology, as considered appropriate, provided it is consistent and is made available for supervisory review/scrutiny, as and when required.” What’s more, banks have been permitted to experiment with the benchmark and the methodology till December. In a word, it’s flexibility. Banks can now go in for whatever method of pricing best suits them.

While there were fears that high base rates would have led to firms seeking more funds through the market by placing commercial paper or bonds, the flexibility to determine their own methodology for computing the base rate will allow banks to combat that threat. A note by Edelweiss Capital says that “the banks would set base rates in the lower range (5-7%) to ensure minimal disintermediation to other forms of credit by top rated corporates”.

How do banking stocks perform compared with other stocks during the business cycle? The chart shows the market capitalization of the stocks that make up the BSE Bankex as a percentage of total market capitalization.

Note what happened during the last banking cycle. In June 2003, when the bull run had just begun, the Bankex stocks had a market cap equal to 8% of total market cap. By March 2004, almost a year into the bull market, they accounted for a high 9.4% of total market cap. Interestingly, though, the Bankex’s market cap started declining after that, falling to 7.3% of total market cap and remaining remarkably steady there in March 2006, March 2007 and March 2008. In March 2009, when the current rally started, it was 7.6% and it’s around 9% now, which means that banks stocks have outperformed in the rally so far. In the month to 9 April, while the Sensex is up 4.9%, the Bankex is up 6%.

But history shows that as the recovery gathers steam and as the central bank gets more and more serious about applying the brakes to growth through higher interest rates, bank stocks start doing worse than other sectors.

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