[sbinews] =?iso-8859-1?q?Benchmark_rate_=97_fact_or_fiction?_-Businessli?= ne

  • From: "Rajendra Pai" <rspai@xxxxxxxxxxxxx>
  • To: sbinews@xxxxxxxxxxxxx
  • Date: Thu, 02 Sep 2004 09:07:18 +0530

Benchmark rate ? fact or fiction? 
A. Vasudevan 

There have been elaborate discussions on different interest rates, giving the 
impression that they were, in fact, the benchmark. For instance, the auction 
rate on government bonds, the repo rate, the `corridor', and the prime-lending 
rate of banks. Yet, the `official' benchmark has been the Bank Rate. But 
transparency demands that the official rate provides the link between the 
present and the future and does not allow exploitation of short-term trading 
opportunities. That would help derive a meaningful yield rate and better 
understanding of market expectations, says A. Vasudevan.  

ONE OFTEN comes across the word `benchmark' in discussions on economic policy 
and corporate business issues, as critical to assessing certain variables. 

However, neither theoretical economics nor economics teachers refer to this 
word as a concept. One, therefore, suspects that it has emanated from the 
practitioners of business management. 

Benchmark, a point of reference 

The dictionary meaning of `benchmark' is that it is a marked point of known or 
assumed elevation, so relevant in land surveys or construction of irrigation 

But in the world of finance, the word has come to denote a number in respect of 
interest rate or yield rate or overall performance of the company. 

It is rarely expressed in terms of ranges or bands. It is not an objective: It 
is merely a point of reference. 

If `benchmark' is a reference point, it could well be used in all the areas of 
economics ? say, in respect of fiscal deficit or inflation rate or the overall 
fiscal performance of a State, or growth rate of the economy, or order of 
credit expansion, or the level of the exchange rate. 

However, this is rarely the case although potential output could well serve as 
benchmark despite misgivings about its estimation. 

Assume that the central bank, as a regulator, announces a rate that it 
considers the benchmark and that which is perceived as investment friendly. It 
cannot prescribe a rate for `prime' borrowers as it is not in full knowledge of 
such borrowers and their credit record. The rate can neither be a ceiling nor a 
floor loan rate. Obviously, banks can lend at different interest rates. But 
banks would consider the announced benchmark as the average of rates. They also 
have to ensure that the rate spread among the borrowers is not large and 
adverse selection eliminated. Besides, they would be wary of being questioned 
by the regulator in case the actual average lending rate exceeds the benchmark. 
On the other hand if the actual average rate is lower than the benchmark, the 
regulator may choose not to intervene. 

The above case, however, is not realistic. Regulators encourage banks to 
announce the benchmark rates, but keep a watch on the rate spread. For, when 
much of the borrowing is at rates that are far in excess of the banks' 
announced benchmark rate, the regulator would become alert so that credit 
disbursements are not unsustainably large. 

Commercial banks prefer to determine loan rates on certain objective criteria. 
They would not object to the central bank providing signals about what it 
considers as the appropriate benchmark. 

If such a signal, openly heralded or informally mentioned, were available, then 
banks would adopt a variety of methods to ensure that their actual loan rates 
are broadly in line with the signalled rate. 

For example, they could ration credit or charge different rates for their 
borrowers on the basis of their calculations of creditworthiness or announce 
benchmark loan rates in terms of ranges for each group of borrowers, thereby 
creating multiple reference points for each bank. 

In case the last option is favoured, banks would benefit by colluding with one 
another in announcing multiple benchmark rates that are near-convergent across 
banks for each group of borrowers. 

Or, the big sized banks would first announce such benchmark rates and let 
smaller ones follow their lead (the `herd' behaviour!). 

In the event, rate competition among banks would be at a discount. At best, 
banks could be differentiated only on the basis of range of services they offer 
and the quickness of their delivery. 

`Prime' borrowers 

Still the question as to how the benchmark rate, be it single or multiple, gets 
determined remains. In India, when banks announced the prime rates, they were 
set at levels lower than what was then charged for major or `prime' borrowers. 

This became a benchmark and the rates were subsequently fine tuned to be 
competitive with the rates at which prime borrowers could mobilise resources 
either through issuance of alternate financial instruments such as commercial 
paper or from foreign markets (or foreign currency loans). 

This, however, is not the way economics students at Indian universities view 
the determination of interest rates. For the student, the loan rate is uniquely 
determined on the basis of the supply of and demand for funds. It is an 
equilibrium rate and is at once the benchmark rate. 

However, the student would be willing to consider the existence of different 
benchmark rates for different borrowers, representing multiple equilibrium 
rates. An average of multiple equilibrium rates would then give a unique 
equilibrium rate for the bank as a whole. 

Typically, the actual rate deviating from the equilibrium rate can only be 
temporary as there would be a tendency on the part of lenders and borrowers to 
move to the equilibrium rate. 

Determining benchmark rates 

The word, `equilibrium', however, is generally viewed with derision, ever since 
Kaldor's criticism of it around the 1980s. But if one were to closely examine 
the processes through which bankers arrive at benchmark rates, there is very 
little of difference between the bankers' judgments and the students' 

The only difference between the two processes is that while bankers consider 
themselves as suppliers of loans subject to structural or exogenous 
constraints, and view the demand for funds as what `the traffic can bear', the 
economics students would regard the demand and supply sides as forces that work 
on objective economic factors. 

Viewed differently, for the bankers there would be no forces at work to move 
towards their pre-determined benchmark rates in the event the actual rates 
deviate whereas for the economics students, there would be a tendency to move 
to equilibrium rates. 

In reality, there is no knowing where exactly the demand for and supply of 
funds would be equal simply because the demand for funds is not available as a 

Nor are central bankers sure of the effects of changes in interest rates on 
investments or growth, irrespective of whether the commodity prices are `fixed' 
or `flexible'. 

That is why central banks vary their official rates by typically small 
percentages. But whether such interest rate smoothening would have the desired 
effects in a given period is unknown. This is particularly so in the case of 

There have been many elaborate discussions in India at different times on 
different interest rates, giving the impression that the discussed rate was in 
fact the benchmark rate. 

As a result, it is difficult to be certain about the rate that the regulator 
focuses upon. In the mid-1990s, the Bank Rate was a reference one. 
Subsequently, the discussions surrounded the auction rate on government bills 
and bonds, the repo rate, the `corridor', and the prime-lending rate of banks 
in different hues (the short- and the long-term ones). 

Yet, the `official' interest rate has continued to be the Bank Rate. But 
transparency requires that the official rate provides the link between the 
present and the future and does not permit exploitation of short-term trading 

That would facilitate derivation of a meaningful yield rate and better 
understanding of market expectations. 

(The author, formerly Executive Director of the Reserve Bank of India, can be 
accessed at asurivasudevan@xxxxxxxxxxx) 

IndiaInfo Mail - the free e-mail service with a difference! www.indiainfo.com 
Check out our value-added Premium features, such as an extra 20MB for mail 
storage, POP3, e-mail forwarding, and ads-free mailboxes!

Powered by Outblaze
Mailing list (sbinews@xxxxxxxxxxxxx) related information:

News/articles about SBI and Banking related matters published  in the print 
media, Internet etc will be circulated through this Mailing List. 

The messages in this list will help in improving awareness of SBI and its 
activities vis-a-vis the happenings in the Banking industry. This should be of 
help to all staff members of SBI, particularly those who are preparing for 
promotional written tests/interviews/group discussions. Subscription to this 
Mailing List is simple and FREE. Please check the procedure below. Please share 
this information with other colleagues/branches that could be interested in 
subscribing to this Mailing List. 

The messages circulated here should not be deemed to have the official 
endorsement of the SBI or any of its employees. The correct factual position 
may be ascertained from official sources. 

To join this mailing list, just send an email to sbinews-request@xxxxxxxxxxxxx 
with the word 'subscribe' without the quotes in the subject of the email 

To leave this mailing list, just send an email to sbinews-request@xxxxxxxxxxxxx 
with the word  'unsubscribe' without the quotes in the subject of the email 

Archives (old messages) are available for viewing at:
Click on the month-year at the lower left corner to view messages posted during 
that month. 

This is an announcements/newsletter type mailing list i.e. only the Moderator/s 
can post messages to the list. 

This mailing list is maintained and moderated by Sri. R.S.Pai, currently 
working as Chief Manager(IT-Internet Banking), SBI, Corporate Centre, Mumbai. 
Visit http://rspai.tripod.com for some useful Banking, Reference and Utilities 

Other related posts:

  • » [sbinews] =?iso-8859-1?q?Benchmark_rate_=97_fact_or_fiction?_-Businessli?= ne