The Reserve Bank of India [Get Quote] has initiated a review of the benchmarking system for pricing floating rate loans, a move that could impact 70 to 75 per cent of banks' loan portfolios.

Benchmarking in loan pricing refers to selecting a base rate on which other costs are pegged to arrive at the interest rate that banks charge customers who avail of floating rate loans.

Sources close to the development said the review follows a recent observation by the banking regulator that most banks do not fix floating interest rates in a transparent manner.

The move comes when the delinquency rate is increasing as a result of rising interest rates as part of the central bank's efforts to control inflation. Many banks are shifting to floating rate loans for products such as auto loans that were earlier offered at a fixed rate.

"One needs to first sort out the pricing methodology before factoring in the scope of delinquencies for risk-management purposes," said a source. Banks mark long-term loans to floating rates; short-term loans usually carry fixed rates.

Sources said a floating rate benchmark should normally be risk-free. Most banks use their respective Prime Lending Rates as the base for floating rate loans. RBI believes this rate is not risk-free because it is calculated after incorporating costs and risks attached to the operation of each specific bank.

RBI has directed banks to use risk-free market rates like call rates or Mumbai inter-bank offered rates or yields on government securities as the benchmark to peg other costs and arrive at the interest rate for floating rate loans.

Some banks, however, have informally pointed out to RBI that market-determined rates like Mibor are polled and not fixed in a transparent manner.

"In some cases, banks have even complained that the process of polling is not transparent since some banks rig rates depending on their lending portfolio for a certain maturity or redemption pressure on the deposit base," said a source.

Instead, banks have said RBI should ideally specify call rates or the yields on government securities as the benchmark since they are calculated on the basis of transactions on the negotiated dealing system. NDS is RBI's screen-based anonymous dealing system that is a mandatory trading platform for all government securities.

The other option could be to ask banks to review PLR at periodic intervals, depending on the varying cost of funds so that the floating rate can be reset. Typically, banks are quick to raise floating rates when interest rates rise but are less prompt about reducing them when rates decline.

"If RBI reviews the interest rate benchmarking policies for floating rate loans, there should be a proper electronic system to allow bankers to adopt these market-determined rates," said a top executive at a large private bank.