Banks have asked the regulator, RBI to allow them freedom to decide interest rates on loans below Rs. 2 lakh to help them reach out to unbanked sections which at present are serviced by microfinance institutions and moneylenders at high rates.

Currently banks cannot charge more than their benchmark prime lending rates (ranging from 11% to 16%)on loans to the extent of 2 lakhs. This ceiling applies to borrowings by farmers and small businessmen in rural India as this cap is not applicable to personal loans.

If RBI grants this freedom to banks, interest rates are bound to rise but they would still be competitive compared to microfinance institutions that charge between 30 percent and 35 percent.

Some private lenders have told RBI that their distribution network would help them to grow the market significantly if rates are freed.

"The differential in rate is gives scope for pilferage in the system leading to a situation where the beneficiary may not get the full benefit of lower rate," pointed out a banker who attended the meeting with the RBI.

Bankers say that there may be situations where branch officers take personal favour to sanction the loan at low interest rates when micro finance institutions charge double the rate.

Due to political pressures in India it is unlikely that RBI may soon consider deregulating rates for small borrowers. The ceiling on such loans is aimed at protecting the interests of small borrowers, who would otherwise be charged higher rate since the transaction cost of financing such loans is high for a bank.