The Base Rate is the minimum interest rate of a bank below which it cannot lend, except in some cases allowed by the RBI. It is the minimum interest rate of a bank below which it is not viable to lend. The base rate, introduced with effect from 1st July 2011 by the Reserve Bank of India, is the new benchmark rate for lending operations of banks. Thus all categories of domestic rupee loans should be priced only with reference to the Base Rate, subject to the conditions mentioned in RBI circulars dated April 9, 2010 and January 19, 2015.
The reason for introducing Base Rate was to bring out the transparency in bank lending rates as well as to improve monetary policy transmission.Since the Base Rate will be the minimum rate for all loans, banks are not permitted to resort to any lending below the Base Rate.
Base Rate replaced the benchmark prime lending rate (BPLR) ,the interest rate which commercial banks charged their most credit worthy customer. Following the announcement in the Annual Policy Statement for the year 2009-10, a working group was constituted under the chairmanship of Shri Deepak Mohanty to review the benchmark prime lending rate. It was observed that the benchmark prime lending rate, which was introduced in 2003, had failed in its objective. The banks were lending below BPLR rates due to competitive pressures. For the same reason, it was also difficult to assess the transmission of policy rates of the Reserve Bank to lending rates of banks. Hence a need was felt for transition to a more transparent and effective interest rate mechanism.
Calculation of Base Rate
Base rate includes all those elements of the lending rates that are common across all categories of borrowers. An illustrative methodology of calculation of base rate has been provided in the RBI guidelines. As per the methodology, base rate is arrived at by adding the following
- The cost of deposits ,which is the interest rate on total deposits
- Adjustment for the negative carry in respect of Cash Reserve Ratio(CRR) and Statutory Liquidity Ratio (SLR); The negative carry on CRR and SLR arises because the return on CRR balances is nil and the return on SLR balances is lower than the cost of deposits. Negative carry cost on CRR and SLR is calculated as difference between effective cost and cost of deposits, where
- the effective cost is the ratio of cost of deposits( adjusted for return on SLR investments) and deployable deposits(total deposits less the deposits locked as CRR and SLR balances)
- cost of deposits is the interest rate on total deposits
- Unallocatable overhead cost for banks which would comprise a minimum set of overhead cost elements, which includes components like legal and premises expenses, depreciation, cost of printing and stationery, expenses incurred on communication and advertising etc.
- Average return on net worth, which is the amount of net income returned as a percentage of shareholder’s equity. It is an indicator on profitability and return on shareholder’s funds.
Banks are free to choose any benchmark to arrive at the base rate. The interest on all categories of loans is determined with respect to the base rate except the following loans; (a) DRI advances ( that is Differential rate of interest scheme whereby banks offer financial assistance at concessional rates) (b) loans to banks’ own employees (c) loans to banks’ depositors against their own deposits. Base rate is to be reviewed at least once in a quarter and has to be disclosed to the public. Each bank arrives at its base rate separately. Banks are free to choose any methodology to arrive at the base rate which is consistent , appropriate and transparent.
Historical bank group-wise and occupation-wise weighted average lending rate on quarterly and yearly basis is given in RBI database (under Statistics /Financial Sector /Key Rates). Financial Benchmarks India Pvt Ltd (FBIL) is proposed to be the entity publishing various indices of market interest rates including base rate.
Revisions to Base Rate
Banks used to follow different methodologies for computing their Base Rate. While some use the average cost of funds method, some had adopted the marginal cost of funds while others use the blended cost of funds (liabilities) method. It was observed by RBI that Base Rates based on marginal cost of funds are more sensitive to changes in the policy rates. Accordingly in the first Bi-monthly Monetary Policy Statement 2015-16 announced on April 7, 2015 it was stated that in order to improve the efficiency of monetary policy transmission, the Reserve Bank will encourage banks to move in a time-bound manner to marginal-cost-of-funds-based determination of their Base Rate’.
In this revised method, components of Base Rate will include marginal Cost of Funds (average rates at which deposits were raised in the last one month preceding the date of review, weighed by their outstanding balance in the bank’s books), Negative Carry on CRR/SLR (Negative carry on the mandatory CRR arises because the return on CRR balances is nil. Negative carry on SLR balances may arise if the actual return thereon is less than the cost of funds), Un-allocable overhead costs (comprises solely of costs incurred for the bank as a whole and, hence, not allocable to any particular business activity/unit) and Average return on Networth (which is the minimum rate of return on equity required to be obtained by the bank as determined by the Board or management of the bank). The draft guidelines of RBI may be seen here.
The actual lending rates on the loans will be determined by adding the components of spread to the Base Rate in all cases. The proposed effective rate of implementation is 1 April 2016.
The Marginal Cost of Funds based Lending Rate (MCLR) system has come into effect on April 01, 2016 vide Reserve Bank of India (Interest Rate on Advances) Directions, 2016. All rupee loans sanctioned and credit limits renewed w.e.f. April 1, 2016 will be priced with reference to the Marginal Cost of Funds based Lending Rate (MCLR) which comprise of Marginal cost of funds, Negative carry on account of CRR, Operating costs and Tenor premium. Existing loans and credit limits linked to the Base Rate/ BPLR shall continue till repayment or renewal, as the case may be. However, existing borrowers will have the option to move to the Marginal Cost of Funds based Lending Rate (MCLR) linked loan at mutually acceptable terms.
- Statutory Liquidity Ratio (SLR)
- cash reserve ratio (CRR)
- Liquidity Adjustment Facility (LAF)
- Marginal Standing Facility (MSF)
- Market Stabilization Scheme (MSS)
- Policy Rate