What is Base Rate, How it is Calculated, And its Effect on Bank Customers

The Base rate is one of the more recent reforms implemented by the Reserve Bank of India (RBI). It was introduced on July 1, 2010, to replace the archaic Benchmark Prime Lending Rate (BPLR) and bring greater transparency to the pricing of bank loans, allowing for a more accurate assessment of monetary policy transmission.

In simple terms, the base rate is used as the banks’ internal benchmark rate for lending. As per the RBI norms, banks cannot offer loans at interest rates lower than the base rate set by the RBI. Read on to know more about the base rate system in India.

What is a Base Rate?

When you take a loan from a lending institution, there is an interest rate that is applied to the principal amount that you pay to the lender. A bank’s base rate is the lowest interest rate at which it will lend money to customers. Consider it a criterion below which the RBI does not allow banks to lend to customers. All banks are mandatorily required to set a base rate and charge interest rates based on the bank’s spread, the borrower’s credit profile, and repayment tenure.

The base rate includes all costs involved in the process of lending. The bank’s base rate system applies to all new and existing loans that are up for renewal.

Uses of the Base Rate System

• The interest rate on all loan categories is determined primarily based on the base rate. Few exceptions are a DRI advance, loans to bank employees, and loans to bank depositors against their deposits. 
• The base rate could be used as a reference benchmark rate in addition to external market benchmark rates for floating rate loan products. 
• The base rate helps maintain transparency in the pricing of lending products, and it must be reviewed at least once a quarter. Banks must display the information on their base rate in all branches and on their websites.

How is the Base Rate Calculated?

A base rate is made up of different costs incurred during lending. Here are some of the factors that lenders take into account when setting the base rate: 

• Deposit costs
• Administrative costs
• A bank’s profitability in the previous fiscal year
• A few other parameters with specified weights are considered

The cost of deposits is given the most weight in determining the new benchmark. Banks have the flexibility to consider the cost of deposits of any tenure when calculating their current base rate.  

Who Calculates the Base Rate in India?

To ensure uniformity in the lending system, the Reserve Bank of India (RBI) sets the base rate for all banks in the country. Based on the RBI’s base rate, each bank can set its rate (not less than the RBI’s base rate) for different loan categories under the purview of RBI’s guidelines.

Banks may use any benchmark to calculate the base rate for a specific tenor, which must be disclosed in full. They are free to use any methodology they deem appropriate if it is consistent and available for supervisory review or scrutiny. At the bank’s discretion, borrowers will need to pay the base rate plus borrower-specific charges such as operating costs, credit risk premiums, and tenure premiums. 

Also Read

Prime Lending Rate, MCLR, RBI Base Rate Impact on Loans Explained

MCLR (Marginal Cost of Funds Based Lending Rate)

Factors that Determine the Base Rate in India

Each bank can set its own rate under the RBI’s guidelines and standards. According to RBI guidelines, it must include all the components of the lending rate that are common across various categories of borrowers. As we all know, the base rate varies from one bank to the next. However, the following four factors typically determine a bank’s base rate:

• The cost of the funds i.e. interest rate given for deposits. 
• Operating costs associated with providing the loan product, such as the cost of raising funds. 
• The minimum rate of return (profit), as well as 
• The Cash Reserve Ratio or the CRR (Is the percentage of cash deposits that banks must keep with the Reserve Bank of India every two weeks) Currently, the CRR is 4.50%.

Current Base Rate of Banks in 2022 

What are the Effects of the Base Rate?

Effect on Corporates: Large corporations benefited from rates as low as 4%-6%  under the BPLR system. However, since the implementation of the concept of the base rate, no bank has been permitted to lend at a rate lower than the base rate. This has made corporate lending more expensive.

Effect on Retailers: The impact on a retail customer varies based on specific circumstances; it could be an increase or decrease of 25 basis points compared to their current rate of interest. Existing customers, however, will be unaffected by this change. (100 basis points = 1%) 

Difference Between the Base Rate, BPLR and MCLR

The Benchmark Prime Lending Rate (BPLR) is the interest rate commercial banks charge their customers’ most creditworthy customers. The main issue was its lack of transparency. Banks could lend to privileged customers at rates lower than the BPLR. Each bank used its BPLR methodology, making it difficult for borrowers to compare rates across institutions. 

In contrast, the Marginal Cost of Funds Based Lending Rate (MCLR) is determined by the current cost of funds. In contrast, in determining the base rate, the average cost of funds is considered. It also provides transparency in how banks determine interest rates on advances. Rates based on this system are more sensitive to changes in the policy rate.  

MCLR and the base rate system are India’s most widely used rating systems and are based on the same principle to provide transparency. However, the base rate is calculated using the profit margin, whereas the MCLR is computed using the tenor premium.

Final Word

The RBI introduced the base rate system in July 2010 to displace the archaic Benchmark Prime Lending Rate (BPLR) system to bring greater transparency to the pricing of bank loans. Banks have the freedom to set their base interest rates, subject to RBI guidelines, but this rate cannot be lower than the base rate designated by the RBI. Individuals or corporations can now access a transparent methodology of interest rate calculation when applying for a loan. The base rate system would apply to all new loans and renewals of existing loans. Existing loans based on the BPLR system may be serviced until maturity.

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