In the 1970, Govt began nationalization of private banks, and started administering their interest rates on them.
Which meant that the Govt would decide how much loan interest rate the banks should charge on borrowers. During the LPG era, in 1991 the M.Narasimham committee suggested bank deregulation. The committee further recommended that the Government should not dictate individual banks’ interest rates as it’s detrimental for the market.
The central bank (RBI) should only give methodology to banks. The Reserve Bank of India introduced the Marginal cost of funds-based lending (MCLR) methodology for fixing interest rates from 1 April 2016. It replaced the base rate structure, which had been there since July 2010. In this article we’ll discuss what the base rate system is, it’s calculation methodology & latest updates on it.
What’s base rate?
Base rate refers to the minimum interest rate set by the RBI below which it is not permissible for Indian banks to lend to their borrowers. The central bank rules specify that no bank can offer loans at an interest rate lower than the base rate. Introduced in June 2010, base rate is simply the standard lending rate offered by commercial banks.
It was decided to increase transparency, accountability and to ensure that banks enable the trickling down of the benefit of lower interest rates to it’s borrowers. Loans are priced by adding the base rate to a suitable spread,which was subject to the credit risk premium.
Why was base rate introduced?
MCLR system was unable to sustainably pass down low interest rates to its consumers due to various apprehensions feared by banks thus to fix these issues, Base rate was introduced. It was done in order to enhance transparency, fairness & accountability in the credit market and ensure that banks pass on the lower cost of funds to their customers. Loan pricing is derived by adding base rate to a suitable spread depending on the credit risk premium.
What factors are used to determine base rate?
Now that we know what the base rate in India is and why it was introduced, we’ll now check out factors used to determine it. All banks have the freedom to determine its base rate so long as it follows the guidelines of the RBI. The base rate may be different for different banks but there are four important factors that determine the base rate set by a particular bank such as:
- Cost of funds or. interest rate provided by the bank on deposits
- Operating costs of the bank
- Amount of the Cash Reserve Ratio
- The minimum rate of return
The base rate offered by different banks may be different based on any one or more of these above-mentioned components. The difference in interest rates is generally the most common factor.
How is it different from a bank prime lending rate (BPLR)?
BR is a more objective reference number than the BPLR. BPLR is the rate at which a bank is willing to lend to its trustworthy, low NPA risk customer. However, banks quite often lend at rates below BPLR. For instance, most home loan rates are below BPLR levels. Some large corporations also get loans at rates substantially lower than BPLR. For all banks, BR will be higher than their BPLR.
After MCLR’s & BR’s failure, RBI on 1st October 2019 ordered that banks must link their loan interest rates with the “External Benchmark (EB) + Spread + Risk premium” system. EB maybe – RBI repo rate, 91-day T-bill yield, 182-day T-bill yield or any other benchmarks by Financial Benchmarks India Ltd. Further, banks are required to update the latest data of EB, at least once every three months.
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