RBI’s Changes in Calculation of Base Rate Explained


Base rate
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The Reserve Bank of India has made reforms in the way benchmark lending rates of banks are calculated.  It has decided to move to Marginal cost based lending rates (MCLR). It will replace the existing base rate system from April 2016. This post explains the changes made by the RBI.

What is base rate?

The concept of base rate was introduced in the year 2010. The Base rate is the rate below which banks can’t lend. Each bank has to set its own base rate as per the guidelines laid down by the RBI.

One of the factors considered to calculate base rate is Cost of funds or interest rate on deposits. Banks’ lending rates will have to be higher than the cost of funds of bank to be profitable. Hence, interest rate of deposits is considered to calculate the minimum lending rate or base rate.

In the existing system banks are free to use either of the three methods to calculate cost of funds: Average, blended or marginal costing method. The method preferred by most banks is average costing.

But, from April 2016 onwards only marginal costing method will be used. The base rate system will be replaced by Marginal Cost of Funds based Lending Rate (MCLR).

Why the need for this change was felt?

The need was felt due to ineffective transmission of monetary policy rates into lending rates. Theoretically, if the RBI decreases the repo rate, the interest rate on lending should also decline by more or else the same amount. But, it didn’t happen. While RBI cut its repo rate by 125 basis points in 2015, lending rates came down only by 60 basis points.

Banks claimed that they could not reduce the lending rates as their base rates didn’t come down with the decline in the the repo rate.

As already mentioned, most banks preferred average costing method to arrive at base rate. But, average costing is not desirable as rate of interest on deposits of longer term maturity takes time to change as per the recent conditions of the market. Average costing led to a situation where decline in repo rate did not fully reflect in the base rate of the banks. It led to stickiness of the base rate and thus banks could not lend below this rate.

According to the new rules, RBI mandated Banks to calculate lending rate based on marginal costing basis. [To know about the other components of base rate, go to the end of the article]. Marginal cost is the interest rate offered on only new deposits. The new deposit rates reflect the more relevant and recent cost of funds for the banks and hence any changes in the repo rate will be more effectively refected in the lending rates.

What are the other changes that the RBI made?
  • Five different MCLR rates will be published as opposed to one. [for overnight loans, one-month, three-months, six-months and one-year loans.] In the current base system, cost of 3-6 month deposits are used to compute base rates for all loans
  • The marginal cost of funds will included repo rate also in the calculation. It is not included in the current base system.
  • This rate has to be revised monthly. The present base rates gets revised only occasionally.

To sum up, the decision by the RBI to move to marginal cost based lending rates could ensure effective monetary policy transmission. It will compel banks to factor in the changes in repo rate in their lending rates. It will also bring in uniformity and transparency in the way lending rates are calculated by banks.

Notes:

  1. The other main components (apart from cost of funds) used to calculate base rate/ MCLR are
  • Negative carry on account of CRR: Banks have to keep some of its deposits with RBI as cash reserve ratio. This deposits cannot be lend by the banks and thus banks cannot earn interest on it. The cost of such funds are included in the loans given to the people.
  • Operating expenses incurred by the bank.
  • The third main component to calculate current bank rate is minimum rate of return/ profit. Under the MCLR, tenor premium is used instead of minimum rate of return.

2. The existing base rate was introduced in 2010. Prior to the base rate, we used benchmark prime lending rate (BPLR) to determine the interest rates. BPLR is the rate at which banks are willing to lend to its most trustworthy, low-risk customers. But, banks were allowed to lend below BPLR. It made the system of lending rates opaque and hence, base rate system was proposed to bring in transparency.

Further readings:

RBI unveils new math for banks’ base rate

What is Marginal Cost of Funds based Lending Rate (MCLR) reform by the RBI

 

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