Base rate is the minimum rate set by the Reserve Bank of India below which banks are not allowed to lend to their customers. The Base Rate system was introduced in June 2006 and was operational till April 2016. The average cost of funds, operating costs, negative carry-in cash reserve ratio, and margin of profit are used to establish the base rate.

In this article, we will see the meaning of base and how is it calculated with relevant examples.

What is Base Rate?

• The Reserve Bank of India establishes a minimum rate below which banks are not permitted to lend to their customers.
• The base rate is meant to increase credit market transparency and ensure that banks pass on lower funding costs to their clients.
• Based on the credit risk premium, the loan will be priced by adding a base rate and a reasonable spread.
• In India, the Base Rate system was introduced in 2010 to replace the Benchmark Prime Lending Rate (BPLR) system. The move aimed to enhance transparency, accountability, and efficiency in the transmission of monetary policy.
• However, the Base Rate system had limitations, leading to the introduction of the Marginal Cost of Funds-based Lending Rate (MCLR) system in 2016.

Illustration

• Let us consider the RBI has set a base rate of 6%. Then no bank can lend below 6% to their customers.
• The actual lending rate of the banks would include a spread beyond the base rate including the bank's profit and the credit risk of the sector and the customer.
  • Let us imagine the bank spread of Bank A is 2% and Bank B is 2.4% lending to a customer.

• The above table illustrates lending by both Bank A and Bank B for Agriculture sector.

How is Base Rate Calculated?

Many factors are taken into account when calculating the base rate. Each bank is permitted to set its own base rate, which is based on the RBI's guidelines. The bank claims that the base rate must be calculated by taking into account the following factors:

• Average cost of funds: It is the interest rate on deposits.
• Operating Costs/Unallocatable Overhead Costs: These are the costs of running the business on a day-to-day basis and include items such as legal fees, depreciation, administrative costs, stationery costs, and so on.
• Negative Carry in the Cash Reserve Ratio: This is the cost that banks must bear to maintain a certain level of cash reserves with the RBI.
• Profit Margin/Average Net Worth Return: The profitability and net amount received are part of this.
• As a result of differences in one of these criteria, base rates may range from bank to bank. The majority of the time, it's the difference in deposit interest rates.

Advantages of Base Rate

Monetary policy effectiveness

• By changing the base rate, central banks can impact the cost of borrowing for commercial banks, which in turn affects the interest rates at which banks lend to consumers and companies.
• This makes it possible for central banks to control inflation, boost or suppress economic growth, and advance financial stability.

Consistency and transparency

• Base rates make the determination of interest rates consistent and open.
• They act as a common benchmark by which lenders and borrowers can compare the cost of loans.
• This openness fosters fair competition among lenders, increases market efficiency, and makes it easier to find the best prices.

Predictability for borrowers

• Borrowers can anticipate changes in interest rates and make financial plans appropriately when base rates are steady or move in a predictable manner.

Risk management for lenders

• Lenders may adjust their lending rates according to the base rate to take into account changes in the market, credit risk, and funding costs.
• As a result, lenders are better equipped to control their profitability, lower their risk, and adapt to changes in the larger economy.

Market signaling

• Central banks employ variations in the base rate to convey their stance on monetary policy and their evaluation of the state of the economy.
• Market participants can understand these signals to decide on investments, savings, and consumption in an informed manner.

International benchmarking

• Base rates can be used to compare interest rates in various nations.
• This makes it possible to compare borrowing costs across borders and gives information on how appealing various markets are to investors and companies.

Limitations of Base Rate

• Lack of Transparency in Calculation: While the Base Rate system aimed to bring transparency, the actual calculation of the Base Rate by banks varied widely. This lack of uniformity made it difficult for borrowers to understand how their lending rates were determined.
• Inflexibility in Transmitting Policy Rate Changes: The Base Rate system did not provide a mechanism for timely transmission of changes in the central bank's policy rates, such as the repo rate. This led to delays in passing on the benefits of rate cuts to borrowers.
• Rigidity in Interest Rate Adjustment: Under the Base Rate system, banks were not able to adjust the lending rates of existing borrowers in line with changes in their own cost of funds. This lack of flexibility made it challenging for banks to respond to changing market conditions.
• Dependence on Old Borrowings: Banks calculated the Base Rate based on their average cost of funds, which included older and costlier sources of funding. As a result, new borrowers did not benefit from changes in interest rates as much as existing borrowers.
• Lack of Transmission to End Borrowers: Due to the rigidity of the Base Rate system, the benefits of monetary policy rate cuts by the central bank often did not reach borrowers effectively. Banks were reluctant to lower their Base Rates, affecting the transmission of policy changes.
• Impact on Profitability of Banks: Banks faced challenges in balancing their profitability while determining Base Rates. They needed to cover their operational costs, but setting rates too high could lead to uncompetitive lending rates.
• Complexity: The Base Rate system was considered complex and lacked transparency for borrowers who wanted a clear understanding of how their lending rates were determined.
• Evasion of Policy Intent: Some banks found ways to circumvent the intended benefits of the Base Rate system, leading to instances where lending rates did not accurately reflect changes in market conditions or policy rates.

Conclusion

Base Rate stands as a critical component of the monetary policy framework, influencing lending rates across the banking sector. Its evolution, from the Base Rate system to the MCLR system, reflects the commitment to enhance transparency and efficiency in the lending process. The base rate must ensure that the monetary policy is transmitted to its customers in letter and spirit which is not the case due to the impact of mounting Non-Performing Assets (NPA) of the banks.