Base rate is the rate below which a Bank cannot give loans. Introduced on 1st July 2010 on the directive of RBI, Base rate replaced the old system of BPLR (Benchmark Prime Lending rate)
Why it was needed?
Before base rate a system of BPLR was in place. However almost all banks lent below BPLR to its corporate customers and charged high rate from its retail and SME borrowers, which meant that big corporates kept on getting cheaper credit at the expense of small and retail customers.
Thus RBI directed banks to move to a system of Base rate, below which banks can not lend.
Crux of base rate concept is that this is the minimum cost of funds. For eg if a Bank wants to give loan of Rs 100, what is the minimum rate on which it should be lent so that there is no loss on its lending. Suppose base rate of a Bank is 10. It means that Bank should at least earn Rs 10 each year so that it doesn’t suffer any losses and recovers all its cost
How it is calculated:
As already explained above it is the minimum rate which should be recovered, which means it must be able to cover all the costs associated. Thus we need to understand what is cost of lending funds. This is very interesting and readers must pay attention in understanding this:
There are four components of cost; they are explained as below with example:
Suppose a Bank gets deposit of Rs 100. Bank needs to pay interest on this.. This is the first component called cost of deposits. Now as per rule of RBI, banks need to maintain SLR & CRR, if respective rates are 23 % & 4 % it means banks will not be able to lend Rs 27. On this Rs 27 Banks do not get any interest and there are locked this is called second component and is known as negative carry on CRR & SLR.
Now there is cost, in the form of salary and other expenses, this is third component called unallocatable costs. And last of all a Bank to start a business must have capital. This capital has to remain in business always and can not be used for any other purpose. But interest must be paid for this capital and this is 4th component called return on capital.
Thus Base rate means covering all this component:
- Cost of deposit
- Negative carry on CRR & SLR
- Unallocatable cost
- Return on capital
Thus by summing up cost of all the above component a Bank will arrive at its Base rate.
Exceptions to Lending below Base rate:
- Lending against its own term deposit
- Lending to its own staff
- Lending under Differential rate of interest scheme
- Lending where interest subsidy is available from Government.