Base rate

In recent years, numerous improvements have occurred in India's banking system. As a consequence, banks now have the right to establish their own interest rates as long as they accept the RBI's recommendations. While banks can set and change interest rates, they must also consider the RBI, which has implemented several interest rate reforms, including the introduction of concepts such as the Prime Lending Rate Regime and the Benchmark Prime Lending Rate (BPLR), to ensure that interest rates offered by different banks are more or less similar and competitive. The base rate is one of the RBI's most recent ideas. Let's take a look at what it is, how it is calculated, and the factors that impact it.

What is base rate?

The base rate is the minimal interest rate established by the Reserve Bank of India below which Indian banks are not authorised to lend to their clients. Unless otherwise mandated by the government, the RBI regulation states that no bank may issue loans at interest rates lower than the base rate. Base rate, which was introduced in June 2010, is simply considered as the basic loan rate given by commercial banks. It has been determined to boost transparency and guarantee that banks pass through the benefits of lower interest rates to borrowers. Loans are priced by multiplying the base rate by a reasonable spread, subject to a credit risk premium.

Calculation of base rate

The Reserve Bank of India, the country's principal regulatory authority, determines the base rate. The RBI establishes the base rate in order to provide uniform rates to all Indian banks, whether they are nationalised or private. The base rate includes all aspects of lending rates that are common among different types of borrowers.

A variety of criteria are considered while calculating the base rate. These include, among other things, the cost of deposits, the bank's administrative costs, the bank's profitability in the preceding fiscal year, and unallocated overhead costs. While calculating the lender's base rate, the bank additionally takes into account various other criteria with predetermined weights. The greatest weight is placed on the cost of deposits when calculating the new benchmark. However, banks are permitted to include the cost of deposits of varied maturities when calculating their base rate.

Factors determining base rate

As previously stated, each bank is allowed to set its own base rate as long as it adheres to the RBI's standards and norms. According to RBI standards, the base rate must encompass all characteristics of lending rates that are common to all types of borrowers. While individual banks may have different base rates, there are four main components that often influence the base rate established by a certain bank. These are some examples:

• Cost of funds i.e. interest rate provided by the bank on deposits
• Operating costs
• The minimum rate of returns
• Cost of the Cash Reserve Ratio

While the Base Rate was the minimal lending rate under RBI standards, in April 2016, the RBI created a new concept known as the MCLR, or Marginal Cost of Funds Based Lending Rate, as a successor for the Base Rate. The MCLR is the new internal standard that all financial firms are supposed to follow. The MCLR rate was implemented in place of the base rate, and all loans sanctioned by banks from April 2016 have been controlled by the new system known as MCLR.

MCLR (Marginal Cost of Funds based Lending Rate)

The Reserve Bank of India (RBI) establishes a fixed internal reference rate for banks. This interest rate is then utilised by banks and lending institutions regulated by the RBI to determine the minimum interest rate applicable to various loan categories. The RBI updates this rate every now and then when there is a significant shift in the country's economic operations. Banks are often not permitted to lend money at a rate lower than the MCLR. Learn more about MCLR, its implementation, and how it differs from the base rate here.

What is MCLR?

The Marginal Cost of Funds Based Lending Rate is the lowest interest rate that a bank can charge for lending. Except in specific situations approved by the Reserve Bank of India, the bank cannot provide any loan at a rate lower than that (RBI).

The MCLR is currently used as a benchmark and was created to counteract the base rate system. It has been in force for all kinds of domestic rupee loans since April 1, 2016. Simply said, beginning in April 2016, interest rates on all loans, regardless of category, will be determined by the MCLR.

In contrast to the base rate, which is established by the average cost of funds, the MCLR is decided by the actual cost of funds. The RBI created the MCLR because rates based on this approach are more sensitive to changes in policy rates. This also guarantees that the country's monetary policy is adequately implemented in all areas.As a result, the MCLR guarantees that banks' lending rates follow policy rates. Furthermore, it gives transparency in the mechanism used by banks to determine interest rates on advances.

Calculation of MCLR

The parameters necessary to compute it are as follows:

• The marginal cost of financing.
• Tenure premium.
• Operating charges.
• cost of CRR (Cash Reserve Ratio) maintenance.

All of this is determined by extremely specific conditions, and the final MCLR is only disclosed after a thorough study.

Factors that Determine the MCLR

• Marginal Cost of Funds: It consists of the marginal cost of borrowings as well as the return on net worth. The marginal cost of borrowings has a 92 percent effect, whereas the other component has just an 8 percent influence. It is also affected by the report rate as well as the interest rates set by banks.
• Operating Costs: These expenses are related to making the loan, obtaining finances, and conducting the day-to-day activities.
• Cost of Carry in the Cash Reserve Ratio (CRR): Banks must evaluate the cash deposits they must maintain with the Reserve Bank of India.
• Tenor Premium: This is the premium that will be paid for long-term loans in order to minimise the risk associated with long-term lending. Banks may publish the internal benchmark (MCLR) for overnight, one-month, three- month, six-month, and one-year maturities once a month.