Base Rate - What it is & How Does it Work?

The base rate is the minimum interest rate at which a commercial bank in India is allowed to offer a loan to a borrower. This along with the credit risk premium decides the actual cost of the loan. All commercial banks in India have the freedom to decide their respective base rates, as per rules and regulations framed by the RBI.

The RBI introduced the base rate as the standardised rate of lending for all banks in India on July 1, 2010. Loans that were approved as well as those up for renewal after this date could be switched to the new base rate system. However, banks also had the option to continue with the Benchmark Prime Lending Rate (BPLR) for loans taken by borrowers before July 1, 2010.

The following table illustrates the current base interest rates of the various commercial banks in India:

As you can see from the base rate meaning itself, it was a measure taken by the RBI for increased transparency, clarity and removal of disparity in the lending process. The BPLR (Benchmark Prime Lending Rate) system that was operational before the introduction of the base rate had led to non-uniform lending rates by banks. This is because under the BPLR system banks could fix the rate of interest in consultation with their boards and there were no restrictions on lending at a rate below the BPLR which led to inconsistencies in different loan rates.

For instance, while low-risk customers such as corporates were offered loans at a rate below the BPLR, salaried individuals had to pay the usual lending rate. Removal of BPLR and adherence to base rate definition has brought about a reform in the banking system by setting a standard for the rate of lending without any bias. The benefits have been directly transferred to you, the borrower who is no longer in the dark about the interest rate policy of a bank while applying for a loan.

As mentioned in the above sections, base rate is the minimum rate set by the RBI, below which commercial banks cannot lend to borrowers. A variety of factors are considered when calculating the base rate. These include the cost of deposits, bank's administrative costs, bank's profitability in the previous fiscal year and unallocated overhead costs. 

While calculating the lender's base rate, the bank also takes into account some other factors with predetermined weightage. 

The cost of deposits is given the most importance in calculating the new benchmark. However, banks are free to consider the cost of different types of deposits when calculating their base rates.

Here are most crucial factors affecting the base rate:

• Interest rate provided by banks on deposit or cost of funds

• Minimum rate of returns

• Operating cost

• Cash reserve ratio cost

Note that base rate offered by two lenders may be different owing to alterations in any one of the above-mentioned factors.

Now that you are aware of what is the base interest rate and how it came into effect, it is time to understand how it is calculated. As you know already, each bank has a unique base rate that it arrives at in line with the RBI regulations. Computation is done based on lending rate factors that are common to all lender categories such as:

• Fund cost or rate of interest of the deposits

• Minimum profit rate

• Operating expenses

• CRR (Cash Reserve Ratio) cost

• The primary function of the base rate is to ensure transparency in the pricing of lending products. Thus, the base rate must be known via all branches and on the bank’s official website.

• The Reserve Bank of India (RBI) has set a base rate for each loan category. This base rate must be followed by banks when pricing a loan. However, there are some categories like DRI advances, bank employee loans, and depositor loans that may be priced without following the base rate system.

• When the base rate is modified, the change applies to all loan categories that are associated with the current base rate.

• Banks must review the base rate every quarter. It is a mandatory action that should be taken upon the approval of the ALCOs (Asset Liability Management Committees) or the board.

• Any modification in the base rate must be conveyed to the general public immediately.

• Banks must offer details to the RBI regarding the applicable minimum and maximum lending rate through quarterly reports.

Large corporations enjoyed rates as low as 3% to 6% during the BPLR (Benchmark Prime Lending Rate) system. However, since the introduction of the base rate, banks are not allowed to lend a loan with an interest rate that is lower than the base rate.

The effect of the base rate on retail customers is subjective. Depending on the present rate of interest, the rate could either increase or decrease by 25 basis points compared to the present interest rate. You must, however, note that the change will not have an impact on the interest rate of existing customers.

BPLR system allowed banks the flexibility to offer varying interest rates to their customers. The rate at which a bank was interested to lend money to its different customers was defined as the Benchmark Prime Lending Rate or BPLR. There was no standardisation in the process and hence a lack of transparency on how a bank arrived at BPLR for a borrower.

On the contrary, the very definition of base rate establishes it as the threshold interest rate below which a borrower cannot be offered a loan. This clarity has brought more objectivity to the lending process by standardising the lending rate across all authorised financial institutions. This has helped do away with favouritism during the loan approval process with individuals/corporates from different financial backgrounds having access to a fixed and transparent interest rate when applying for a personal loan.