With the launch of financial sector reforms, banks got the freedom to set their interest rates subjected to RBI guidelines. Interest rate of a bank is basically determined by that bank itself.
The bank’s asset and liability management committee meets to set the interest rate charged from its customers.
Though banks have the freedom to determine interest rates, RBI has introduced many measures in the past to reform this interest rate set by banks. First one of these was the Prime Lending Rate Regime. Then the Benchmark Prime Lending Rate (BPLR) was introduced to bring similarity between the interest rate set by different banks.
Base Rate is the latest such reform that regulates the interest rate setting by commercial banks. The base rate was introduced by the RBI in July 2010 as the standard lending rate for commercial banks. Practically, base rate is the minimum interest rate at which a bank can lend. More than that, base rate is the standard interest rate for each bank.
Now base rate is modified by introducing MCLR in the determination of base rate. According to this norm by the RBI, banks should revise base rate according to their Marginal Cost of funds based Lending Rate (MCLR) on a monthly basis.
Factors that determine the base rate
Each bank can determine their base rate in accordance with the norms given by the RBI. According to the RBI, Base Rate shall include all those elements of the lending rates that are common across all categories of borrowers.
The base rate may differ from one bank to the other. But the following four components usually determine the base rate of particular bank. These components are:
- Cost for the funds (interest rate given for deposits),
- Operating expenses,
- Minimum rate of return (profit), and
- Cost for the CRR (for the four percent CRR, the RBI is not giving any interest to the banks)
The base rate of one bank may differ from another bank due to difference in one these factors most probably due to difference in interest rate.
Modification of base rate under MCLR norm
According to the MCLR regulation, banks have to use the MCLR methodology in calculating and setting their base rate.
Under MCLR, cost for the funds is calculated on the basis of marginal cost.
Following are the main components of MCLR.
- Marginal cost of funds;
- Negative carry on account of CRR;
- Operating costs;
- Tenor premium.
Marginal cost is estimated by including repo rate and other costs incurred by the bank for getting funds.
Though base rate is the minimum interest rate that the bank can charge from the customers, certain types of loans are still exempted from base rate. These categories are:
(a) Differential Rate of Interest (DRI) advances,
(b) loans to banks’ own employees,
(c) loans to banks’ depositors against their own deposits,
(d) interest rate subvention given by government to agricultural loans and rupee export credit, and
e) some specific cases of restructured loans.