BASE RATE

Term

BASE RATE

Meaning :

Base rate would be the new benchmark of pricing of loan products by the banks in India. Base rate would be coming into effect from 1st July 2010. The main idea behind implementing base rate is to incorporate more transparency in the lending mechanism of banks. Responding to the widespread feeling that banks do not set their lending rates in a scientific and transparent manner, the Reserve Bank of India has come up with Base Rate system.

The proposed system will replace the existing system of benchmark prime lending rates (BPLR) with base rates. The formula for calculating the base rate will take into account the cost of deposits, cost of complying with CRR and SLR requirements, and the need to retain a profit margin. Plus there will be a markup depending on the cost of operation for a particular type of product and premiums for credit risk and tenor of loans.

If you are a home loan borrower, the rate you see will be a sum of two costs: a base rate plus borrower-specific charges. A bank faces several costs. The first, called base rate, is common across all borrowers and will be made up of the cost of deposits (or what it costs the bank in interest payments to keep your money as deposits), the money notionally lost by the bank in statutory obligations that throw off no interest, general overhead costs and profit margin. Add to this the specific cost due to the product you buy, its tenor (length) and your own credit risk.
Product-specific costs mean that an unsecured loan would have a higher cost attached to it compared with a home loan, which has the house as the collateral.
Your credit rating with Credit Information Bureau (India) Ltd (Cibil) will now come into play and people with good credit scores will see the charges related to their own risk come down, meaning lower rates. Tenure-related cost would mean that the longer the loan is held, the higher the cost.
Analysts say the base rate for even the best banks would be in the region of 9%. With the cost of deposits at around 6% and adding around 0.75% to compensate for the lower yields on statutory holdings of government bonds and zero yield on cash reserves, an additional 1.25% to unallocable overheads and an average of 1% return on assets, the base rate would add up in this illustrative case to 9%.

Why BPLR didn’t work?
For years, home loan borrowers on floating rates felt cheated by banks as they paid more when interest rates rose, but did not pay less when they fell. Banks kept rates high for old customers and reduced them for new ones by keeping the benchmark prime lending rate (BPLR) sticky.
Not only did banks set BPLR in a non-transparent manner, they had several BPLR rates, each for a different category of loans—corporate and retail to name two.
To deal with this problem, among others, the Reserve Bank of India (RBI) announced the move from a BPLR model to a base rate system. The new rate will apply to all fresh loans but old loans, when they come up for renewal, can switch.