If you are happened to read the recent newspapers, it is most likely to read a news talking about the base rate system for the banks. Every banks announcing the base rates for lending loans. What is that?. I have written earlier in March 2010, about the implementation of the base rate system from 1st July, 2010. In this article, I will explain the use of base rates and how it will impact the banks and borrowers. It is one of the reforms on banking system by RBI to reduce the lending risk for banks. In the next sections, we will see that in detail. If you like the article, Please subscribe to our future articles here.
Say Bye to Prime Lending Rate (PLR)
Before setting the base rate system, banks used another rate system called Prime Lending Rate (PLR) to set their lending rates. The problem with this system is, banks manipulated this PLR to lower level to offer discounted lending rates for the borrowers. It may cause the loss for the banks if they offer loan with much cheaper price. The real intention of the RBI is to make the banking system much stronger after the global financial crisis.
The banks meet huge loss because of the default loans. The main reason is, when banks offer loans with cheaper price to lure the customers, most of the customers without adequate financial support too get the loans. It will end in default (can not repay the loans). Base rate system provides more transparency on setting the rates. Each bank use some criteria to set their base rates.
What is Base Rate System?
As I have mentioned in the previous section, Base Rate System is for the banks to set a level of minimum interest rates charged while giving out the loans. This Base Rate System has many advantages over the older method of Prime Lending Rate (PLR). One advantage is, in the Prime Lending Rate (PLR), one could sanction the loan for lower price for the preferred customer or the corporate bodies and retail customers may have to pay more for the same type of loans. In the base rate system, there will not be much variance on the loans.
However, the base rate system will not be applicable for the following type of loans:
- Agricultural Loans
- Loans given to own employees
- Loans against deposit
- Export Credit
Base rate system is arrived at taking into the account, the cost of deposits and cost of keeping aside cash to meet CLR and SLR. It is convenient for the banks to adjust the lending rates after the changes on policy rates by the RBI.
Transparency on Base Rate System
Another advantage of base rate system is transparency on calculation method to arrive the base rates. Every bank has to declare to the public how they have calculated the base rates. Fro example, SBI has calculated the base rate by taking into account of past six month deposits.
Excerpt from RBI’s Circular on Base Rate System:
Base Rate shall include all those elements of the lending rates that are common across all categories of borrowers. While each bank may decide its own Base Rate, some of the criteria that could go into the determination of the Base Rate are: (i) cost of deposits; (ii) adjustment for the negative carry in respect of CRR and SLR; (iii) unallocatable overhead cost for banks such as aggregate employee compensation relating to administrative functions in corporate office, directors’ and auditors’ fees, legal and premises expenses, depreciation, cost of printing and stationery, expenses incurred on communication and advertising, IT spending, and cost incurred towards deposit insurance;and (iv) profit margin.
Base Rates for Banks
The following table presents the base rates announced for some of the leading banks.
I hope this article would be useful to know the purpose of bringing the new rate system into the banks. It is end of PLR and beginning of new rate system. We have to wait and watch, how the banks set their rates when there is any change in the policy rates. Keep update on the banking news by subscribing to our free newsletter.
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