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Computation of Base Rate based on Marginal Cost of Funds

CA Sumat Singhal 
on 31 March 2016

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The Reserve Bank vide its circular DBOD.No.Dir.BC88/13.03.0/2009-10 dated April 9, 2010 introduced the Base Rate system with effect from July 1, 2010, which replaced the Benchmark Prime Lending Rate (BPLR) system. The Base Rate includes all those elements of the lending rate that are common across all categories of borrowers. Banks are allowed to determine their actual lending rates on loans and advances with reference to the Base Rate and by including such other customer specific charges as considered appropriate. All categories of loans are required to be priced only with reference to the Base Rate. The Base Rate system is applicable for all news loans and for those old loans that come up for renewal. Since the Base Rate is the minimum rate for all loans, banks are not permitted to resort to any lending below the Base Rate.

At present, banks follow different methodologies for computing their Base Rate. While some use the average cost of funds method, some have adopted the marginal cost of funds while others use the blended cost of funds (liabilities) method. It was observed that Base Rates based on marginal cost of funds are more sensitive to changes in the policy rates

Revised Methodology

On the basis of supervisory findings and discussions with banks, the extant guidelines on computation of Base Rate as well as the methodology for determining lending rates have been reviewed. The banks will now be required to compute their Base Rate as under:

(a) Components of Base Rate

The components of Base Rate will include Cost of Funds, Negative Carry on CRR/SLR, Un-allocable overhead costs and Average return on Net worth which will be calculated as under:

(i) Cost of Funds

The marginal cost of funds should be used for computing the cost of funds. The marginal cost should be arrived at by taking into consideration all sources of fund other than equity. Cost of deposits should be calculated using the latest interest rate/card rate payable on current and savings deposits and the term deposits of various maturities. Cost of borrowings should be arrived at using the average rates at which funds were raised in the last one month preceding the date of review. Each of these rates should be weighted by the proportionate balance outstanding on the date of review.

Illustratively, marginal cost will be arrived at as under:

Sl

Source of funds (excluding equity)

Rates offered on the date of review/rates at which funds raised

Balance outstanding in the books of the bank on the date of review as a percentage of total funds (excluding equity)

Marginal cost
(1) x(2)

(1)

(2)

1

Deposits

a

Current Deposits

0.00

7%

0.00

b

Savings Deposits

4.00

21%

0.84

c

Term deposits

Upto one month

4.5

2%

0.09

One month to six months

7.00

10%

0.70

Six months to one year

7.5

26%

1.95

More than one year

8.0

22%

1.76

2

Borrowings

RBI

7.25

2%

0.15

Other banks and institutions

7.20

2%

0.14

Bonds and debentures

9.0

8%

0.72

Marginal cost of funds

6.35

(ii) Negative carry on CRR and SLR

Negative carry on the mandatory CRR arises because the return on CRR balances is nil. Negative carry on SLR balances may arise if the actual return thereon is less than the cost of funds.

Negative carry on the mandatory levels of CRR and SLR balances should be calculated using the following formula:

Where

Dcost = marginal cost of funds calculated at (a)(i) above.
SLR : mandatory level of Statutory Liquidity Ratio
Tr : 364 T-Bill Rate
CRR : mandatory level of Cash Reserve Ratio

(iii) Un-allocable overhead cost

The unallocable overhead costs should comprise solely of costs incurred for the bank as a whole and, hence, not allocable to any particular business activity/unit. These components would be fixed for 3 years, subject to review thereafter.

(iv) Average Return on net worth

Average return on net worth is the hurdle rate of return on equity determined by the Board or management of the bank. It is expected that the component representing ‘return on networth’ will remain fairly constant and any change would be made only in case of a major shift in the business strategy of the bank.

Taking all these components into account, banks will then publish an MCLR for overnight loans, one-month, three-months, six-months and one-year loans. This MCLR will act as the minimum or base lending rate for that tenor of loans irrespective of the borrower.

The final lending rate will be MCLR plus the spread that banks will charge for individual categories of borrowers.

In its circular, RBI said banks should specify the dates on which interest rates would be reset for borrowers. This reset must have at least once a year but can happen more frequently as well.

Fixed-rate loans granted by banks will also be exempt from MCLR. However, in case of hybrid loans where the interest rates are partly fixed and partly floating, interest rate on the floating portion should adhere to the MCLR guidelines.

Starting 1 April 2016, lenders will calculate their lending rates based on the marginal cost of funds, or the rate offered on new deposits. The new rules will likely to make loans cheaper for new borrowers. For existing borrowers, it may take as much as a year for the benefits to be transmitted.

While RBI has cut its benchmark rate by 125 basis points in 2015, lending rates have come down only by 60 basis points, RBI said in its December monetary policy review. One basis point is one-hundredth of a percentage point.

Reserve Bank of India (RBI) governor Raghuram Rajan has repeatedly emphasized the need for banks to pass on interest rate cuts, saying less than half had been passed on to consumers this year.

With the inclusion of shorter term MCLR rates, banks can compete with the commercial paper market as well.

The new rules will reduce the cost of borrowing for companies.

Time frame for implementation

a. In order to give sufficient time to all the banks to adopt the above as well as the spread guidelines contained in our circular dated January 19, 2015, the proposed effective date of these guidelines is April 1, 2016.

b. Banks should submit a road map clearly indicating the time frame for adopting the above to Department of Banking Supervision, Central Office within a period of two months from the date of the final circular.


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