Base Rate

 

RBI is set to introduce a new formula for calculating the base rate. Here's what it means for borrowers

 

Diwali seems to have come early for borrowers with the RBI cutting rates by 50 basis points and the country's largest lender, the State Bank of India, reciprocating with a 40 bps reduction in its base rate.However, the RBI has also announced another `gift' that could make a bigger impact on your EMIs.

 

By end November, the central bank will finalise its draft guidelines on the new methodology for computing base rates. All lending rates are pegged to the base rate, the floor below which banks cannot lend. Earlier this month, it had circulated a proposal to link computation of base rate with banks' marginal cost of funding (see table). Once RBI's proposal is finalised, there will be uniformity and better transmission of rate cuts to borrowers.

The banking regulator has pitched for a base rate formula linked to marginal cost of funds, stating that it would be more sensitive to changes in policy rates. It is likely to come into force from April next year. Currently , banks compute their base rate on the basis of average cost of funds, marginal cost of funds or blended cost of funds (liabilities). The proposed methodology would ensure that any future repo rate cuts would be effectively passed on to customers

Advantage borrowers

The new formula, coupled with the recent rate cut, will leave more money in borrowers' wallet. The base rates of banks could soften a tad and this could reduce the lag between changes in the deposit rates and lending rates resulting in the higher benefits for the borrowers.

However, given that regulatory interventions, including introduction of the current base rate system, by the RBI to ensure effective transmission have not met with great success in the past, concerns around the latest move are bound to arise. But industrywatchers are more confident about the new methodology's effectiveness, as it will be directly linked to the interest paid by banks on various deposits. The anomaly in the existing base rate computation method will reduce considerably if not eradicated completely . Under the new system we will see frequent rate resets by banks

 

While it is likely that rates will trend down ward once the new formula comes into force, it can cut both ways. You will have to brace yourself for any prompt uptick in interest rates too when policy rates are hiked in future. Also, the greater transparency does not necessarily mean borrowers will have a complete idea of the formula workings and rationale behind changes. The consumers may still not be able to (independently) compute the base rate. However, since the proposed formulae will be uniformly adopted by all banks and will be more sensitive to policy measures, it is expected to bring in the desired result of the central banks' policy measures being transmitted to borrowers.

NEW BASE RATE DECODED

How is the base rate calculated now?

Banks follow varying methodologies. Some use the average cost of funds method, some have adopted the marginal cost of funds way while others use the blended cost of funds method.

How will it be done after April?

The RBI wants adoption of the marginal cost of funds methodology. Cost of funds is the pivotal factor influencing the base rate. The banking regulator has proposed that banks should arrive at cost of borrowing by factoring in average rates at which they raised funds in the past one month prior to the date of reviewing the base rate. Marginal cost of funds will consist of current and savings deposits, FDs , borrowings from RBI and other institutions and bonds.

How will borrowers benefit?

The RBI believes base rates linked to marginal cost of funding will be more transparent and ensure effective transmission of policy measures to borrowers. Interest rate resets could become more frequent. At present, banks often do not pass on benefits of the central bank's rate cuts to the borrowers. CRISIL says the new methodology could reduce the current level of base rates by around 50 bps.

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