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RBI proposes formula to calculate Base Rate

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With an attempt to bring about uniformity among banks for calculation of the base rate and for effective transmission of policy rates to the customers, RBI proposed a new formula for calculating the Bank Rate.

The Base Rate is the minimum interest rate of a Bank below which it cannot lend, except in cases allowed by RBI.

The Base Rates differ across banks and there is no uniformity in the calculation.

Methods of calculating the Base Rate

  • At present, banks are using various methodologies: marginal cost of funds method, average cost of funds method, blended cost of funds (liabilities) method etc.
  • RBI has suggested the banks to consider marginal cost of funds as a parameter to calculate the individual lending rates as the Base Rates based on marginal cost of funds are more sensitive to changes in the policy rates
  • 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

RBI will implement this proposal from April 1st 2016 and has asked the banks to submit road maps two months prior to the implementation of the proposals, indicating the time frame within which they will be adopting the framework.

Why are uniform base rates desirable?

It is important in order to improve the efficiency of monetary policy transmission.

What is monetary policy transmission?

RBI takes monetary policy decisions to stabilise the economy and keep the price levels within rational limits. But these decisions will be effective only if the entities such as banks, markets, financial institutions etc modify their working accordingly. This is a very simplistic explanation of monetary policy transmission, though the actual process is very complex, so much so that it is called a ‘black box’ among economists.