Reserve Bank of India – The New Base Rate Formula

Reserve Bank of India decided to awe the citizens of India by cutting rates by 50 basic points. And, the disclosure was followed by reduction of 40 bps by State Bank of India – the largest lender of money in the country. According to finance investment companies in Delhi, India the reserve bank of India Governor Mr. Raghu Ram Rajan  has cut the interest rates by 50 basis points (bps), to a 4 ½ year low of 6.75%.

In addition to this, Mr. Raghu Ram Rajan, the governor of Reserve Bank of India also unveiled that the Indian Central Bank is also working on a new base rate formula that can potentially have a much larger impact on the EMI payment schemes by the end of this December.

What is Base Rate:

Base rate is the minimum rate set by the Reserve Bank of India, below which banks are not allowed to lend to its customers. Deciding the base rate helps in boosting the transparency in the credit market and ensuring that banks pass on the lower cost of fund to their customers.

Although the news is in the air that the new base rate is going to get finalized by the end of this year, how it’s going to benefit the common man is yet not clear. In order to understand the benefits of the new base rate thing you need to understand first how base rate is calculated by the banks and what the change would exactly mean in terms of operations.

How it Works:

Generally there are two prime methods for calculating the base rate. While some uses the average cost of funds method, other banks uses the marginal cost of funds methods, and yet another group uses the blended cost of funds or liabilities method.

Earlier in September this year RBI insisted banks to adopt the marginal cost of funding method while calculating base rates so that it gives uniformity and a better transmission of rate cuts to prospective borrowers.

 In other words RBI wants the lenders to arrive at the cost of borrowing method by taking into account the average rates at which they have raised funds prior to the month of reviewing the rate cut. This method was to be taken in consideration in case of fixed deposits, current and savings account, and borrowing from RBI and other lenders including bonds.

Benefit of the Borrowers:

Earlier banks were concentrating more on their profit margins rather than passing the cut rates effectively. Hence, the main objective behind this norm is to discipline the banks and promote them to strictly following the monetary policies set by RBI.

Inference:

In a nutshell, the changes about to be rolled out by RBI will make everything very transparent. A reduction in rate cut is also set to happen and the borrowers are likely to reap the benefit of rate cuts as much as the banks their interest rates.