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New base rate formula to ease our interest burden

While writing about the RBI rate cut bonanza last week, I had mentioned that slashing the interest rates by 0.50% is not the end of the story.

More rate reductions could be forthcoming, due to other policy announcements... one being the revised methodology for the Base Rate calculation.

As you know, the interest that we pay on our loans from the banks, is linked to their Base Interest Rates.

Each bank fixes its Base Rate based on its cost of funds. However,
a) at present, different banks follow different formulas to calculate their Base Rate;
b) but more importantly, the drop in policy interest rates is not passed on, "commensurately and concurrently" to the borrowers.

For example, in 2015, RBI has slashed the policy interest rates by a total of 1.25%. But, the average reduction in Base Rates / lending rates has been around 0.60-0.70% only.

On the other, banks have been quite proactive in reducing the deposit rates by 1.10-1.30%.

Clearly, banks are taking undue advantage in not passing on the benefit of rate cuts to its helpless borrowers.

Thankfully, RBI Governor Dr. Raghuram Rajan is well aware of this and is batting for us. He wants the transmission of the monetary policy to happen more efficiently and expeditiously.

One of the measures, in this regards, is the Base Rate Computation. RBI is working towards a more effective and transparent formula to compute the Base Rate; which all banks would have to commonly adopt and follow.

In fact, in a few years time, RBI wants that the floating rate loan interest rates to be linked to an external benchmark.

For the present, RBI has issued draft guidelines on "Base Rate for transmission of monetary policy rates to banks' lending rates". These are proposed to be finalized by end-Nov 2015.

Some important aspects of these Draft Base Rate Guidelines are presented below for your knowledge and information.

Components of Base Rate
Base Rate will comprise four components.

(a) Cost of funds
At present, banks follow different methodologies such as the average cost of funds, marginal cost of funds or blended cost of funds. Base Rates, based on marginal cost of funds, are expected to be most sensitive to the changes in the policy interest rates. As such, all banks will be asked to apply marginal cost method to calculate their cost of funds for the Base Rate purposes.

Example of Marginal Cost of Funds to be applied in Base Rate computation

(b) Negative carry on CRR and SLR
CRR and SLR are the portion of deposits that banks have to compulosrily keep with RBI or invest in Govt. Securities. RBI does not pay any interest on the CRR balances. And, the returns on SLR balances may sometimes be lower than the actual cost of funds. Thus, banks incur a loss on these RBI-mandated CRR and SLR deposits. (This, by the way, is for the safety of our money deposited with the banks.)

(c) Unallocable overheads
Costs that are incurred, for the bank as a whole, would be the unallocable overheads. These should be fixed for 3 years and reviewed thereafter.

(d) Average return on net worth
This is the average rate of return on equity, as determined by the management of the bank. It is expected to remain fairly constant, unless there is a major change in the bank's business strategy.

Banks should clearly specify the components of the spread, they would like on apply, on the above marginal-cost-based Base Rate.

Lending Rates
In all cases, the interest rates on loans would be calculated by adding the components of the spread to the Base Rate.

Effective Date
April 1, 2016 has been proposed as the effective date, for banks to adopt the new Base Rate Formula guidelines.

Concluding, next financial year onward, we hope and pray for
1. More policy interest rate cuts by the RBI and
2. Quick and Comparable reduction in the Base Rates / Lending Rates by the banks.

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