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Understanding base rate

The base rate or minimum lending rate was introduced by the RBI in 2010 after the erstwhile Benchmark Prime Lending Rate failed to respond to monetary policy changes.

The run-up to its implementation saw frenzied media speculation on its impact, especially on home loans for retail borrowers. However, before we discuss its effect on retail loans, it will be instructive to explore why the RBI introduced the base rate and how banks have worked out their individual rates. At the same time, it is necessary to clear some misconceptions in the public domain.

The base rate was designed to replace the flawed benchmark prime lending rate (BPLR), which was introduced in 2003 to price bank loans on the actual cost of funds. However, the BPLR was subverted, resulting in an opaque system. The bulk of wholesale credit (loans to corporate customers) was contracted at sub-BPL rates and it comprised nearly 70% of all bank credit. Under this system, banks were subsidising corporate loans by charging high interest rates from retail and small and medium enterprise customers. This system defeated the purpose of having a prime lending rate, or the rate that banks charge from its best customers. It also resulted in another problem: bank interest rates ceased to respond to monetary policy changes that the RBI introduced periodically. Subsequently, in October 2009, the central bank decided to move all banks to a new interest rate system, which would not only be transparent, but also transmit monetary policy signals to the economy. Six months later, in April 2010, after a series of circulars, discussion groups and a rigorous consultative process, the RBI announced its decision to implement the base rate from 1 July 2010. The banks are not allowed to lend below this rate. Analyst estimates suggest that banks could get about Rs 30,000-40,000 crore through the small savings route.