Photo: Pradeep Gaur/Mint
Photo: Pradeep Gaur/Mint

Use marginal cost to calculate base rate: RBI to banks

RBI, in its first bi-monthly monetary policy, had suggested that banks should move to 'marginal cost of funds' benchmark in a time-bound manner

Mumbai: The Reserve Bank of India (RBI) on Tuesday proposed that to calculate the minimum lending rate, or base rate, all banks should move to marginal cost of funds based calculation instead of the present practice of picking any kind of cost of funds as a reference.

To force banks to pass on the policy transmission effectively, RBI, in its first bi-monthly monetary policy on 7 April, had suggested that banks should move to ‘marginal cost of funds’ benchmark in a time-bound manner.

Marginal cost of funds is calculated using the latest interest rate/card rate payable on current and savings deposits and the term deposits of various maturities.

The other components that go into calculating base rate remained the same as it was previously. Banks will continue to factor negative carry on mandatory cash deposit with RBI and bond investment—cash reserve ratio and statutory liquidity ratio respectively, un-allocable overhead costs and average return on networth.

Base rate system was introduced in 1 July 2010 so that banks cannot lend below a certain benchmark and also to ensure that policy transmission takes place more effectively.

However, policy transmission could not become very effective as banks adopted various methods in calculating their cost of funds. For example, any change in policy rates does not get absorbed easily in the longer tenure of deposits and hence when a bank uses average cost of funds to calculate its base rate, the impact is minuscule. Besides, the longer tenure deposits do not come up for re-pricing immediately and hence the cost of deposits for banks theoretically remain at an elevated level.

That explains why banks did not hurry to cut their rates despite RBI bringing down policy rates by 75 basis points since January.

On Monday, HDFC Bank Ltd cut its base rate by 35 basis points to 9.35%. One basis point is a hundredth of a percentage point.