Banking News

How banks determine ‘Base Rate’ and ‘Spread’ in respect of interest on advances?


The interest rate on advance levied by banks comprises ‘Base Rate’ of the respective bank and ‘Spread’ over the base rate decided by the banks Board. Though ‘Base Rate’ is constant for computation of interest on all advances, the ‘Spread’ over base rate varies on each category of advances depending upon tenure of loan, risk profile attached to type of advance.

The minimum rate of interest charged by commercial Banks in India on their advances cannot be less than their base rate. This condition of minimum rate of interest is not applicable on following type of loans.

  1. DIR loans where all the banks uniformly charge at 4%p.a, keeping in view of social objective.
  2. In case of advance made against customer’s own deposit in the same bank.
  3. Loans and advances made under ‘Interest Subvention Scheme’ where the banks claim the subsidy from the Government.

Meaning of base rate:

The base rate is designed to price bank loans on the actual cost of funds worked out by individual bank. The Base Rates are reviewed by individual banks their base rate based on cost of funds at least once in a quarter. The change in Base Rate whenever felt necessary, the bank will implement the same with the approval of the Board or the Asset Liability Management Committee (ALCO) as per the bank’s practice.

Methodology of Base Rate calculation:

Banks have the freedom to decide a methodology to calculate their base rate provided it should be reasonable, transparent and consistent. It may be on the basis of average cost of funds or on marginal cost of funds or any other methodology in vogue. With regards to base rate arrived on the basis of card rate of deposits, RBI has clarified that where the card rate for deposits of one or more tenor is the basis, the deposits in the chosen tenor/s should have the largest share in the deposit base of the bank.

Time limit for changing methodology of Base Rate calculation:

Banks were currently allowed to change their Base Rate methodology after five years from the date of its finalization.  As per new guidelines, the periodicity of five years is now reduced to three years. However, banks are not allowed to change their methodology of Base Rate calculation during the review cycle.

Determination of ‘Spread’ charged to a customer:

Spread can be defined as the difference between base rate and the rate charged to the customer on loans and advances. In the other words it can be called as profit margin decided by the bank on specific type of advance based on loan pricing policy, credit risk and tenor of advance. The decision of increasing the spread on account of credit risk profile should be supported by full-fledged risk profile review of the borrower. The change in tenor premium should not be borrower specific. Every bank has the right to adopt its own policy on deciding components of spread. The range of spread decided on different categories of advances shall be approved by the Board of the bank. It is mandatory on the part of concerned bank to spell out the rationale for and range of the spread for various categories of borrowers. It is also mandatory on the part of the banks that the pricing policy should reveal the delegation power of powers in respect of loan pricing. The spread decided by the bank must be consistent with its internal pricing policy and same should be made available for supervisory review/scrutiny of RBI as and when required.

Based on the recommendations of Mr.Anand Sinha working group on ‘pricing of Credit’ RBI has revised guidelines on ‘Interest Rates on Advances’. The following additional guidelines of central bank on interest rate are expected to force commercial banks to pass on repo-rate cut benefit to the borrowers.

  1. The spread charged to an existing borrower should not be increased except on account of deterioration in the credit risk profile of the customers or change in the tenor premium.
  2. The decision of increasing the spread on account of credit risk profile should be supported by a full-fledged risk profile review of the borrower.
  3. The change in tenor premium should not be borrower specific or loan class specific. In the other words, the change in tenor premium will be uniform for all types of loans for given residual tenor.
  4. The spread norm iii is not applicable for consortium advances where in participant banks need to maintain uniform rate in line with other lenders of consortium advances.

The above norms under additional guidelines on interest rate on advance are effective from one month after RBI Circular dated 19.01.2015

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