The Financial and Banking sector of any country plays a paramount role in the functioning of the economy through intermediation. This sector has undergone numerous reforms in the past few years. One of the outcomes of these reforms is that now banks are more liberalized and have the freedom to determine the interest rates on their own. Banks are allowed to determine the lending rates on loans and advances concerning the base rate. The Base Rate is one of the amendments to the lending rate introduced by the RBI. Let’s now discover what it is, the term associated with it, and the factors determining it.
What is Base Rate?
A Base rate is defined as the minimum interest rate set by the country’s central bank below which banks are not permitted to lend to their customers. This rate is usually taken as the standard interest rate by all the banks functioning in the country. Introduced in June 2010, the base rate is simply regarded as the standard lending rate offered by commercial banks.
Why is Base Rate System used?
In the earlier days, the ostensible problem with the credit market was the lack of transparency. There used to be some segments in the banking system that were hidden or kept unknown to the customers. Banks use to give no clear information on the interest rate charged for a loan. So, to bring transparency and awareness to the credit field and to ensure that banks pass the benefit of lower interest rates to borrowers, the RBI implemented the notion of Base Rate across all the banks.
Factors Determining the Base Rate
Base Rates must consider and include all the elements of lending rates which are across various categories of borrowers. It is practicable that the base rate may be different for different banks. The four significant components that typically decide or determine the base rate set by a particular bank include
- Cost of Funds i.e., interest rates provided by the banks on deposits
- Operating Costs
- The Minimum rate of Returns
- Cost of the Cash Reserve Ratio.
So, the base rate presented by one bank can be dissimilar to the rate of another bank owing to any one or more of the above-declared factors. The most prevalent factor is the difference in interest rates provided by the banks on deposits.
What is DRI Scheme?
DRI Scheme stands For Differential Rate of Interest Scheme. It was launched to provide credit access to the low-income group. It is better known as DIR Scheme. This scheme was set in motion from the year 1972. The loan scheme empowers or authorizes the banks to lend money to weaker and incapable sections of society at a concessional interest rate. In simpler terms, DRI Scheme was introduced to financially assist low-income groups. The loan scheme visualizes lending by banks to the incapable section of the society at a uniform concessional rate of interest. There is no requirement or obligation of collateral or third-party guarantee. The assets which are created or bought from the loan amount will be hypothecated to the banks.
Every bank must review its base rate quarterly. Since the primary intention of implementing the base rate is transparency in the prices of the lending product, every bank has to reveal its base rate details in all their branches and on their official websites too. DRI Scheme is enhancing the Financial Inclusion Goal of India. In April 2016, RBI introduced a new concept known as MCLR (Marginal Cost of Lending Rates) as a replacement for the Base Rate. So, the MCLR is the new internal benchmark that all institutions will follow.