Base Rate

Article byPrakhar Gajendrakar
Edited byCollins Enosh
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Base Rate?

The Base Rate is the minimum interest rate a commercial bank can offer a borrower. Commercial banks cannot offer loans below the base rate. This minimum limit was introduced in 2010. It replaced the benchmark prime lending rate (BPLR) system. The BPLR system was followed between 2003 and 2010.

Base Rate

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Every country has a regulatory authority known as the central bank. The central bank regulates commercial banks, financial institutions, and monetary policies. For example, thee central bank uses the minimum interest rate on loans to control the economy. To tackle inflation, central banks raise the minimum limit that is commercial banks are forced to charge higher interest rates from borrowers.

Key Takeaways

  • The base rate is the minimum interest rate charged by commercial banks when it lends to individuals and businesses. The central bank regulates this minimum limit.
  • It is calculated based on the average cost of funds and altered every quarter.
  • The minimum interest rate depends on two essential factors—the repo rate and the reverse repo rate.
  • In 2016, this system was replaced by the Marginal Cost of Funds Based Landing Rate (MCLR). The MCLR is calculated based on the marginal cost of funds.

Base Rate Explained

The base rate is set by the central bank of the particular country. Central banks do not allow commercial banks to lend money below the base rate. In July 2010, the base rate replaced the BPLR system—benchmark prime lending rate—BPLR was introduced in 2003.

In the BPLR system, central banks instructed commercial banks to form a committee and determine the lowest interest rate they would offer their most creditworthy customer. This agreed-upon minimum interest rate was fixed as the benchmark prime lending rate. In theory, commercial banks were not allowed to lend money below the BPLR.

Practically though, more than two-thirds of loans offered sub-BPLR rates to their borrowers. Due to the loophole,e a new minimum interest rate system was introduced.

Clearly, the one size fits all approach did not work. From 2010 onwards, commercial banks were allowed to set their minimum interest rates. Central banks serve as regulatory authorities to oversee banks and financial institutions. Central banks ensure foreign reserves, design monetary policies, amend fiscal policies, monitor the GDP, and ensure adequate liquidity. In addition, central banks regulate the minimum interest rate for commercial banks.

Central banks lend short-term credit to commercial banks in exchange for collateral. Its purpose is to deal with the shortage of funds faced by commercial banks in the financial market. In lieu, central banks charge an interest rate known as the repo rate.

An increase in the repo rate triggers an increase in lending rates. In turn, the money supply is reduced, and inflation is controlled.

When commercial banks lend money to the central bank, they charge a particular interest rate the reverse repo rate. Commercial banks lower the minimum interest rates on loans when reverse repo rates decrease.

Further, when lending rates are reduced, it increases credit growth in the economy. As a result, more money flows into the market. This triggers an increase in economic activity—new industries emerge—healthy competition is witnessed in the market.

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Video Explanation of Base Rate Fallacy

 

How To Calculate Base Rate?

To calculate base rates, we consider four critical factors:

  • Cost of funds
  • Operating costs
  • The minimum marginal return rate
  • CRR (cash reserve ratio) – the fraction percentage of total deposits a commercial bank safe keeps with the central bank in the form of liquid cash that they cannot use for investing or lending purposes.

Based on these factors, the base rate formula is expressed as follows:

Base Rate Percentage = Cost of Funds Incurred by Banks + Minimum Rate of Return
+ Operating cost + Cash Reserve Ratio (CRR)

Example

Let us look at a base rate example to understand the limit better.

On 22 September 2022, The Bank of England Monetary Policy Committee increased the minimum interest rate from 1.75% to 2.25%. In addition, it will increase the HRMC interest rates for repayment and late payments.

The loan interest changes will be applicable from 3 October 2022. Commercial banks and financial institutions treat the Bank of England’s minimum interest rate as the benchmark in England.

In September 2022, The Magyar Nemzeti Bank (central bank of Hungary) raised the minimum interest rate and the overnight deposit rate by 100 points each—it increased to 11.75% and 11.25%, respectively.

In 2022, The Magyar Nemzeti Bank will be the first EU central bank to increase loan interest rates—it has hiked minimum interest rates by more than 1000 points since 2021. The Hungarian central bank took this action to counter excessive inflation—of 13.7%. It has become a concern for Hungary.

Base Rate v.s MCLR

Let us look at base rate vs MCLR comparisons to distinguish between the terms.

  • The base rate is calculated based on the average cost of funds, whereas the MCLR (Marginal Cost of Funds Based Landing Rate) is calculated based on the marginal cost of funds.
  • The former was introduced in June 201,0 and the latter in April 2016. Both terms refer to minimum interest rates—commercial banks cannot offer loans below this rate.
  • The former is altered every quarter, whereas the latter is changed every other month.
  • The former failed to achieve transparency and hence was replaced by the latter.
  • Despite policy cuts, the base rate could not reduce the cost of funds. In contrast, MCLRis an internal benchmark linked to tenors.
  • MCLR is more reliable than the base rate.

Frequently Asked Questions (FAQs)

What is the base rate of The Bank of England?

The current minimum interest rate on loans set by The Bank of England is 2.25%. Commercial banks treat this as a benchmark. The minimum interest on loans is monitored closely since it impacts the economy directly.

Who decides base rates in banking?

Every country has a central bank; the central bank regulates markets, banking, and lending. The central bank controls the minimum interest rate set by commercial banks and financial institutions. For example, The Bank of England monitors interest rates in the UK, and the Reserve Bank of India (RBI) regulates lending in India.

What is the base rate fallacy?

It refers to scenarios where individuals misjudge an event by focusing on specific information and ignoring other data. The concept explains how people arrive at certain conclusions. It is a flawed decision-making approach commonly witnessed in business, finance, law, and medical research.

This article has been a guide to what is Base Rate and its meaning. Here, we explain its calculation along with example & compare it with MCLR. You can learn more about it from the following articles –

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