RBI releases draft guidelines on interest rate methodology
Moneylife Digital Team 01 September 2015
The Reserve Bank has brought out draft guidelines for banks adopting marginal cost of funds methodology while calculating base rates, which it thinks are more sensitive to changes in policy rates
The Reserve Bank of India (RBI) on Tuesday, released draft guidelines on base rates for helping transmission of monetary policy rates to banks’ lending rates. The revised methodology in the draft guidelines consist components of base rate, spread, and actual lending rates on the loans determined by adding the components of spread to the base rate in all cases.
"It is expected that the guidelines would be helpful in the medium term goal of banks pricing their floating rate loans linked to an external benchmark. The components of base rate will include cost of funds, negative carry on cash reserve ratio (CRR)/statutory liquidity ratio (SLR), un-allocable overhead costs and average return on networth," RBI said in a release.
At present, banks are following different methodologies in computing their base rate – on the basis of average cost of funds, marginal cost of funds or blended cost of funds (liabilities). Base rates based on marginal cost of funds should be more sensitive to changes in the policy rates. In order to improve the efficiency of monetary policy transmission, the Reserve Bank said it will encourage banks to move in a time-bound manner to marginal-cost-of-funds-based determination of their base rate. 
Earlier in its first bi-monthly policy, the central bank had said that for monetary transmission to occur, lending rates have to be sensitive to the policy rate.
Based on supervisory findings and discussions with banks, the RBI has reviews its extant guidelines on computation of base rate as well as the methodology for determining lending rates. The banks will now be required to compute their base rare on revised methodology. 
a) Components of Base Rate
The components of base rate will include cost of funds, negative carry on CRR/SLR, un-allocable overhead costs and average return on networth which will be calculated as under:
(i) Cost of Funds
The marginal cost of funds should be used for computing the cost of funds. The marginal cost should be arrived at by taking into consideration all sources of fund other than equity. Cost of deposits should be calculated using the latest interest rate/card rate payable on current and savings deposits and the term deposits of various maturities. Cost of borrowings should be arrived at using the average rates at which funds were raised in the last one month preceding the date of review. Each of these rates should be weighted by the proportionate balance outstanding on the date of review.
ii) Negative carry on CRR and SLR
Negative carry on the mandatory CRR arises because the return on CRR balances is nil. Negative carry on SLR balances may arise if the actual return thereon is less than the cost of funds.
(iii) Unallocable overhead cost
The unallocable overhead costs should comprise solely of costs incurred for the bank as a whole and, hence, not allocable to any particular business activity/unit. These components would be fixed for 3 years, subject to review thereafter. 
(iv) Average Return on networth
Average return on net worth is the hurdle rate of return on equity determined by the Board or management of the bank. It is expected that the component representing ‘return on networth’ will remain fairly constant and any change would be made only in case of a major shift in the business strategy of the bank.
(b) Spread
RBI said, as per its circular issued on 19 January 2015, banks should delineate the components of spread with the approval of their Boards. For the sake of uniformity in these components, broad components of spread finalised by Indian Banks' Association (IBA) should be adopted by all banks.
(c) Interest Rates on Loans
The actual lending rates on the loans will be determined by adding the components of spread to the base rate in all cases, the central bank said.
(d) Time frame for implementation
RBI says the proposed effective date of these guidelines would be 1 April 2016. Banks should submit a road map clearly indicating the time frame for adopting the above to the Department of Banking Supervision within two months from the date of the final circular, RBI said.
Comments or feedback can be e-mailed or sent by post to the Chief General Manager, Directives Division, Department of Banking Regulation, Reserve Bank of India, Central Office, 13th Floor, Shahid Bhagat Singh Marg, Mumbai- 400 001 on or before 15 September 2015, the central bank said.
MG Warrier
8 years ago
It is time banks started taking note of realities concerning interest rates. There is a limit up to which the demand for 'rate cuts' by RBI can cover up the real culprit in the prvailing high interest rates on loans and relatively low deposit rates. The present draft guidelines released by RBI should be an eye opener for big banks and even IBA. The need for high margins is a function of high NPAs, inefficient fund management, sagging employee morale which affects incremental business(both deposit mobilisation and credit expansion). A regulatory or supervisory organisation will not be in a position to 'apply mind' for the institutions it regulates or supervises. It is in banks' interest not to allow things to go back to olden days when interest rates were regulated.
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