Reserve Bank of India (RBI) proposed the base rate system to replace the prime lending rate (PLR) for banks to bring about more transparency in the lending operations of the bank across the country. The base lending rate shows the actual cost to banks that has to be covered through lending.
RBI’s definition of base rate has 4 components
a) cost of deposits
b) negative carry on CRR and SLR
c) overheads cost and,
d) returns on net worth
When you take a home loan or car loan, there is an interest rate that you have to pay to the lender. The base rate is the minimum rate that a bank will lend money at. One could consider it as a floor below which RBI will not allow banks to lend.
Earlier, banks used to price the loans by a system called benchmark prime lending rate (BPLR). Each bank has its own BPLR methodology which made it difficult for borrowers to compare rates of loans across banks.
Base rates make it easier for to compare rates of interest across banks and to get a more transparent sense of how the interest rate is calculated.