RBI has the responsibility of controlling the money supply, Inflation rate. They try to achieve this by using the open market operations (OMC). Several tools are available with them. For example, they have the power to change the repo rate, a lending rate to the commercial and PSU banks, upward or downward depending upon the economic reality. The other tool in their armor is to adjust the cash reserve ratio (CRR) and/or statutory liquidity ratio (SLR) to such appropriate levels to achieve the targeted economic growth rate with controlled inflation. When the money supply is tight, RBI decided to lower the CRR or SLR as the case may be. For example, by lowering the current CRR which is at 4% to 3%, the economy would receive Rs. 87000 crores of additional liquidity.
Prior to 2010, the concept of prime lending rate (PLR) was in vogue. Prime lending rate is the rate of lending to prime (low risk) customers. All other lending rates were correlated to the PLR prevailing in the bank at that time. For example, if PLR of a commercial bank was 9% a marginally higher risky customer was able to borrow at say PLR + 2% meaning 9% + 2% = 11%. In the past, banks often kept the PLR at an artificially higher level to make it expensive for risky borrowers and also lent money to their prime customers below their prime rate. Since PLR varied bank to bank, and the way it was administered gave concerns to the RBI that they decided to introduce the base rate system, sometime in 2011. To bring uniformity, RBI gave instructions to the banks to calculate their base lending rate using the following model.
Sum of (cost of average deposit + negative carryon cost of CRR + unallowable overhead cost + expected average return on net worth)
While the process itself is complicated, no bank so far has shown its calculation explicitly as to how they arrived at the base rate. The OMO seems to be not working properly due to lack of adequate information in deriving the base lending rate.
Thousands of customers who had borrowed housing and other loans on variable interest rate system have been badly affected several times due to the increase in interest rates in the last 2 to 3 years. While the existing borrowers are stuck with the loan with no guarantee in interest rates, the banks are attracting new customers with lower rates of interest.
As customers demand more and more transparency, sooner or later RBI will interfere with the banks in the way they implement their base lending policy.