Base rate is the minimum interest rate below which banks can not lend, except in specific cases permitted by RBI ( like DRI loans, loans to bank's own employees, loans against deposits). As per RBI guidelines, each bank has to calculate its own base rate and review it on a quarterly basis. Banks are also required to disclose their base rates to the public at large through their websites.
Base rate was brought in as an improvement over the Benchmark Prime Lending Rate (BPLR) system as it indicates the total cost to banks, which the banks have to cover as a part of their lending operations. In simple terms, under the base rate system, the final interest rate of a loan would be calculated as the base rate plus the risk cost associated to the loan. The risk cost forms the part of spread and depends on the credit rating of the borrower.
Base Rate vs. BPLR
At the time when it was introduced, base rate promised to bring heightened transparency into the lending mechanism followed by banks. Though, many were skeptical about the fact whether banks would actually disclose their procedures of arriving at their respective base rates, it was pitched to be better than the BPLR mechanism followed by banks at the time.
Customers were said to be dissatisfied with BPLR as they felt that banks were lending to powerful and strong corporates at sub BPLR rates. At times, there was a difference of 4% amongst the BPLR's of the various banks. Also, lack of transparency on how actually was the Prime Lending Rate (PLR) determined was cause for concern amongst customers.