Base Rate

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 1. Introduction and Purpose of the Base Rate

The primary objective of the Base Rate is to enhance transparency and competitiveness in the loan interest rate setting process.

As stated in the directive , the Nepal Rastra Bank Act, 2058 (2001) assigns the responsibility for maintaining price and financial sector stability to the NRB. Recognizing the impact of interest rate fluctuations on the stability of the financial sector and the broader economy, the NRB has prioritized financial sector stability.

The directive highlights that variations in interest rates directly impact the stability of the financial sector through cost and return mechanisms. Implementing a transparent process for setting loan interest rates for banks and financial institutions is expected to have a positive impact on their efficiency and competitiveness. This, in turn, is anticipated to strengthen the monetary policy transmission mechanism and improve the effectiveness of monetary policy.

Therefore, with the aim of encouraging banks and financial institutions to set loan interest rates competitively and transparently, the monetary policy for the fiscal year 2076/77 (2019/20) introduced the concept of the Base Rate.

2. Defining the Base Rate

When banks and financial institutions provide loans to their customers, they must determine the loan's interest rate. This rate can be fixed or variable. The Base Rate is defined as:

"the rate that includes the identifiable and uniformly applicable components of loan interest rate determination for borrowers who obtain loans from banks and financial institutions."

It is crucial to understand that the Base Rate is not the actual interest rate on a loan, but rather the basis for determining the interest rate.

3. Key Components of the Base Rate

The directive outlines the primary elements that constitute the Base Rate. The most important of these is the Cost of Fund. Other key components are:

  • Operating Cost: The cost incurred for the institution's operation.
  • Cost of Mandatory Cash Reserve Ratio (CRR): The cost incurred due to maintaining the mandatory cash reserve ratio at zero return.
  • Cost of Statutory Liquidity Ratio (SLR): The cost incurred while maintaining the statutory liquidity ratio, which yields a return lower than the cost of deposits.
  • General Return: The return that needs to be provided for the institution's investors' capital investment.

When setting the final loan interest rate, banks and financial institutions use the Base Rate as a reference rate. They then add premiums to this rate based on factors such as the customer's/sector's specific risk and the loan's tenor. The document suggests that regular calculation of the Base Rate, especially in situations of interest rate volatility, makes it easier to determine interest rates in line with market conditions.

4. Base Rate Calculation Methodology

 

Base Rate = Cost of Fund (%) + Cost of Mandatory Reserve (%) + Cost of Statutory Liquidity  (%) + Operating Cost (%) 


The calculation for each component is detailed as follows:

  • Cost of Fund (Cost of Fund %): Calculated as the weighted average interest rate of domestic deposits and loans/borrowings.

  • Cost of Fund % = Weighted Average Interest Rate of Domestic Deposits and Loans/Borrowings

  • Cost of Mandatory Reserve: Calculated using the following formula:

  • Cost of Mandatory Reserve % = (Average Balance of Mandatory Reserve x Cost of Fund %) / Average Balance of Lending Eligible Fund

  • Average Balance of Lending Eligible Fund = Average Balance of Domestic Deposits + Average Balance of Domestic Loans/Borrowings - Average Balance of Statutory Liquidity

  • Cost of Statutory Liquidity: Calculated using the following formula:

  • Cost of Statutory Liquidity % = (Net Statutory Liquidity Balance x (Cost of Fund % - Weighted Average Interest Rate of Government Securities)) / Average Balance of Lending Eligible Fund

  • Net Statutory Liquidity Balance = Average Balance of Statutory Liquidity - Average Balance of Mandatory Reserve

  • Operating Cost: Calculated using the following formula:

  • Operating Cost % = (Total Operating Expenses x 100) / Average Balance of Lending Eligible Fund

Explanation of Terms in Operating Cost Calculation:

For the purpose of this calculation, "Total Operating Expenses" refers to the institution's total operating expenses, excluding Finance Expenses under NFRS as per format 4.36 of the financial statement framework specified in NRB directive number 4, and Employee Bonus. Additionally, expenses directly related to deposit collection, such as insurance premiums and medical treatment expenses provided to depositors, are not to be included in Total Operating Expenses.

5. Additional Provisions Regarding Base Rate Calculation

The directive includes further stipulations for calculating the Base Rate:

  • The Base Rate calculation must be based on the financial statements and data from the previous period. Expenses of an annual nature, for which monthly data is not available, must be calculated proportionally.
  • When calculating the average balance of Statutory Liquidity and Mandatory Reserve, the minimum required amount mandated by the NRB directive must be used.
  • Total Operating Expenses, as specified by the NRB, based on the profit and loss statement in the financial statement, including employee expenses and other operating expenses, must be used.

Note:

  • Calculations are based on the previous period and annualized.
  • Under operating expenses, 15% of non-fund operating expenses are estimated, and it is assumed that this can be covered by non-fund income. - NRB Directive F. No. 15/1

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