Marginal Cost of Funds Based Lending Rate [MCLR]

On 1st April 2016, the Reserve Bank introduced the Marginal Cost of Funds Based Lending Rate [MCLR] to replace the base rate system, in force since 2010. The aim was to tackle the problems related to the base rate regime and ensure that banks provide floating rate loans at better prices to end consumers.

The commercial banks in India currently use the Marginal Cost of Funds Based Lending Rate [MCLR] as the lending rate for some of their loans. The rate is calculated and set by each bank individually.

What is Marginal Cost of Funds Based Lending Rate [MCLR]

Marginal Cost of Funds Based Lending Rate [MCLR] is the minimum rate of interest below which banks are not allowed to lend (except in certain exceptional cases). It can also be called the reference rate or internal benchmark for financial institutions.

Earlier, banks had no compulsion to lower their interest rate even after rate cuts by RBI. But, on the other hand, when policy rates were increased, financial institutions quickly increased their rates. The introduction of MCLR ensures that the benefits of revision of policy rates by RBI are promptly transferred to the borrower.

Another aim of introducing the Marginal Cost of Funds Based Lending Rate [MCLR] was to bring greater transparency to lending rate calculation. Before MCLR, banks would charge their customer a spread over their base rate. The spread was based on factors such as loan category, customer type, etc., whose calculation was not uniform and scientific.

For instance, certain financial institutions would charge their prime customers below the base rate while keeping the rate much higher for ordinary folks. With MCLR, the spread will be based on the risk and tenure of loans instead of an arbitrary figure.

How is Marginal Cost of Funds Based Lending Rate [MCLR] Calculated?

The following factors are taken into account for the calculation of the Marginal Cost of Funds Based Lending Rate [MCLR]:

• Marginal Cost of Funds

This is the cost banks bear to arrange the funds lent to the borrower. The marginal cost of the fund consists of two parts: the marginal cost of borrowing(92%) and the return on net worth (8%).

The marginal cost of borrowing is the average rate at which the bank raised deposits of similar maturity in the specified period. The net worth denotes the Tier 1 Capital of banks.

• Tenure Premium

Longer repayment tenure increases the risk for the bank. The bank passes on this risk to the consumer through tenure premium, which forms part of the MCLR calculation.

• Negative Carry on CRR

All banks are required to keep a portion of their funds with RBI in the form of a Cash Reserve Ratio (CRR). Banks earn no interest on this reserve. The negative earnings of banks on CRR are also factored in the calculation of the Marginal Cost of Funds Based Lending Rate [MCLR].

• Operating Cost

The costs and overheads incurred by banks to maintain their day-to-day operations form a part of the Marginal Cost of Funds Based Lending Rate [MCLR].

More efficient banks have lower operating costs, leading to lower Marginal Cost of Funds Based Lending Rate [MCLR] for their customers.

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How Does Repo Rate affect Marginal Cost of Funds Based Lending Rate [MCLR]?

RBIs repo rate affects the cost of borrowing for banks. In case of a hike in repo rate, banks will translate the same to their Marginal Cost of Funds Based Lending Rate [MCLR]. Hence customers will see a spike in their interest rates and EMIs. However, the hike will affect only loans borrowed at floating interest rates, not fixed rates.

Marginal Cost of Funds Based Lending Rate [MCLR] ensures that banks price their loans to borrowers fairly and are more transparent in their spread calculation. It clearly has many advantages over the base rate system.

FAQs on Marginal Cost of Funds Based Lending Rate [MCLR]

Q.1. What is the Marginal Cost of Funds Based Lending Rate [MCLR]?

Marginal Cost of Funds Based Lending Rate [MCLR] is the minimum rate of interest below which banks are not allowed to lend (except in certain exceptional cases). It can also be called the reference rate or internal benchmark for financial institutions.

Q.2. Why was the Marginal Cost of Funds Based Lending Rate [MCLR] introduced?

Marginal Cost of Funds Based Lending Rate [MCLR] was introduced to tackle the problems related to the base rate regime and ensure that banks provide floating rate loans at better prices to end consumers.

Q.3. What factors are taken into account in the calculation of the Marginal Cost of Funds Based Lending Rate [MCLR]?

The marginal cost of funds, tenure premium, negative carry-on CRR, and operating costs are considered in the calculation of the Marginal Cost of Funds Based Lending Rate [MCLR].

Q.4. What are the deadlines to disclose the Marginal Cost of Funds Based Lending Rate [MCLR] for banks?

Banks need to publish their Marginal Cost of Funds Based Lending Rate [MCLR] within predefined timelines. Also, they are to be revised each month to factor in the changes in repo rate and other factors.

Q.5. Which loans are not linked to Marginal Cost of Funds Based Lending Rate [MCLR]?

Loans to customers against their deposits, advances to the bank's employees, special loan schemes by the government, and fixed-rate loans with tenures above three years are some examples of loans not linked to the Marginal Cost of Funds Based Lending Rate [MCLR].