What is MCLR? Read here all about Marginal Cost of funds based Lending Rate!

Dear Readers,

Today let's discuss about MCLR. The article is important for upcoming exams and will help you both in the Mains exam and during the Interviews.

What is Base Rate?

Before the execution of MCLR rate, there was the method to decide the interest rate for loans. This rate is called the Base Rate. Now, all loans (except few)are MCLR (Marginal Cost of Funds based Lending Rate) based. This method has replaced the base rate system.

Therefore, it is necessary for you to understand what is Base Rate System and why RBI moved to MCLR than this base rate system.

Base Rate – It is the lending rate of banks below which banks were not allowed to lend.

Let us assume, that the base rate of Bank of Baroda bank (BOB) is at 7%. Then the bank will never lend the money below 7%. The Bank adds spread rate along with the base rate and determines the interest on the loan to the customer. This spread is the rate of the interest which is over and above the base rate.

For e.g.– If the base rate of the Bank of Baroda bank (BOB) is 7% and spread rate is 0.25%, then you will get the interest on the loan at 7.25%. Thus, the interest rate on your loan is nothing but Base rate + Spread rate. The rate on the spread is based on things like – risk profile of the customer and the duration of the loan.

Why is MCLR needed?

When the RBI decreases the repo rate, it requires the banks to undergo the periodic changes in their lending rates and deposit rates as well. But banks used to respond very lately. Means, when RBI reduced the repo rate by 10% then banks never used to reduce it or they may reduce the lending rate after few months.

And when RBI increase the repo rate, bank react fastly and increase the lending rate of interest. However, they are slow in reacting or reducing the rate of interest on their loans when there is a decrease in interest rate by RBI.

Therefore, after reducing the interest rate by RBI, bank charges the higher rate of interest on loans to their customer.

Therefore, it became imminent to bring such reform where the change in the repo rate is reflected in the lending rates and deposit rates of the bank.

MCLR does so by a monetary transmission which necessitates the bank to consider the repo rate before calculating their MCLR. Monetary transmission leads to the effective passing of repo rate change into interest rate change by the banking system.

It aims to

To improve the transmission of policy rates into the lending rates of banks.
To bring transparency in the methodology followed by banks for determining interest rates on advances.
To ensure availability of bank credit at interest rates which are fair to borrowers as well as banks.
To enable banks to become more competitive and enhance their long-run value and contribution to economic growth.

MCLR - It is the minimum interest rate of a bank below which it cannot lend.

However, there are exceptions in which it is allowed by RBI and it includes personal loans, automobile loans and loans under government schemes. This method of fixing interest rates for advances was introduced by the RBI with effect from April 1, 2016, and serves as an internal benchmark or reference rate for the bank that will help in pricing all rupee loans sanctioned and credit limits.

On the basis of MCLR, the interest rate for different customers should be fixed in accordance with their riskiness. For example, If there is a high probability of risk involved like in long-term loans, then they would be charged with the higher interest rate. The base rate is now determined on the basis of the MCLR calculation.

The MCLR is revised monthly by considering factors such as the repo rate and other borrowing rates that were not considered under the base rate system.

The new methodology uses the marginal cost reflected in the interest rate provided by the banks for obtaining funds while setting their lending rate. This includes interest rates from both the deposits and while borrowing from RBI. Hence, the interest rate is given by a bank for deposits and the repo rate are the decisive factors in the MCLR calculation.

MCLR Calculation

In economics, marginal refers to the changed situation. In order to calculate MCLR banks need to consider the changed situations. There are different factors of MCLR, namely;

1. Negative carry on account of CRR: It is the cost that the banks bear while keeping reserves with the RBI. No interest is given by RBI on CRR held by banks and therefore the cost of such funds kept idle are met by interest charged on loans.

2. Operating cost: It includes operating expenses bear by the banks.

3. Tenor premium: It is the higher interest that can be charged on long-term loans.

4. Marginal Cost: The marginal cost is the most important component of MCLR. It comprises the Marginal cost of borrowings and returns on net worth. According to the RBI, the Marginal Cost should be charged on the basis of following factors:

The interest rate is given for various types of deposits such as savings, current, term deposit, foreign currency deposit etc.
Borrowings – Short-term interest rate (Repo rate)or Long term rupee borrowing rate.
Return on net worth – in accordance with capital adequacy norms.

In short, the MCLR is determined mainly by the marginal cost for funds primarily, the deposit rate and the repo rate. Any change accompanying the repo rate is reflected in marginal costs and hence the MCLR should also be changed.

According to the RBI guidelines, actual lending rates will be determined by adding the components of spread to the MCLR. Spread is the higher interest rate charged by banks depending upon the riskiness of the borrower.

According to the RBI guidelines, “Banks will review and publish their MCLR of different maturities every month on a pre-announced date.” Such periodic revisions will compel the banks to consider the change in repo rate if any made by the RBI during that month.

How is MCLR different from base rate?

Note: CRR costs and operating expenses are the common factors for both base rate and the MCLR. The factor minimum rate of return is explicitly excluded under MCLR.