Marginal Cost of Funds based Lending Rate (MCLR) is the minimum interest rate, below which a bank is not permitted to lend, barring a few exceptional cases as permitted by the Reserve Bank of India (RBI).
This article covers the following:
1. How does MCLR work?
MCLR, or Marginal Cost of Funds based Lending Rate, replaced the existing base rate system with a new measure for determining the lending rates for commercial banks. It was implemented by the RBI on 1 April 2016, to determine the rates of interests for advances. It is an internal rate of reference for banks, to determine the minimum rates of interests for loans. For this, they take into account the additional or incremental cost of arranging additional rupee for a prospective buyer.
After implementation of MCLR, the interest rates will be determined according to MCLR as per the relative riskiness of different types of customers. Previously when the RBI reduced the repo rate, the banks took a long time to reflect it in the lending rates for the borrowers. Under the MCLR regime, banks are under an obligation to adjust their interest rates as soon as the repo rate changes.
2. How to calculate MCLR?
The calculation of MCLR is linked to the tenor or the amount of time that is left for the loan repayment. This tenor-linked benchmark is internal in nature. The determination of the actual lending rates is done by means of adding the elements spread to this tool. The banks then publish their MCLR after reviewing it. This review and publication take place for varying maturities, monthly or as per a pre-announced date. The four main elements of MCLR are made up of the following:
a. Tenor Premium
There is uniformity in the tenor period for all sorts of loans for the said residual tenor. This means that the tenor premium is not specific to a loan class or a borrower.
b. Marginal Cost of Funds
This concept is quite new in the MCLR method and is made up of components like the Return on Net Worth and the Marginal Cost of Borrowings. The weight of the Marginal Cost of Borrowings is 92 percent while the weight of Return on Net Worth in the Marginal Cost of Funds is 8 percent.
This 8% is equivalent to the risk of weighted assets as denoted by the Tier I capital for banks. The Marginal Cost of Borrowing is the average rate using which the deposits of maturities that are similar were raised during a specified time period prior to the date of review. It is weighed in the bank’s books by their outstanding balance.
c. Operating Cost
This is linked to providing the cost of raising the funds, barring the costs recovered separately by means of service charges. It is, therefore, connected to providing the loan product as such.
d. Negative carry on account of CRR
The need for negative carry on the CRR (Cash Reserve Ratio) takes place because of the return on the CRR balance is zero. In the scenario when the actual return is less than the cost of the funds, there arises the negative carry on mandatory Statutory Liquidity Ratio Balance.
3. How is MCLR different from Base Rate?
MCLR can be viewed as an improved version of plain vanilla base rate. It is a risk-based approach to determine the final lending rate for the borrowers. It takes into account unique factors which were previously not considered in base rate. Firstly, MCLR is calculated based on marginal cost of funds instead of the overall cost of funds. Such marginal costs take into account repo rate which did not form part of the base rate.
While calculating MCLR, banks need to incorporate all other kinds of interest rates which they incur while mobilizing the funds. Previously, the tenure of the loan was not given importance in order to determine the rate of interest. In case of MCLR, the banks should include a tenor premium which means charging a higher rate of interest for loans which have a long-term horizon.
4. What are the deadlines to disclose monthly MCLR?
Banks decide the actual lending rates on floating rate advances including the elements spread to the MCLR. Banks also have the liberty to make available all categories of advances on the fixed and the floating interest rates. Additionally, banks need to follow specific deadlines in order to disclose the MCLR or the internal benchmark as follows:
i. One Month
ii. Overnight MCLR
iii. For three months
iv. One Year
v. MCLR for a maturity as the bank deems fit
To link all loans to the benchmark, the lending cannot be below the MCLR for any maturity. Even the fixed rate loans of a duration of three are also priced with regards to this. Certain loans that are not linked to MCLR include advances made to bank’s depositors against their own deposit, advances that are made to the bank’s employees, Government of India formulated special loan schemes, some loans like the fixed rate loans of above three years tenor, etc.
