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The Reserve Bank of India (RBI) sets a fixed internal reference rate for banks. This interest rate is, then, used by banks and lending institutions that come under RBI to define the minimum interest rate applicable to different loan types.
This rate is updated by RBI every once in a while when there is a drastic change in the country’s economic activities. Banks are usually not allowed to lend money at a rate below this reference rate called the MCLR.
Know more about MCLR, its implementation, and how it is different from the base rate here.
Marginal Cost of Funds based Lending Rate (MCLR) is the minimum lending rate below which a bank is not permitted to lend. MCLR replaced the earlier base rate system to determine the lending rates for commercial banks.
RBI implemented MCLR on 1 April 2016 to determine rates of interests for loans. It is an internal reference rate for banks to determine the interest they can levy on loans. For this, they take into account the additional or incremental cost of arranging an additional rupee for a prospective buyer.
After the implementation of MCLR, the interest rates are determined as per the relative risk factor of individual customers. Previously, when RBI reduced the repo rate, banks took a long time to reflect it in the lending rates for the borrowers.
Under the MCLR regime, banks must adjust their interest rates as soon as the repo rate changes. The implementation aims at improving the openness in the structure followed by the banks to calculate the interest rate on advances.
It also ensures the prospect of bank credits at the interest that is true to the consumers as well as the banks.
MCLR is calculated based on the loan tenor, i.e., the amount of time a borrower has to repay the loan. This tenor-linked benchmark is internal in nature. The bank determines the actual lending rates by adding the elements spread to this tool.
The banks, then, publish their MCLR after careful inspection. The same process applies for loans of different maturities – monthly or as per a pre-announced cycle.
The four main elements of MCLR are made up of the following:
The cost of lending varies from the period of the loan. The higher the duration of the loan, the higher will be the risk. In order to cover the risk, the bank will shift the load to the borrowers by charging an amount in the form of a premium. This premium is known as the Tenure Premium.
The marginal cost of funds is the average rate at which the deposits with similar maturities were raised during a specific period before the review date. This cost will reflect in the bank’s books by their outstanding balance.
The marginal cost of funds has several components like the Return on Net Worth and the Marginal Cost of Borrowings. Marginal Cost of Borrowings takes up 92% while the Return on Net Worth accounts for 8%. This 8% is equivalent to the risk of weighted assets as denoted by the Tier I capital for banks.
Operational expenses include the cost of raising funds, barring the costs recovered separately through service charges. It is, therefore, connected to providing the loan product as such.
Negative carry on the CRR (Cash Reserve Ratio) takes place when the return on the CRR balance is zero. Negative carry arises when the actual return is less than the cost of the funds.
This will impact the mandatory Statutory Liquidity Ratio Balance (SLR) – reserve every commercial bank must maintain. It is accounted negatively as the bank cannot utilise the funds to earn any income nor gain interests.
MCLR is set by the banks on the basis of the structure and methodology followed. To summarise, borrowers can benefit from this change. MCLR is an improved version of the base rate.
It is a risk-based approach to determine the final lending rate for borrowers. It considers unique factors like the marginal cost of funds instead of the overall cost of funds.
The marginal cost takes into account the repo rate, which did not form part of the base rate. When calculating the MCLR, banks are required to incorporate all kinds of interest rates that they incur in mobilizing the funds.
Earlier, the loan tenure was not taken into account when determining the base rate. In the case of MCLR, the banks are now required to include a tenor premium. This will allow banks to charge a higher rate of interest for loans with long-term horizons.
Banks have the liberty to make available all loan categories under fixed or floating interest rates. Additionally, banks need to follow specific deadlines to disclose the MCLR or the internal benchmark. They could be one month, overnight MCLR, three months, one year or any other maturity as the bank deems fit.
The lending rate cannot be below the MCLR for any loan maturities. However, there are other loans that are not linked to MCLR. These include loans against customers’ deposit, loans to the bank’s employees, special loan schemes by the Government of India (Jan Dhan Yojana), fixed-rate loans with tenures above three years.