Why the reform?
Commercial banks were reluctant to change their individual lending rates and deposit rates with periodic changes in repo rate. Which means, there was a significant delay between RBI’s repo rate change and the transmission of that change to the borrowers of the banks. The purpose of altering the repo is realized only if the banks are replicating the action with their individual lending and deposit rates. Thus, in adopting the MCLR regime, RBI aims to
- Bring the much-needed transparency in financial institutions while determining their interest rates
- Pass the benefits of reduced interest rates to customers ASAP
- Ensure availability of loans to customers that is fair to both, customers as well as the lender
- Understanding MCLR: MCLR is the minimum interest rate that a bank can lend at. Under the MCLR regime, banks are free to offer all categories of loans on fixed or floating interest rates. The actual lending rates for loans of different categories and tenors are determined by adding the components of spread to MCLR. Therefore, the bank cannot lend at a rate lower than MCLR of a particular maturity for all loans linked to that benchmark. However, certain exceptions can be made when allowed by the RBI.
- Calculating MCLR: MCLR is a tenor-linked internal benchmark, which means the rate is determined internally by the bank depending on the period left for the repayment of a loan. The MCLR is based on a range of factors in order to broaden the use of this tool. The four major elements of MCLR include the following:
- Tenor premium: It is the premium charged by the banks for the risk associated with lending for higher tenors. Tenor is the amount of time left for repayment of the loan. Higher the duration of the loan, 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 premium. Tenor premium is not specific to a loan class or borrower, but is uniform across all types of loans.
- Marginal Cost of Funds: Marginal cost of funds (MCF) is calculated by taking into account all the borrowings of a bank. Banks borrow funds from various sources, including fixed deposits (FD), savings accounts, current accounts, equity (retained earnings), RBI loans, etc. The rates of interest on these borrowings is used for the calculation of MCF. MCF includes Marginal cost of borrowing and Return on net worth. 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.
- Negative Carry on CRR: CRR or Cash Reserve Ratio is a proportion of the bank's fund that banks in India are supposed to submit to the RBI in form of liquid cash, mandatorily. It is accounted for negatively as this money cannot be used by the bank to make any income and does not earn interest. Under MCLR, banks are given certain allowance for that, called Negative Carry on CRR, which is calculated as under:
- Operating cost: Banks incur various expenses for raising funds, opening branches, paying salaries and so on. All operating costs associated with providing loan products are included in operating costs. However, cost of providing services, which are recovered by way of service charges, are not included.
Though there are various differences between the two, given below are the major ones-
- Base rate was set by the RBI and MCLR is set by the banks themselves based on their business strategy. This means that borrowers can benefit for competitive interest rates and get loans at a cheaper rate.
- Base rate loans interest rate will be updated once in a quarter. However, MCLR loans interest rate will be published on monthly basis.
- 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 horizon. This is represented in the table below-
|Base Rate Calculation||MCLR Calculation|
|Cost of funds||Marginal cost of funds|
|Operating expenses||Operating expenses|
|Profit margin||Tenure premium|
|Cost of maintaining CRR||Cost of maintaining CRR|
- Cost of fund consideration for base rate loans calculation is not standard and banks consider the older cost on deposit to arrive at the cost of fund. However, in the case of MCLR loans, the cost of fund is the deposit rate applicable for that particular month.
- The loan pricing system is more transparent for MCLR than for base rate, because of the computing formula.
- MCLR 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. Hence, it is an improved version of the base rate.
Repo rate & MCLR based loans
Borrowers under the MCLR system benefit from a cut in the repo rate. But, the interest rates can increase if the RBI increases the repo rate. MCLR has an effect on loans which are borrowed at floating rates of interest only. Loans taken on fixed rates are unaffected by the change in MCLR. Borrowers who would like to switch to MCLR based loan should take into account the amount charged as fees by the bank for initiating the change. Few banks have waived off switch charges to benefit their customers, few others charge a fixed amount as conversion fees, while select banks compute the fees as a fixed percentage ranging from 0.5% to 2% of the loan sanction amount. Thus, when considering the cost of making the switch, these fees should be considered along with the related charges.