Marginal Cost of Funds based Lending Rate

For banks, the Reserve Bank of India (RBI)  establishes a fixed internal reference rate. This interest rate is then utilized by RBI-regulated banks and lending institutions to determine the minimum interest rate for various loan categories. The RBI updates this rate on a regular basis when there is a significant change in the country's economic activities. Banks are normally prohibited from lending money at a rate lower than the MCLR, or marginal cost of capital.

What exactly is MCLR?

The MCLR (Marginal Cost of Funds based Lending Rate)  is the lowest lending rate at which a bank is not allowed to lend. The MCLR system superseded the previous base rate mechanism in determining commercial bank lending rates. Every month, banks must examine and disclose their MCLRs for various maturities  — overnight, one month, three months, six months, and one year. Loans are measured against a specific MCLR. Home loans, for example, are frequently benchmarked on the one-year MCLR. On April 1, 2016, the RBI implemented the MCLR to set lending interest rates. It's an internal reference rate that banks use to figure out how much interest they can charge on loans. They do this by factoring in the additional or incremental cost of securing an extra rupee for a potential buyer.

The MCLR Implementation's Outcome

• Following the installation of MCLR, interest rates are calculated based on each customer's relative risk factor. When the RBI cut the repo rate in the past, banks took a long time to reflect the change in lending rates for borrowers.
• Banks must modify their interest rates as soon as the repo rate changes under the MCLR regime. The implementation intends to increase the transparency of the system used by banks to calculate advance interest rates.
• It also assures that bank credits will be available at a rate that is fair to both the consumers and the bank.

What is the rationale for the reform?

With repeated changes in the repo rate, commercial banks were hesitant to change their individual lending and deposit rates. That is, there was a large lag between the adjustment in the repo rate by the RBI and the transmission of that change to the banks' borrowers. Only if the banks replicate the move with their own lending and deposit rates does the goal of changing the repo become a reality. As a result, RBI's adoption of the MCLR regime intends to bring much-needed transparency to financial institutions' interest rate determination.

How do you determine the MCLR?

The loan duration, or the period of time a borrower has to repay the loan, is used to compute the MCLR. Internally, this tenor-linked benchmark is used. By adding the factors spread to this instrument, the bank determines the actual loan rates. The MCLR (Marginal Cost of Funds based Lending Rate) helps banks better transmit policy rates into lending rates. These reforms are designed to increase openness in banks' methods for establishing advance interest rates. After that, the banks disclose their MCLR after a thorough examination. The same procedure applies to loans with varying maturities – monthly or on a pre-determined schedule.   The following are the four major components of MCLR:

• Premium for tenors

The cost of borrowing varies depending on the length of the loan. The danger increases as the loan term lengthens. To compensate for the risk, the bank will shift the burden to the borrowers by charging a premium. The Tenure Premium is the name for this premium.

• The fund's marginal cost of capital

The average rate at which deposits with similar maturities were raised during a particular time before to the review date is known as the marginal cost of funds. This expense will be reflected in the bank's books as a balance due.

• The Return on Net Worth and the Marginal Cost of Borrowings are two components of the marginal cost of financing. The Marginal Cost of Borrowings accounts for 92% of the total, while the Return on Net Worth accounts for 8%. This 8% is similar to the risk of weighted assets, as measured by bank Tier I capital.
• Operating Costs Operating those include the cost of collecting cash, with the exception of costs recovered independently through service charges. As a result, it is linked to the provision of the loan product in general.
• As a result of the CRR  , there is a negative carry.

When the return on the CRR balance is zero, negative carry on the CRR (Cash Reserve Ratio) occurs. When the actual return is less than the cost of the funds, negative carry occurs. This will have an impact on the necessary Statutory Liquidity Ratio Balance (SLR)  — a reserve that every commercial bank is required to keep. It is recorded as a loss because the bank is unable to produce any income or earn interest on the cash.

What is the difference between MCLR and Base Rate?

• The banks determine the MCLR based on the structure and methods used. To summarise, this adjustment will benefit borrowers. The modified base rate (MCLR) is a better version of the base rate.
• The final loan rate for borrowers is determined using a risk-based strategy. Instead of considering the overall cost of money, it incorporates unique factors such as the marginal cost of funds.
• The repo rate, which was not included in the base rate, is factored into the marginal cost. Banks are required to factor in all types of interest rates that they incur when mobilizing money when computing the MCLR.
• Previously, the loan tenure was not considered while setting the base rate. Banks are now obligated to include a tenor premium in MCLR calculations. Banks will be able to charge a higher interest rate on long-term loans as a result of this.

What are the deadlines for monthly MCLR disclosure?

Banks have the option of making all loan types available at fixed or fluctuating interest rates. Banks must also adhere to strict deadlines when disclosing the MCLR or internal benchmark. They could be one month, overnight MCLR, three months, one year, or any other maturity determined by the bank. For any loan maturity, the lending rate cannot be lower than the MCLR. Other loans, on the other hand, are not tied to the MCLR. These include loans secured by customers' deposits, loans to bank employees, government-sponsored special lending schemes (Jan Dhan Yojana  ), and fixed-rate loans with terms longer than three years.

Also, read Bank Guarantee: Uses, Eligibility & Process, Advantages Liquidity ratio: Meaning, calculation, and Benefits Money Market Instruments in India: An Overview