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.
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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 The MCLR system superseded the previous base rate mechanism in determining commercial bank lending rates.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.
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.
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:
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 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.
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.
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.
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