MCLR - Marginal Cost of Funds based Lending Rate

The Reserve Bank of India keeps introducing new method for commercial banks to zero-in on lending rates in the fiscal year. Marginal Costs of Funds based Lending Rates (MCLR) will be applicable from April 2016 completely changing the lending rates system as followed by all banks across the country. This rate will be subject to change on monthly basis, to take into account the risk associated with all types of customers depending on factors such as repo rates and other borrowing rates.

Repo rate factors were not utilised in the earlier base lending rate method. RBI expects banks to fix five benchmark rates for different loan tenures; these may vary from one to one year.

How Does MCLR Work?

MCLR is not a hard concept to master. This new method is based on the 'marginal cost' or the formula banks uses to create its base lending rate and the interest rate while borrowing money from deposits and/or the RBI. MCLR takes these two factors into account:

• Repo rates that banks provide to get funds from the RBI is used as primary factor for its calculation, and
• Interest rates offered by banks on deposits.

Generally, changes with high impact are made to regulate vast, slow reacting target system. The slow reacting systems are the collective network of various private and public sector banks in India. Banks are usually hesitant to update their i-base lending rate and interest rates on deposits corresponding to the changing repo rate on regular basis.

Reason being that banks use the liquidity adjustment facility (LAF) of RBI in order to source their short-term funds from the apex bank. This saves them from changing their lending and deposit rates periodically. RBI hopes that MCLR will help put a faster feedback oriented method in place which will overcome disadvantages of the current base rate method.

Impact of MCLR on Banks

With this new method of MCLR, banks will now be forced to use the current base lending rate while calculating their MCLR. Earlier base rate system did not obligate banks to implement RBI's rate cuts immediately or in an equivalent quantum. With MCLR, the banks will be forced to realign their interest rates on monthly basis. Banks can subscribe to the latest repo rates and implement the same to keep up with the RBI's updated rates.

In a growing economy like ours, cut in lending rates made by RBI must reach the common man at the earliest, as these cuts would encourage public to subscribe to loans and invest in various investment options. This is possible only when banks will implement cut rates as quickly as possible in a uniform and responsible way. MCLR has been introduced to encourage banks to adopt the latest repo rates as promoted by the RBI.

Differences between Base Rate System and MCLR:

The basic different between both are the factors used to calculate them. Below are factors used in calculating both Base Rate and MCLR:

• Base lending Rate is calculated based on the interest rate offered on deposits whereas MCLR is calculated on the basis of marginal cost of funds.
• Both are bank's operating costs.
• Base lending rate yields profits to banks in terms of minimum rate of return and MCLR yields profit in terms of Tenor Premium.
• n Base rate method the cost incurred to maintain Cash Reserve Ratio (CRR) is specified minimum fraction of overall deposits held by customer in any private/public sector Indian Bank. The bank deposits CRR with RBI in form of cash or deposits.

  In MCLR method RBI does not offer interest to banks for holding the CRR. The banks can negate the effects of such non-performing assets and cover the cost by charging the same from loans offered to the prospective customers. These will make contributions to MCLR.

Following are some point for clarification:

Marginal Cost of Fund - This includes the following component:

• Return on the net worth after a particular deposit has matured, and
• Marginal cost of borrowing funds from deposits or RBI.

According to RBI rules the banks must consider the following factors while deciding the Marginal cost of funds,

• Short term interest rate, repro rate, borrowing rate for longer terms etc.,
• Costs must be in line with set norms and return on net worth.
• Interest rates applicable for different type of deposits including term, current, savings banks and deposits in foreign currency.

It is to be noted that while calculating marginal costs of funds, the marginal costs associated with borrowing should be 92% and return on net worth should be 8%.

Bank's Operational Costs - Costs incurred by banks for its everyday operations.

Tenor Premium - Denotes the idea that long term loans can yield higher rate of interest.

How to Calculate MCLR?

It depends on four major factors:

• Operational costs of banks
• Marginal Costs of funds
• Costs incurred for CRR with RBI
• Higher rate of interest charged from long term loans by way of Tenor Premium.

MCLR ensures that the lending rates are revised based on the prevailing repo rate, tenor premium and the marginal costs of funds incurred by bank. As a result lending rates may change frequently than earlier. These rates are reviewed and revised every month but they are fixed for at least 1 year for long-term loans.