What is marginal cost of fund based lending rate (MCLR)?
On December 17th, 2015, the Reserve Bank of India has come up with a revised methodology for calculation of interest rates on advances. As opposed to the earlier regime of base rate, banks shall also now have to publish a marginal cost of fund based lending rate (MCLR) which shall be computed on the basis of marginal cost of fund of the bank, shall be subjected to more frequent revisions and shall be different for loans of different tenors. The brief highlights of the scheme, as per the RBI press release, have been quoted below:
- All rupee loans sanctioned and credit limits renewed w.e.f. April 1, 2016 will be priced with reference to theMarginal Cost of Funds based Lending Rate (MCLR) which will be the internal benchmark for such purposes.
- The MCLR will be a tenor linked internal benchmark.
- Actual lending rates will be determined by adding the components of spread to the MCLR.
- Banks will review and publish their MCLR of different maturities every month on a pre-announced date.
- Banks may specify interest reset dates on their floating rate loans. They will have the option to offer loans with reset dates linked either to the date of sanction of the loan/credit limits or to the date of review of MCLR.
- The periodicity of reset shall be one year or lower.
- The MCLR prevailing on the day the loan is sanctioned will be applicable till the next reset date, irrespective of the changes in the benchmark during the interim period.
- Existing loans and credit limits linked to the Base Rate may continue till repayment or renewal, as the case may be. Existing borrowers will also have the option to move to the Marginal Cost of Funds based Lending Rate (MCLR) linked loan at mutually acceptable terms.
- Banks will continue to review and publish Base Rate as hitherto.
What was the need for introducing the concept of MCLR?
In India, like most other nations, the monetary policy is set by the Reserve Bank of India (RBI), the central bank. RBI decides the policy rates which, to a large extent, determine the cost of funds for banks and thus the interest rates at which loans are available to corporate and individuals. When RBI reduces the repo rate, it reduces the cost at which banks can borrow from the RBI and hence, the cost of funds for banks. The banks are then expected to pass on the benefit of rate cut to the end consumers in the form of reduction in base rate (to which almost all variable rate loans are linked), thus reducing the interest rate for all borrowers in the economy.
However, in the real world, such rate cuts by RBI are not readily and fully transmitted by the banks to the customers. Banks, like all companies, operate with profit motives and try to protect their margin as long as they can. As a result, in an increasing interest rate scenario, banks are quick to increase their base rate in order to hold on to their margin; however, in a reducing interest rate scenario, banks are often reluctant in passing the benefit of lowered cost of funds to customers.
Reserve Bank of India has often harped on the need for increasing transparency in the way banks calculate their rate of interest as well as higher sensitivity of the rate of interest to the policy rate changes. After all, if any rate change by the RBI is not transmitted to the rate of interest available to the end customers, the effectiveness of changing policy rate as a monetary tool is greatly reduced.
In fact, the RBI had in 2010 introduced the concept of base rate as a way to increase transparency and sensitivity of bank’s pricing mechanism to the changes in RBI’s monetary policy. However, in the computation of base rate, the banks were offered significant freedom in deciding the way in which they could compute their own base rate. The only constraint, as per the RBI circular no. RBI/2014-15/65
DBOD.No.Dir.BC.13/13.03.00/2014-15, was that the lending rate should be transparent and consistent and should be open to scrutiny from the regulators.
This flexibility offered to lenders in the computation of base rates has, however, resulted in non-transmission of rate cuts by RBI to reduction in base rates. In fact, in 2015, the RBI has reduced repo rate by 125 bps; however, for most lenders, the base rate has reduced by only 50-75 bps. Even then, a lot of large banks, like State Bank of India and ICICI Bank, have increased the spread on base rate for various loan products and as a result, nullifying to an extent, the effect of increase in base rate on rate of interest for new customers. This is reflected in the following graph that shows how base rate of various banks have changed in 2015 vis-a-vis repo rate of RBI.
This is more apparent in the following graph that compares change in repo rate with change in base rates of major banks from the respective rates as on 01.01.2015.
The RBI has in the past identified three different methods by which most banks compute their base rate – the average cost of fund, marginal cost of fund and blended cost of fund. In subsequent communications, RBI has noted that arriving at base rate on the basis of marginal cost of fund is most sensitive to changes in policy rates. Marginal cost of fund takes into account the rate at which banks raise fresh funds from the market (in the form of current account, savings account, corporate and retail deposits, from the money market or from other banks and RBI) whereas average cost of fund takes into account the average rate at which banks have raised their entire outstanding liabilities. Thus, in a bank which has a large percentage of higher tenor older deposits, the average cost of fund would not be very sensitive to changes in policy rates. This was part of the reason why a large number of banks adopted the average cost of fund methodology, which did not change a lot along with changes in policy rates.
Accordingly, the RBI has decided to encourage the banks to move on to computation of base rates on the basis of marginal cost of fund method vide Monetary Policy Statement dated 07th April, 2015. Subsequently, RBI came up with draft guidelines dated September 01, 2015 and final guidelines on December 17, 2015. The revised base rate computed through this methodology shall be henceforth known as the Marginal Cost of fund linked Lending Rate (MCLR). However, the banks shall continue to separately publish their base rate as before.
Thus the main motives of RBI in adoption of the new methodology are the following:
- Increasing the transparency of the way in which banks compute their interest rates
- Improving the transmission of changes in RBI policy rates into lending rates charged by banks
How is MCLR different from Base Rate?
|The banks were given completely leeway in deciding on the methodology of computation of base rate, subject to certain restrictions, like ensuring transparency, consistency and being subject to scrutiny.||The methodology has been defined by RBI. The MCLR shall be computed on the basis on marginal cost of fund of the bank. The same shall be adjusted for negative carry on CRR (the bank does not earn any interest on CRR), operating costs, return on net worth and a tenor premium.|
|The banks had to issue only one base rate for all tenors.||The banks will now have to issue at least five different MCLR for different tenors i.e. overnight MCLR, one month MCLR, three month MCLR, six month MCLR and one year MCLR. They will also have the discretion to issue MCLR corresponding to higher tenors.|
|The base rate was subject to quarterly review||MCLR shall be reviewed monthly on a pre-announced date. Some banks which do not have adequate system to carry out monthly review have been permitted to carry out quarterly reviews till 31st March, 2017.|
|Floating rate interest rate was reset as and when base rate or the benchmark rate to which the interest rate was linked were reset||Banks will have the option to define the interest rate reset date. The interest rate reset date may either be linked to the date of sanction of the loan or the date of reset of MCLR. The periodicity of reset shall be one year or lower.|
Implication for Banks:
- This will result in increase in operational and regulatory costs. Banks will now have to continue with the base rates and also come up with calculation of five different MCLR on a monthly basis. As a result, banks will now have at least six different benchmark rates at any point of time, five of which will be subjected to frequent changes. For existing loans linked to base rate, the same may be linked to MCLR on the basis of terms acceptable to both customers and bank, which means a large portion of existing customers will continue to have loans linked to base rate. Further, the frequency of reset of MCLR loans will also be different for different customers.
- A large part of the asset portfolio of the bank will become more sensitive to the cost of fund of the bank. Compared to the previous regime, this will reduce margins of bank in the falling interest rate scenario as banks will no longer be able to hold on to their base rates for longer durations. However, banks may be able to reduce the price sensitivity of the portfolio by reducing the frequency of reset of floating rate loans.
- Impact will be gradual as existing loans shall continue to remain linked to base rate unless under terms mutually acceptable to both borrowers and lenders.
- For banks which are more reliant on longer term deposits as opposed to current and saving accounts (CASA), this will reduce their profit margin in case of falling interest rate scenario. This is because the cost of funds for legacy deposits will continue to remain high whereas the banks will have to reduce the price for their loan portfolio. The reverse effect will be seen in case of an increasing interest rate scenario.
- Asset liability management shall become more crucial for banks.
Implication for Customers:
- RBI allows the existing customers to switch over to the MCLR regime; however, it shall be done on mutually acceptable terms. It is possible that banks may charge a higher premium on MCLR to discourage existing customers from switching to MCLR, especially in the current falling rate scenario. However, customers shall have the option to avail MCLR linked loans in other banks in case there is a large disparity between pricing of loans available in their bank and other banks.
- On the whole, this is expected to benefit customers, especially in the current falling rate scenario as benefits of rate cuts will be readily passed on to customers. However, on the flip side, customers may also see a sharper spike in interest rates when RBI starts increasing its policy rates.