Marginal Cost of Funds Based Lending Rate - MCLR

The marginal cost of funds based lending rate refers to the minimum interest rate of a bank below which the bank cannot lend, except in some cases allowed by the

Reserve Bank of India. MCLR is an internal benchmark/reference rate for a bank. MCLR outlines the method by which the minimum interest rate for the loan is determined by a bank- based on marginal cost or the additional or incremental cost of arranging one more rupee to the prospective borrower. In this article, we will look at the Marginal Cost of Funds Based Lending Rate - MCLR in detail.

MCLR Methodology

The Reserve Bank of India has introduced the MCLR methodology for fixing interest rates for advances with effect from April 1, 2016. All loans sanctioned and credit limits renewed with effect from April 1, 2016, will be priced concerning the Marginal Cost of Funds based Lending Rate which will be the internal benchmark (reference rate determined internally by a bank) for such purposes. After the implementation of MCLR, the interest rates will be determined according to the relative riskiness of individual customers. Previously, when Reserve Bank of India reduced the repo rates, the bank took a long time to reflect it in the lending rate for the borrower. Under the MCLR, banks must adjust their interest rates as soon as the

repo rate changes. Know more about the Statutory Audit of Banks

Objective of MCLR

The principal objective of the Marginal Cost of Funds Based Lending Rate is listed as follows:

• Improving the transmission of the policy rate into lending rates of the bank
• Bringing transparency in the methods followed by various banks for the determination of interest rate
• Ensuring the availability of bank loans at rates that fair to both lenders and borrowers
• Enabling the lender and bank to be competitive and improve their worth in the long run

Base Rate Vs MCLR

The vital difference between the base rate and MCLR is explained in detail below:

Base Rate

The minimum rate of interest at which the banks offer loan to their customers is called the base rate.

• Base rate calculation depends on different factors like profit, bank deposit rates, bank costs, cost of funds, the minimum rate of return that is margin or profit, operating expenses and cost of maintaining cash reserve ratio.
• Base rate is not dependent on the repo rate set by the Reserve Bank of India (RBI).
• Banks can change the base rate quarterly

MCLR

The marginal cost of fund based lending rate is associated with repo rate cuts by the Reserve Bank of India (RBI). This has been implemented to make the banking system even more transparent.

• The MCLR calculation is based on the marginal cost of funds, tenor premium, operating expenses and cost of maintaining the cash reserve ratio
• The main factor of difference between MCLR and the base rate is the calculation of marginal cost under MCLR. Marginal cost is charged based on the following factors
  • The interest rate for various types of deposits
  • The interest rate for different types of borrowings
  • Return on net worth
• MCLR is primarily determined by the marginal cost of funds and especially by deposit rates and repo rates.
• The marginal cost of funds based lending rate (MCLR) can be different for different loan tenures.

MCLR Calculation

The MCLR is a tenor linked internal benchmarks. The actual lending rates are calculated by adding the components of spread to the MCLR. Banks will review and publish the MCLR of different maturities, every month, on a pre-announced date. The MCLR calculation comprises of the following:

Tenor Premium

Tenor means that the amount of time left for the repayment of a bank loan. There is uniformity in the tenor period for all sorts of loans for the said residual tenor. This means that the tenor premium is not specific to a loan class or a borrower.

• The change in the tenor premium cannot be borrower specific or loan type-specific
• The tenor premium is uniform for all types of bank loans for a given residual tenor

Marginal Cost of Funds

The marginal cost of funds is a novel concept under the MCLR methodology; it comprises the Marginal cost of borrowings and returns on the net worths, appropriately weighed. Marginal cost of fund = (92% x Marginal cost of borrowing) + (8% x Return on net worth) Thus, the marginal cost of borrowings weights 92% while the return on net worth has 8% weight in the marginal cost of funds. Here, the weight given to return on net worth is set equivalent to the 8% of risk-weighted assets prescribed as Tier capital for the bank. The marginal cost of borrowings refers to the average rates at which deposit of similar maturity was raised in the specified period preceding the date of review, weighed by the outstanding balance in the bank book. Rates offered on the deposits of a similar maturity on the date of prices at which funds raised x Balance outstanding as the percentage of total funds as on any day, but not more than seven calendar days before the date from which the MCLR becomes effective.

Negative carry on account of Cash Reserve Ratio (CRR)

Negative carry on the essential CRR arises because the return on CRR balances is nil. Negative carry on the mandatory Statutory Liquidity Ratio (SLR) balances will arise if the actual return is less than the cost of funds.

Operating Cost

The operating cost is associated with providing the loan product, including the cost of raising fund, but excluding the costs which are separately recovered by way of service charge.

Deadlines to Disclose monthly MCLR

Banks have the liberty to make available all loan categories under fixed or floating interest rates. Additionally, banks need to follow specific deadlines to disclose the MCLR or the internal benchmark. Banks may publish every month the  MCLR for the following maturities:

• Overnight MCLR
• One-month MCLR
• Three-month MCLR
• Six-month MCLR
• One year MCLR
• MCLR for any other maturities which the bank considers fit

To link all bank loans to the benchmark, the lending cannot be below the MCLR for any maturity. The loan that is not linked to MCLR includes loans against customers' deposits, loans to the bank's employees, special loan schemes by Government of India (Jan Dhan Yojana), fixed-rate loans with tenures above three years etc.