What Is MCLR And Its Impact On Indian Economy

MCLR stands for Marginal Cost of Funds Based Lending Rate and it was first introduced in the year 2016, in order to tackle the problems related to base rates. MCLR was aimed to assist borrowers who are willing to avail various types of loans, to get the benefit of the rate cut provided by Reserve Bank of India (RBI). As a borrower, if you have availed the loan prior to April 2016, you can reap the benefits of RBI’s bank rate cuts by shifting your loans. Also, loans taken on or after April 2016, are directly linked to the MCLR rate.

What is MCLR Rate?

The MCLR rate is an internal reference rate which is fixed by the Reserve Bank of India (RBI). It is used by the banks across the country to define the minimum lending rate or interest rate, on various types of loans. It is protocol set by the apex bank RBI, that banks cannot lend any loan below the MCLR rate, or else they will have to face strict regulatory action. Only in some exceptional cases, banks are allowed to lend below the MCLR rate, with prior authorization from RBI. Earlier, banks and financial institutions used to lend loans on the basis of base rates, and this caused the prime customers and big corporates to get an undue advantage. The lending interest rate is determined on the basis of marginal cost or incremental cost of arranging each rupee to lend to the borrower.

Since the base rate was individual banks’ and financial institution’s internal policy, this caused a huge monetary loss, especially to the borrowers. Even after rate cuts, it took a lot of time for the financial institutions to lower their lending rates and pass on the rate-cut benefits to customers.

Example: If the base rate lending is 7%, certain financial institutions lend their prime and important customers at 7% or below. On the other hand, for ordinary borrowers, this rate of interest still stands at 10-12%. This created a huge disparity between the prime customers and the non-prime ones. In order to curb this practice, it was important to bring a standardized system to fix the lending rates.

What is the Importance of MCLR Rate?

Earlier, the banks and financial institutions were working fine with the base rate and BPLR (Benchmark Prime Lending Rate), on loans. Banks were earlier calculating the base rate on the basis of various methodologies as per their discretion. Some banks were using the method of the average cost of funds, while others used the marginal cost of funds. Then, why did RBI felt the need to move banks towards the MCLR system. RBI was not satisfied with the arrangement of the base rate system. RBI also figured out that the base rate system was not responding well to the changes in policy rates which is important for proper implementation of monetary policies in the country. 

Hence RBI decided to move the banks and financial institutions to the new system of MCLR and benefit borrowers, equally. Before making this system compulsory for all the banks and financial institutions, there was no such defined system which followed uniform principles of lending. RBI shifted the banks to the MCLR system to ensure that the benefits of the rate cuts and policy changes were swiftly transferred to the borrowers with impact given on lending rates. Thus, MCLR was given effect to accomplish the following objectives:

1. To give economy a boost through the inclusion of RBI policy rates into the banking system
2. Improve transparency between the banks and RBI to fix the lending rates on various categories of loans
3. Ensure smooth credit delivery and a fair system of credit interest rates for banks and borrowers
4. It enhances the competitiveness of banks and financial institutions and boosts their long-term value by contributing to country's economic growth

How to calculate MCLR?

MCLR is calculated based on the loan tenure, i.e. the amount of time a borrower has, to repay the loan. This tenure-linked benchmark is internal in nature and the banks determine the final lending rates by taking into consideration all these elements. The banks then arrive at the final MCLR rates and publish the same after careful inspection. 

The four main elements of MCLR are the following:

1) Tenure premium

The cost of lending to the banks depends upon the total period of the loan, that is for how much time the loan is availed by the borrower. If the duration of loan is high, higher will be the risk to the banks and financial institutions. To cover themselves from this risk, the bank will shift the load to the borrowers by imposing an additional amount in the form of premium and this is known as the Tenure Premium.

2) Marginal cost of funds

The marginal cost of funds is the average rate at which deposits having similar maturity dates were raised during a specific period. The cost of such funds will be reflected in the bank’s books with the valuation of their outstanding balance. The marginal cost of funds is made up of several components like the Return on Net Worth and the Marginal Cost of Borrowings where the Cost of Borrowings makes up 92% while the Return on Net Worth makes up for 8% of the total marginal cost of funds. 

3) Operating Cost

Operating expenses include the cost of raising funds and other service charges. It is actually the cost of providing a loan as a product to the borrowers.

4) Negative account of CRR

Negative carry balance on the CRR (Cash Reserve Ratio) is when the return on the CRR balance is negative or zero. Negative carry also arises in cases when the actual return is less than the cost of the funds. This also impacts the SLR (Statutory Liquidity Ratio) that every commercial bank must maintain, as per the guidelines of RBI. Negative carry on CRR denotes that the banks are not able to make profits or earn anything by utilizing the funds or lending loans.

What is the Impact of MCLR on Indian Economy?

The banking system is the backbone of Indian Economy and any negative or positive changes in the banking sector has a direct impact on the Indian Economy. The MCLR system restores the faith of borrowers and businesses in the banking sector by improving transparency in how lending rates are calculated. As a result, more business houses can rely on the banking system for their credit needs.

MCLR also enables faster and effective transmission of policy rates and pass on the benefits so that each borrower can reap the benefits of the monetary policies. It helps the country's financial regulatory body to take more effective monetary policy measures. The MCLR system will ensure that RBI's interest rate cuts will directly reduce Equated Monthly Instalments (EMIs) on various categories of loans. With MCLR in the banking system, the borrower’s entrust their confidence in the banks and financial institutions for all their credit needs. 

What is the Importance of Repo Rates?

A repo rate is that interest rate at which the Reserve Bank offers credit delivery to the commercial banks, across the country. Repo rate is one important tool used by the Reserve Bank to change and infuse credit in the Indian economy. For instance, if the RBI decreases repo rates, commercial banks can borrow more from the RBI, and pass it on to the final borrowers. This increases the credit flow in the economy. Alternately, if RBI increases the repo rate, it ultimately leads to a decrease in credit flow in the economy. With the earlier base rate system, the final borrower could not enjoy the benefits of repo rate changes due to slow transmission by the banks

MCLR in Home Loans

MCLR can pass the benefit of repo rate changes to the final borrowers. This is because the MCLR system can swiftly respond to any RBI decision with respect to repo rates. It is now mandatory for all commercial banks to set different MCLRs as per the loan tenure. If the borrower avails a home loan at yearly MCLR, he will continue paying the yearly EMI as per the decided interest rates, despite any monetary policy changes made by RBI during that year.

The MCLR facility serves the best purpose for home loans as compared to other types of loans. Home loans have comparatively long tenure and any change in home loan interest rates could have a significant impact on the instalment amount over the loan tenure. 

Had MCLR rates not ben there, any rise in the repo rates could significantly disrupt the financial planning of a borrower and even put a considerable financial strain on the borrower. Now, even if the repo rate rises in the future, the borrower will continue reaping the benefits of his original MCLR, by paying lower EMI instalments. 

• The benefits of MCLR can only be offered on floating interest rates on home loans, and not fixed interest rates.

• Borrowers who are under the liability of loan tenures for home loans taken at previous base rates are offered an option to convert to MCLR. They might be asked to pay some conversion fee for the same. 
• Choose for pre-payment option on your home loan to nullify the effect of the interest rate differences.
• The borrower can request the lender to transfer the home loan to a fixed-rate after a suitable cost-to-benefit analysis.

FAQ’s

Q1. Whether the tenor premium charged is for contractual tenure or residual tenure?

Floating rate loans are always subject to periodic resets, and the tenure premium is the most appropriate premium for the residual period up to the next reset date.

Q2. What is the denominator used for arriving at the operating cost while computing MCLR?

Banks can exercise the option of calculating all operating costs as a percentage of the marginal cost of funds for computing MCLR.

Q3. Clarify the definition of short-term borrowings.

A short-term borrowing means borrowing of tenor up to but less than one year.

Q4. Can components of spread be negative?

The components of a business strategy and Credit risk premium shall have either a positive value or be zero. Also, the spread components cannot be negative.

Q5. Are interest rates on fixed-rate loans based on the date of sanction?

The interest charged on fixed rate loans and the fixed portion of hybrid loans is the interest rate mentioned in the sanction letter which is issued while the loans are disbursed.

Also Read: Introduction To Financial Regulators In India