For banks, the Reserve Bank of India (RBI) establishes a fixed internal reference rate. This interest rate is then used by banks and lending institutions regulated by the RBI to establish the minimum interest rate applicable to various loan types.
The RBI updates this rate on a regular basis when there is a significant change in the country's economic activities. Banks are typically not permitted to lend money at rates lower than the MCLR.
MCLR's full form is Marginal Cost of Funds Based Lending Rate (MCLR) and it is the lowest lending rate at which a bank may not lend. The MCLR replaced the previous base rate system in determining commercial banks' lending rates.
On April 1, 2016, the RBI implemented MCLR to determine loan interest rates. It is an internal reference rate used by banks to determine the amount of interest they can charge on loans. They consider the additional or incremental cost of arranging an additional rupee for a prospective buyer.
The loan tenor, or the amount of time a borrower has to repay the loan, is used to calculate the MCLR. This tenor-linked benchmark is only for internal use. By adding the elements spread to this tool, the bank determines the actual lending rates.
Following a thorough examination, the banks publish their MCLR. The same procedure applies to loans with different maturities – monthly or on a predetermined cycle.
The four major components of MCLR are as follows:
The tenor premium
The cost of lending varies depending on the length of the loan. The greater the loan's duration, the greater the risk. In order to cover the risk, the bank will shift the burden to the borrowers by charging a premium. The Tenure Premium is the name given to this premium.
The fund's marginal cost
The marginal cost of funds is the average rate at which deposits with similar maturities were raised prior to the review date. This expense will be reflected in the bank's books as an outstanding balance.
The Return on Net Worth and the Marginal Cost of Borrowings are two components of the marginal cost of funds. The Marginal Cost of Borrowings accounts for 92% of the total, while the Return on Net Worth accounts for 8%. This 8% corresponds to the risk of weighted assets as denoted by Tier I capital for banks.
Except for costs recovered separately through service charges, operational expenses include the cost of raising funds. As a result, it is linked to the provision of the loan product as such.
Negative carry as a result of CRR
When the return on the CRR balance is zero, the CRR (Cash Reserve Ratio) carries a negative carry. When the actual return is less than the cost of the funds, negative carry occurs.
This will have an effect on the mandatory Statutory Liquidity Ratio Balance (SLR) – a reserve that every commercial bank is required to maintain. It is accounted for negatively because the bank cannot use the funds to generate income or earn interest.
Banks determine the MCLR based on the structure and methodology used. To summarise, this change will benefit borrowers. The MCLR is an enhanced version of the base rate.
The final lending rate for borrowers is determined using a risk-based approach. It takes into account unique factors such as the marginal cost of funds rather than the overall cost of funds.
The repo rate, which was not included in the base rate, is factored into the marginal cost. Banks are required to include all types of interest rates that they incur when mobilizing funds when calculating the MCLR.
Previously, the loan tenure was not considered when determining the base rate. In the case of MCLR, the banks are now required to include a tenor premium. This will enable banks to charge higher interest rates on long-term loans.
The lending rate cannot be lower than the MCLR for any loan maturities. Other loans, on the other hand, are not linked to the MCLR. Loans against customer deposits, loans to bank employees, special loan schemes run by the Government of India (Jan Dhan Yojana), and fixed-rate loans with terms of more than three years are examples.
The transmission of the RBI's repo rate change will be faster in the case of repo-linked loans, but this does not mean that repo-linked loans will always be cheaper than MCLR-linked loans. It's worth noting that the repo rate is currently near a 15-year low. As a result, repo-linked loans may appear to be less expensive.
When the RBI begins to raise repo, the increase in repo-linked interest rates will be faster as well. In contrast, an increase in the repo rate will take some time to be passed on to the borrower in MCLR-linked loans.
Banks add spreads to the repo rate in the case of repo-linked loans to cover their operating costs and risk premium. This spread varies from bank to bank, so the final rate imposed on the end borrower varies as well, despite the fact that the rate is linked to the same benchmark.
The banks set the lending rate under the BLR system while taking into account their average cost of funds. The loan rates in the MCLR system are determined by the marginal cost of funds. However, the BLR and MCLR systems did not address the issue of low rate cut transmissions to borrowers whenever the RBI decided to cut the repo rate. The RBI directed banks to peg their floating rate loans to any of the recommended external benchmarks, including the repo rate, under the EBLR system, and to reset their lending rates at least once every three months.
Borrowers who have taken or switched to a repo-linked loan have seen their loan interest rates quickly adjusted to reflect changes in the repo rate mandated by the RBI since then.
The Result of MCLR Implementation
Following the implementation of MCLR, interest rates are calculated based on the relative risk factor of individual customers. Previously, when the RBI reduced the repo rate, banks took a long time to reflect it in borrowers' lending rates.
Banks must adjust their interest rates under the MCLR regime as soon as the repo rate changes. The implementation aims to improve the transparency of the structure used by banks to calculate the interest rate on advances. It also ensures the prospect of bank credits at reasonable interest rates for both consumers and banks.
Banks have the option of making all loan categories available at fixed or floating interest rates. Furthermore, banks must adhere to strict deadlines when disclosing the MCLR or the internal benchmark. They could be one month, overnight MCLR, three months, one year, or any other maturity determined by the bank.
For any loan maturities, the lending rate cannot be lower than the MCLR. Other loans, however, are not linked to the MCLR. Loans against customer deposits, loans to bank employees, special loan schemes run by the Government of India (Jan Dhan Yojana), and fixed-rate loans with terms longer than three years are examples of these.
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