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Comprehensive Guide to Understanding the Marginal Cost of Funds-Based Lending Rate

Marginal Cost of Funds-based Lending Rate (MCLR)

In India, banks play a crucial role in transmitting monetary policies to the broader economy. Consequently, the Reserve Bank has consistently aimed to enhance this transmission mechanism by refining the structure of lending interest rates within the banking sector. In line with this objective, the Reserve Bank introduced the base rate system in July 2010, which later gave way to the marginal cost of funds-based lending rate (MCLR) system in April 2016. All banking and non-banking institutions utilize this interest rate as the lowest rate applicable for lending any loan.

The Marginal Cost of Funds Based Lending Rate (MCLR) system requires banks to adjust their lending rates promptly whenever the Reserve Bank of India (RBI) modifies the repo rate. The primary objective of implementing MCLR is to promote transparency and consistency in the interest rates charged by banks on loans and advances. This system aims to strike a balance, ensuring that the interest rates are fair and advantageous for both the banks and the borrowers. By adopting a marginal cost pricing approach for loans, banks can enhance their long-term value and remain competitive in the market.

What is MCLR Rate?

In layman terms, MCLR is the minimum interest rate at which a bank can lend to its borrowers that is, it is a minimum lending rate, ensuring banks cannot lend below this level. Credit limit renewals and loan approvals follow MCLR standards, which are internally set by banks and vary depending on the loan repayment period.

The MCLR consists of four components:

  1. marginal cost of funds [marginal cost of borrowings (comprising deposits and other borrowings) and return on net worth];
  2. negative carry-on account of cash reserve ratio (CRR);
  3. operating costs; and
  4. term premium.

Under the MCLR system, banks are required to determine their benchmark lending rates linked to their marginal cost of funds [unlike the base rate system where banks had the discretion to choose between the average cost or the marginal cost (or blended cost) of funds]. MCLR system enable banks to have the flexibility to provide loans with either fixed or floating interest rates across all loan categories. Even fixed-rate loans with durations of up to three years are determined based on the MCLR. Banks regularly assess and release MCLR values for various maturity periods each month. However, certain loan rates, such as those for fixed-rate loans exceeding three years and specific government-sponsored loan schemes, are not tied to the MCLR. 

How MCLR is Different from Base Rate?

MCLR is established by banks based on their specific structure and methodology. In essence, borrowers stand to gain from this transition, as MCLR represents an enhanced iteration of the base rate. It employs a risk-oriented approach to ascertain the ultimate lending rate, considering factors such as the marginal cost of funds rather than the overall cost. Also, the base rate uses the average finance cost, but MCLR is based on the marginal or incremental cost of money.

The marginal cost encompasses elements like the repo rate, which was absent in the base rate framework. In computing the MCLR, banks must factor in all interest rates incurred in fund mobilization. Unlike the previous base rate system, MCLR now incorporates the loan tenure, with banks mandated to include a tenor premium. Consequently, banks can levy a higher interest rate on loans with longer durations.

Why MCLR was Introduced?

  • It mandates banks to promptly modify their interest rates whenever there is a change in the repo rate.
  • Its introduction aims to enhance transparency and consistency in the interest rates applied to bank loans.
  • By ensuring fairness and mutual benefit for both banks and borrowers, it facilitates banks in enhancing their long-term value and competitiveness through the adoption of marginal cost pricing for loans. 

Outcome of MCLR Implementation

With the introduction of the Marginal Cost of Funds Based Lending Rate (MCLR) system, interest rates are now determined based on the relative risk profile of individual borrowers. Previously, when the Reserve Bank of India (RBI) lowered the repo rate, banks were slow to pass on the benefits to borrowers by reducing their lending rates accordingly.

Under the MCLR regime, banks are required to adjust their interest rates promptly when the repo rate changes. The implementation of this system aims to enhance transparency in the methodology employed by banks to calculate interest rates on loans and advances.

Furthermore, the MCLR system ensures that both borrowers and banks have access to credit at interest rates that accurately reflect the prevailing market conditions. It facilitates a fair and equitable lending environment for all stakeholders involved.

What is the Role of MCLR?

The banking sector plays a vital role in the economy, with its performance significantly affecting economic conditions. The introduction of the MCLR system seeks to enhance trust among borrowers and businesses by offering more transparency in the calculation of lending rates. This transparency fosters greater reliance on the banking system for credit requirements, benefiting both individuals and entrepreneurs.

Furthermore, the MCLR system facilitates the swift and efficient transmission of policy rates, empowering the nation’s financial regulatory authority to implement more impactful monetary policy actions. Additionally, it guarantees that interest rate reductions by the RBI will directly lower Equated Monthly Instalments (EMIs) on loans.

How MCLR is Calculated?

When determining the MCLR, banks must consider all channels through which they acquire funds. These encompass fixed deposits, current accounts, savings accounts, as well as equity or retained earnings. The interest rates associated with these channels contribute to establishing the Marginal Borrowing Cost of the bank.

MCLR System (effective April 1, 2016)
(a) Marginal Cost of Funds [= 92% of Marginal Cost of Deposits and Other Borrowings + 8% of Return on Net Worth]

(b) Negative Carry on CRR
(c) Operating Cost
(d) Tenor Premium/Discount
MCLR = a + b + c + d

  • Tenor linked benchmark.
  • No discretion is allowed on benchmark.
  • Frequency: Monthly on a pre-announced date.
  • Reset period indicated on contract. Maximum one year reset period for floating rate loans.
  • Fixed rate loan over 3-year tenor- exempt from MCLR.

Factors Affecting MCLR

  • Banks must maintain a Cash Reserve Ratio (CRR) set at 4%.
  • The operational expenses linked to offering loan products need to be taken into consideration.
  • Banks have the opportunity to benefit from a provision within the MCLR known as Negative Carry on CRR. This occurs when the balance of CRR reaches zero, indicating that the actual returns are lower than the cost of funds.
  • Other expenses incurred by a bank, such as fundraising, employee salaries, and opening new branches, are not factored into the MCLR calculation but are instead charged separately to customers.
  • The final component is the Tenure Premium, which applies uniformly to all loan types and is not tailored to individual borrowers. This premium rises with longer reset periods. It represents an amount charged by the bank to mitigate the risks linked to extended loan durations.

What are the Deadlines to Disclose Monthly MCLR?

Under the MCLR system, banks have the flexibility to offer various loan products with either fixed or floating interest rates. Furthermore, banks are required to adhere to specific timelines for disclosing their MCLR or internal benchmark rates. These benchmark rates can be based on different maturity periods, such as one month, overnight, three months, one year, or any other tenor that the bank finds suitable for its lending operations. The choice of the appropriate benchmark maturity lies with the discretion of the individual banks.

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What is the marginal cost of funds?

The marginal cost of funds is the cost which one has to bear to raise new (incremental) fund. Suppose I have funds of average interest rate of 10% per annum. I raise some new fund bearing interest rate of 8% per annum then marginal cost of my fund is 8%.

What is negative carry on CRR?

Negative carry on CRR takes place when the return on the CRR balance is zero. Negative carry arises when the actual return is less than the cost of the funds.

How MCLR is determined?

MCLR is determined internally by the bank depending on the period left for the repayment of a loan.

When was MCLR based methodology was introduced first?

MCLR based methodology was introduced by RBI on April 1, 2016.

Why did the RBI implement the MCLR?

The RBI introduced the MCLR with the goal of enhancing transparency in banks' lending rate determination processes. Another objective was to facilitate smooth and prompt adjustments to lending interest rates in line with changes in RBI policies.