Saturday, January 9, 2016

The Indian banking sector has struggled through a number of rate-setting methods over the last few years and has moved from a benchmark prime lending rate (BPLR) system to a base rate (or minimum lending rate) system and now the marginal cost of funds-based lending rate (MCLR).

The Reserve Bank of India has brought a new methodology of setting lending rate by commercial banks under the name Marginal Cost of Funds based Lending Rate (MCLR). It will replace the existing base rate system from April 2016 onwards.  

According to the new rules, every bank will be required to calculate its marginal cost of funds across different tenors. To this, the banks will add other components including operating cost and a tenor premium.

Why the MCLR reform?
  • At present, the banks are slightly slow to change their interest rate in accordance with repo rate change by the RBI. 
  • Commercial banks are significantly depending upon the RBI’s LAF repo to get short term funds. 
  • But they are reluctant to change their individual lending rates and deposit rates with periodic changes in repo rate.
  • Whenever the RBI is changing the repo rate, it was verbally compelling banks to make changes in their lending rate. 
  • The purpose of changing the repo is realized only if the banks are changing their individual lending and deposit rates.

Implication on monetary policy
  • Now, the novel element of the MCLR system is that it facilitates the so called monetary transmission. It is mandatory for banks to consider the repo rate while calculating their MCLR.
  • Previously under the base rate system, banks were changing the base rate, only occasionallyThey waited for long time or waited for large repo cuts to bring corresponding reduction in their base rate. 
  • Now with MCLR, banks are obliged to readjust interest rate monthly. This means that such quick revision will encourage them to consider the repo rate changes.

How to calculate MCLR ?

The concept of marginal is important to understand MCLR. 
In economics sense, marginal means the additional or changed situation. While calculating the lending rate, banks have to consider the changed cost conditions or the marginal cost conditions. 
For banks, what are the costs for obtaining funds? It is basically the interest rate given to the depositors (often referred as cost for the funds). The MCLR norm describes different components of marginal costs. 
A novel factor is the inclusion of interest rate given to the RBI for getting short term funds – the repo rate in the calculation of lending rate.

Following are the main components of MCLR.
1.     Marginal cost of funds;
2.     Negative carry on account of CRR;
3.     Operating costs;
4.     Tenor premium.

What are these components ?

  • Marginal Cost: The marginal cost that is the novel element of the MCLR. The marginal cost of funds will comprise of Marginal cost of borrowings and return on networth.  According to the RBI, the Marginal Cost should be charged on the basis of following factors:
1.  Interest rate given for various types of deposits-  savings, current, term deposit, foreign currency deposit
2.  Borrowings – Short term interest rate or the Repo rate etc., Long term rupee borrowing rate
3.     Return on networth – in accordance with capital adequacy norms.

  • Negative carry on account of CRR: is the cost that the banks have to incur while keeping reserves with the RBI. The RBI is not giving an interest for CRR held by the banks. The cost of such funds kept idle can be charged from loans given to the people.
  • Operating cost: is the operating expenses incurred by the banks
  • Tenor premium: denotes that higher interest can be charged from long term loans (What is it exactly ? -->> A tenor premium is the compensation for the risk associated with lending for a longer time.)

The marginal cost of borrowings shall have a weightage of 92% of Marginal Cost of Funds while return on networth will have the balance weightage of 8%.

Moral of the Story being that in essence, the MCLR is determined largely by the marginal cost for funds and especially by the deposit rate and by the repo rate. Any change in repo rate brings changes in marginal cost and hence the MCLR should also be changed.

How MCLR is different from base rate?

So what is common between the two methodologies ?

It is very clear that the CRR costs and operating expenses are the common factors for both base rate and the MCLR. The factor minimum rate of return is explicitly excluded under MCLR.

Then whats new in it ?
  • The most important difference is the careful calculation of Marginal costs under MCLR. 
  • On the other hand under base rate, the cost is calculated on an average basis by simply averaging the interest rate incurred for deposits. 
  • The requirement that MCLR should be revised monthly makes the MCLR very dynamic compared to the base rate.

Under MCLR:

1.     Costs that the bank is incurring to get funds (means deposit) is calculated on a marginal basis
2.     The marginal costs include Repo rate; whereas this was not included under the base rate.
3.     Many other interest rates usually incurred by banks when mobilizing funds also to be carefully considered by banks when calculating the costs.
4.     The MCLR should be revised monthly.
5.     tenor premium or higher interest rate for long term loans should be included.

Advantages ?
  • With the inclusion of shorter term MCLR rates, banks can compete with the commercial paper market as well.
  • moving towards international standards.
  • will reduce the cost of borrowing for companies.
  • will make the lending rate framework more dynamic as different banks could have different MCLRs for different tenures.

Demerits / Disadvantages/Roadbloacks/Shortcomings ?

  • Banks have been given the option to keep outstanding loans linked to the base rate system even though it said existing borrowers will also have the option to move to an MCLR linked loan “at mutually acceptable terms."
  • Most banks are unlikely to offer this option easily as it means that any immediate hit to profitability may be avoided.
  • Certain loans such as those extended under government schemes or under restructuring package, advances to banks’ depositors against their own deposits, loans to banks’ own employees including retired employees and loans linked to a market-determined external benchmark will be exempt from the MCLR rule.

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