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).
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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.
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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
occasionally. They 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.
A 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.
