Marginal Cost of Funds Based Lending Rate (MCLR)

The Marginal Cost of Funds based Lending Rate (MCLR) is a regulatory measure introduced by the Reserve Bank of India in 2016, setting the lowest limit below which banks cannot lend. MCLR, influenced by factors such as the marginal cost of funds, operating costs, and tenor premium, aimed to improve transparency in interest rates on loans, ensuring customers benefitted from reduced interest rates. However, due to challenges in the transmission of monetary policy, MCLR was replaced by an external benchmark system in 2019. Marginal cost of funds based lending rate is an important topic for GS Paper-3 Economy Subject of UPSC IAS Exam. To explore other interesting Economics concepts similar to MCLR, check out other articles of IASToppers.   

Table of Content

• What is Marginal Cost of Funds based Lending Rate (MCLR)?
• What is the aim of Marginal Cost of Funds based Lending Rate?
• Objective of Marginal Cost of Funds based Lending Rate
• Factors that affect Marginal Cost of Funds based Lending Rate
• Marginal Cost of Funds based Lending Rate requirement for Banks
• What is the problem with Marginal Cost of Funds based Lending Rate?
• Background of banking interest rates in India
• Difference between Marginal Cost of Funds based Lending Rate and Base Rate
• Disclosure Deadlines for Marginal Cost of Funds based Lending Rate
• Conclusion
• FAQs on Marginal Cost of Funds based Lending Rate (MCLR)

What is Marginal Cost of Funds based Lending Rate (MCLR)?

• Marginal Cost of Funds based Lending Rate or MCLR is the minimum lending rate below which a bank is not permitted to lend.
• MCLR is an internal reference rate to determine rates of interests for loans.
  • Internal Benchmark is a reference rate for the pricing of rupee loans determined internally by the banks.
• MCLR was introduced by the RBI on 1^st April 2016 as a minimum lending rate for banks.

What is the aim of Marginal Cost of Funds based Lending Rate?

• The aim of introducing MCLR was to determine interest rates for loans based on the relative risk factor of individual customers.
• It addressed the issue of delayed adjustments in lending rates by banks when the repo rate was reduced by the RBI.
  • In the past, it was not mandatory for banks to immediately decrease their interest rate (repo rate) when the RBI announced a reduction during its usual policy meetings.
  • On the other hand, whenever the RBI increased policy rates, the general complaint was that banks were quick to increase rates.
  • This delay in transmission of interest rate cuts from the RBI to the borrowers has persisted even with the base rate system, which was introduced in 2010.

Objective of Marginal Cost of Funds based Lending Rate

• Enhance transparency in financial institutions’ interest rate determination.
• Ensure that the benefits of reduced interest rates are passed on to customers.
• Enable fair availability of loans to both customers and lenders.

Factors that affect Marginal Cost of Funds based Lending Rate

MCLR is decided based on the 4 main factors:

Marginal cost of funds:

• It represents the average rate at which deposits with similar maturities were raised during a specific period before the review date. This cost is reflected in the bank’s outstanding balance.
• The marginal cost of funds comprises the Marginal Cost of Borrowings (92%) and the Return on Net Worth (8%). The 8% represents the risk of weighted assets, denoted by the Tier I capital for banks.

Negative carry-on account of Cash Reserve Ratio (CRR):

• It is the cost that banks have to incur while keeping reserves with the RBI. Here, RBI is not giving an interest for Cash Reserve Ratio (CRR) held by the banks.
• In other words, Negative carry on CRR occurs when the return on the CRR balance is zero. This leads to a situation where the actual return is lower than the cost of funds.
• Negative carry affects the mandatory Statutory Liquidity Ratio Balance (SLR), which commercial banks must maintain. It is considered negative because the funds cannot be utilized to generate income or earn interest.

Operating costs:

• These include the expenses involved in issuing loans and day-to-day business operations.  

Tenor premium

• It is the premium (additional charge) applied to long-term loans to mitigate the risks associated with long-term lending.

MCLR requirement for Banks

• As per the guidelines of the RBI, banks have to prepare MCLR which will be the internal benchmark lending rates.
  • Based upon MCLR, interest rate for different types of customers should be fixed in accordance with their riskiness.
• Banks can publish MCLR for various maturity periods (overnight, one-month, three-month, six-month, and one-year) on a monthly basis.

What is the problem with Marginal Cost of Funds based Lending Rate?

• Despite the implementation of MCLR, the transmission of monetary policy has not met expectations.
• An Internal Study Group (ISG) formed by the RBI noted that internal benchmarks like Base rate/MCLR have not facilitated effective transmission of monetary policy.
• The ISG recommended transitioning to an external benchmark.

Background of banking interest rates in India

Prime Lending Rate (PLR)

• In 1994, the banks set a standard interest rate called Prime Lending Rate (PLR).
• PLR represented the rate charged by banks to their most creditworthy customers.
• Issue: However, different banks had varying interest rate structures, lacking uniformity.

Benchmark PLR (BPLR)

• To overcome the issues of PLR, in 2003, RBI launched Benchmark PLR (BPLR).
• BPLR was determined based on three factors: Cost of bank funds, operating expenses, and minimum margin.
• Issue: Banks were allowed to lend below BPLR, resulting in inconsistent loan pricing and difficulties in assessing policy rate transmission.

Base Rate System

• In 2010, the RBI introduced Base Rate system in place of BPLR.
• Base Rate became the minimum interest rate below which Scheduled Commercial Banks (SCBs) couldn’t lend, except in certain cases.
• It is determined on the bases of four factors: Cost for the funds, operating expenses, minimum rate of return, and cost for the CRR.
• Issue: Base Rate system faced challenges in ensuring effective monetary transmission and prompt adjustment to changes in the repo rate.
• In 2016, base rate was replaced by MCLR.

Difference between Marginal Cost of Funds based Lending Rate and Base Rate

	MCLR	Base Rate
Definition	Marginal cost of funds-based lending rate	Minimum rate of interest offered by banks
Purpose	Ensures transparency and benefits for borrowers	Sets the minimum lending rate for banks
Factors considered	CRR, marginal cost of funds, tenor premium, operating cost	Profit, bank deposit rates, bank costs
Dependency	Depends on repo rate changes by RBI	Not dependent on repo rate
Variation	Can vary for different loan tenures	Same for all borrowers of the bank
Rate adjustment	Banks adjust rates as per repo rate changes	Banks can choose to change it quarterly

External Benchmark Based Interest Rate

• RBI instructed banks to adopt an external benchmarking mechanism from 1^st October 2019.
  • External Benchmark is a reference rate published by an independent benchmark administrator.
• This is the minimum interest rate at which commercial banks can lend.
• RBI identified the following external benchmarks for banks to follow:
  • RBI’s repo rate
  • 91 Day Treasury Bill yield published by the Financial Benchmarks India Private Ltd. (FBIL).
  • 182 Day Treasury Bill yield published by the FBIL.
  • Any other benchmark market interest rate published by the FBIL.
• Banks are free to offer such external benchmark linked loans to other types of borrowers as well.
• Banks can also decide the spread over the external benchmark.
  • Bank spread is the difference between the interest rate that a bank charges a borrower and the interest rate a bank pays a depositor.

Disclosure Deadlines for MCLR

• Banks have the flexibility to offer loans under fixed or floating interest rates.
• They are required to disclose the MCLR or the internal benchmark based on specific deadlines.
• Deadlines can be set for one-month, overnight MCLR, three months, one year, or any other maturity period as determined by the bank.
• However, certain loans, such as those against customers’ deposits, loans to bank employees, government special loan schemes (e.g., Jan Dhan Yojana), and fixed-rate loans exceeding three years, are not linked to MCLR.

Conclusion

The Marginal Cost of Fund based Lending Rate (MCLR) system brought increased transparency to loan interest determination and aimed to ensure that benefits of reduced interest rates would be passed to customers. While MCLR faced challenges with the effectiveness of monetary policy transmission, the RBI’s introduction of external benchmarking in 2019 offered a more dynamic alternative. However, the interplay of factors like marginal cost of funds, tenor premium, operating costs, and Cash Reserve Ratio makes interest rate determination a complex task for banks, warranting continual refinement and innovation.

Ref: Source-1

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