Change is good, right? Apparently, India's apex bank, the Reserve Bank of India (RBI) adheres to this policy as it introduces a new system for commercial banks to zero-in on lending rates for the fiscal year. The aptly named Marginal Cost of Funds based Lending Rate (MCLR) will be applicable from April-2016 and will completely modify the existing lending rate system as followed by banks across India.
The new system takes into account the risk associated with different class of customers, and will be subject to changes on a monthly basis based on such factors as repo rates and other borrowing rates. The latter includes borrowing and repo rate factors that were not primarily utilised in the earlier Base Lending Rate system. At the basic level, the RBI expects banks to fix five benchmark rates that correspond to differing loan tenures- the time periods stretching from one day to one year.
At its core, MCLR isn't a difficult concept to master. The new system is dependent on the idea of 'marginal cost' or the constantly updated formula that banks utilise to create their base lending rate, and the associated interest rate whilst borrowing money from deposits and/or the RBI. MCLR counts these two factors:
- Interest rate offered by banks on deposits, and
- Repo rate that banks furnish to obtain funds from the RBI, as primary factors for its calculation.
Why the MCLR System?
Usually, high impact changes are made as a means to regulate a vast, slow reacting target system. The latter, in this scenario, are the collective networks of the various public and private sector banks in India. Last year, the RBI affected game changing rate cuts with regards to its base lending rates. However, the banks were slow to adopt these rate cuts and the RBI had to repeatedly rebuke the banks for their uncharacteristic delay. Repo rates keep changing, but the banks are hesitant to correspondingly update their i-base lending rate and interest rates on deposits. A significant reason for the same is that banks choose to utilise RBI's Liquidity Adjustment Facility (LAF) in order to source short term funds from the apex bank. This saves them the trouble of having to periodically update their lending and deposit rates. The RBI hopes that with MCLR, a faster feedback oriented system will be put into effect that will negate the shortcomings of the current base rate system.
How will the Banks be impacted when MCLR is implemented?
If there ever was a wily fox, RBI will be it. After effecting the popular repo rate cuts, a move that made well liked loan options like home loans, simpler to obtain, the apex bank had to face the inconvenient problem of banks taking their own sweet time to implement the corresponding changes in terms of their own base lending rate and interest rates on deposits. Enter MCLR. With this new system, banks are now forced to consider the current base lending rate when calculating their individual MCLR. Unlike the earlier base rate system, wherein banks weren't obligated to implement RBI's rate cuts immediately or in an equivalent quantum, MCLR 'forces' the banks to realign their interest rates on a monthly basis. And, while they are at it, the banks can subscribe to the latest repo rates and implement the same, ergo keep up with RBI's updates.
In a progressive economy, cuts in the base lending rate at the apex bank level must reach the common populace in the shortest time frame. Rate cuts encourage people to subscribe to loans and invest in the popular investment options. Ironically, this is only possible when banks implement said rate cuts in a quick, uniform and responsible way. MCLR is conceived to encourage the banks when it comes to adopting the latest repo rates as promoted by the apex bank of India.
Differences between the Base Rate System and MCLR:
The fundamental difference between both these systems are the factors that contribute to them individually. Summing up, the following factors are utilised to calculate the Base Rate and MCLR respectively,
|Base Lending Rate||Marginal Cost of Funds based Lending Rate (MCLR) |
|Interest rate offered on deposits.||Marginal cost of funds.|
|Bank’s operating costs.||Bank’s operating costs.|
|Profit, in terms of minimum rate of return.||Tenor premium.|
|Costs incurred in maintaining the Cash Reserve Ratio (CRR). This is a stipulated minimum fraction of the overall deposits maintained by the customers in any public/private sector Indian bank. Said bank deposits the CRR with the RBI in the form of cash or deposits.||Negative Carry due to CRR- The RBI doesn’t offer any interest on the monies held by it as CRR from the banks. The bank can negate the effects of such non-performing assets and cover the costs by charging the same from loans that are offered to prospective customers. Hence, contributing to the MCLR.|
Herein, the following pointers need expounding,
Marginal Cost of Funds: The main lynchpin in the MCLR methodology, marginal cost of funds include two components:
- Marginal cost of borrowing from deposits or the RBI, and,
- The return of the net worth after a particular deposit has matured.
As per the rules laid out by the RBI, banks must consider the following factors when deciding upon the marginal cost of funds,
- Applicable interest rates offered for different types of deposits including term, current, savings bank and deposits in foreign currency.
- Applicable short term interest rate, repo rate, borrowing rate for longer tenures, etc.
- In line with set norms, return on net worth.
Herein, note that when calculating the marginal cost of funds, the marginal cost associated with borrowings has a contribution of 92% whilst return on net worth commands a share of 8%.
Bank's Operating Costs: Everyday operational costs that is incurred by the bank in question.
Tenor Premium: Represents the idea that long term loans can command a higher rate of interest.
Summation: It must be noted that the bank's operating costs and commitments with RBI in terms of the CRR are commonalities between the Base Lending Rate method and MCLR. However, in case of the latter, marginal cost plays a key role whilst with the former, the cost is ascertained by simply averaging the interest accumulated on the deposits. Also, MCLR is designed to be updated on a monthly basis as compared to the Base Rate method that is usually static, until jolted into action.
How to Calculate MCLR?
As explained above, going forward, Marginal Cost of Funds based Lending Rate (MCLR) will be the norm when it comes to the calculation of lending rates at the bank's level. Popular loan options such as housing loans will definitely be impacted as banks are instructed to update their base lending rates and interest on deposits more frequently, whilst taking into account RBI's current repo rate. The actual calculation itself depends on four primary factors-
- Marginal cost of funds
- Operational cost of the banks
- Costs incurred in maintaining the Cash Reserve Ratio (CRR) with the RBI
- Tenor Premium wherein more interest is likely charged from long term loans
As is obvious, the concept of 'marginal' is an essential determinant when calculating MCLR. In a purely economic sense, marginal costs relate to the extra costs incurred in the production of additional units that adds to the producer's production capabilities without inviting the same costs as were incurred per unit through the initial production. This can be easily mapped to the banking scenario as well, wherein lending rates can only be calculated after the marginal costs have been taken into consideration. This amounts to the costs that banks have to incur in order to generate funds. Not surprisingly, these costs are nothing but the interest rate that banks pay depositors for creating deposit portfolios with their organization. Further, these marginal costs are broken down into clearly defined sub-components. Herein, the repo rate that banks pay the RBI to ascertain short term funds is a crucial sub-component. Any change in the repo rate will bring a corresponding change in terms of the marginal cost and consequently the MCLR will also change. This is expected to be a clearly laid out path for RBI to ensure that the benefits arising from its periodic repo rate cuts are quickly and conveniently passed down to the target customer base.
How MCLR Works?
Marginal Cost of Funds-based Lending Rate (MCLR) ensures that the rates are revised based on the repo rates prevalent, the marginal cost of funds incurred by the bank and the tenor premium. This means that your bank's lending rates could change more frequently than earlier. MCLR rates are reviewed every month but are fixed for a period of at least 1 year with respect to long-term loans.
Let us take the example of the State Bank of India (SBI). SBI has pegged its MCLR rates at 9.2% for 1 year for the current fiscal. The spread is of 25 basis points more than
the MCLR. The bank has also declared the following MCLR rates for different periods:
- Overnight - 8.95%
- 1 month - 9.05%
- 3 months - 9.10%
- 6 months - 9.15%
- 2 years - 9.30%
- 3 years - 9.35%
So if you are taking a home loan from the SBI now (after April 1, 2016), your interest rate will be 9.45% (9.2% MCLR + 0.25% spread). For a period of 1 year, this interest rate will be valid on your home loan and you have to pay Equated Monthly Instalments (EMIs) based on this. For example, if your loan amount is Rs. 45 lakh, then at the rate of 9.45% and for a tenure of 30 years, you'll be paying an EMI
of around Rs. 37,675.
The following year, the rate will be revised and the new rates will automatically be applicable for another 1-year period. So if MCLR is reduced to 9% next fiscal for the same spread ratio, the interest rate will be reduced to 9.25%. Accordingly, your EMI will go down by around Rs. 500 per month.
However, an increase in MCLR means that you will end up paying more to the bank than what you paid at the beginning of the loan term.
RBI's Take on MCLR:
The Reserve Bank of India's move to implement Marginal Cost of Funds based Lending Rate (MCLR) in the context of Indian banking is a timely and dynamic step. Aimed at inspiring more accountability from the banks with regards to the speedy adoption of updated repo rates, the finger print concerning MCLR reads as follows:
- Post April 1, 2016 all loans sanctioned, and existing credit limits renewed, will adhere to MCLR.Explicitly, MCLR will be regarded as a tenor linked internal benchmark.
- Banks will continue to publish and review Base Rates as usual.
- MCLR will be appended with additional components of the spread to determine the actual lending rate. Herein, spread allows banks to charge a higher interest rate from borrowers who are deemed 'risky'.
- Banks are expected to publish the updated MCLR values for different products on a monthly basis, on a pre-selected date.
- All banks are free to specify dates for interest reset on loan products that subscribe to a floating rate. Banks can choose to offer loans with reset dates that are either associated with the actual sanction date, or the date that corresponds to the review of MCLR. Such resets must happen within a time frame of one year or less.
- All loans/credit limits that are currently subscribing to the Base Rate methodology will continue as usual, until their renewal/repayment. Borrowers can also move from Base Rate to MCLR, provided the same is chalked out through mutually agreed upon terms.
- MCLR that was in vogue at the time of the sanction of loan will continue unhindered till the next reset date. Meanwhile, any change in the associated benchmark will not have any impact on the aforementioned arrangement.
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FAQ on MCLR:
- What are the operational features of MCLR?
- Banks must revise MCLR on a monthly basis, while including the latest RBI repo rates as part of the calculations.
- Marginal costs that the bank incurs when getting funds (i.e, interest paid on deposits, costs incurred in maintaining the Cash Reserve Ratio (CRR), etc.) are factored in when calculating the lending rates.
- Marginal costs must also be considerate to repo rates, a factor that wasn't a priority in the case of the erstwhile Base Lending Rate model.
- MCLR also includes a number of contributing factors, including a range of interest rates that the bank has to satisfy in its bid to accumulate the necessary funds.
- MCLR must also take into account higher interest rates that apply to long term loans. This is also known as Tenor Premium.
- What is 'spread' in banking terms? How does it impact MCLR?
In simple banking terms, net interest rate spread refers to the difference between the interest that the bank earns on such products as loans and securities, versus the interest payable by it on deposits.
With regards to MCLR, the RBI bulletin stipulates that banks must append the varied components of the spread onto the MCLR when determining the applicable lending rate. This will also allow banks to charge a higher interest rate on loan portfolios wherein the borrower is deemed as -risky.
- What happens to existing loans that come under the purview of Base Lending Rate?
The RBI is very clear with regards to the status-quo of Base Lending Rate. It maintains that existing loans/credit limits that subscribe to Base Rate will continue to do so, until repayment or renewal, whichever comes first. Further, existing borrowers, in compliance with their lenders, can opt to move their loan from the Base Lending Rate model to MCLR.
- What about my existing home loan? Is MCLR good for my loan situation?
Don't worry. The RBI was considerate to the request from various Indian banks about not linking existing loan portfolios to the new MCLR modus operandi. These loans will continue to operate per the Base Lending Rate option until they are closed or refinanced. Alternatively, you can request the shifting of your loan to the MCLR model, provided your lender is onboard with this idea.
MCLR is good for you. In 2015, when RBI slashed a record 125 points off its repo rate, the banks delayed passing the ensuing benefits onto the target customers. MCLR will force your bank to constantly update its lending rate (on a monthly basis infact) while adopting the latest RBI repo rate to formulate this number. Consequently, your home loan EMIs will reflect these changes instantly. Note that industry experts do believe that eventually the old system and MCLR will merge into a single entity.