What is Marginal Cost of Funds based Lending Rate (MCLR) reform by the RBI?--
The Reserve Bank of India has announced a new methodology of setting lending rate by commercial banks under the name Marginal Cost of Funds based Lending Rate (MCLR). It will modify the existing base rate system from April 2016 onwards.
As per the new guidelines by the RBI, banks have to prepare Marginal Cost of Funds based Lending Rate (MCLR) which will be the internal benchmark lending rates. Based upon this MCLR, interest rate for different types of customers should be fixed in accordance with their risk assessment.
The MCLR should be revised monthly by considering some new factors including the repo rate and other borrowing rates. Specifically the repo rate and other borrowing rate that were not explicitly considered under the base rate system.
As per the new guidelines, banks have to set five benchmark rates for different tenure or time periods ranging from overnight (one day) rates to one year.
The new methodology uses the marginal cost or latest cost conditions reflected in the interest rate given by the banks for obtaining funds (from deposits and while borrowing from RBI) while setting their lending rate.
This means that the interest rate given by a bank for deposits and the repo rate (for obtaining funds from the RBI) are the decisive factors in the calculation of MCLR.
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.
The RBI calls the effective passing of repo rate change into interest rate change by the banking system as an important part of monetary transmission. Monetary transmission in complete sense is the way in which a monetary policy signal (like a repo rate cut) is passed into the economy in producing the set objectives.
We may take the case of a repo rate reduction by the RBI. It is aimed to reduce overall interest rate in the economy and thus promoting loans for consumption and investment. This consumption and investment boost will be realized only if banks are cutting interest rate in response to the reduced repo rate.
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.
Negative carry on account of CRR: It 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
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.
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%.
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.
According to the RBI guideline, actual lending rates will be determined by adding the components of spread to the MCLR. Spread means that banks can charge higher interest rate depending upon the riskiness of the borrower.
Powerful element of the MCLR system form the monetary policy angle is that banks have to revise their marginal cost on a monthly basis.
According to the RBI guideline, “Banks will review and publish their MCLR of different maturities every month on a pre-announced date.” Such a monthly revision will compel the banks to consider the change in repo rate change if any made by the RBI during the month.
Regarding the status-quo of base rate, the initial guidelines from the RBI indicate that the Base rate will be replaced by the MCLR. “Existing loans and credit limits linked to the Base Rate may continue till repayment or renewal, as the case may be. Existing borrowers will also have the option to move to the Marginal Cost of Funds based Lending Rate (MCLR) linked loan at mutually acceptable terms.”
How MCLR is different from base rate?
The base rate or the standard lending rate by a bank is calculated on the basis of the following factors:
1. Cost for the funds (interest rate given for deposits),
2. Operating expenses,
3. Minimum rate of return (profit), and
4. Cost for the CRR (for the four percent CRR, the RBI is not giving any interest to the banks)
On the other hand, the MCLR is comprised of the following are the main components.
1. Marginal cost of funds;
2. Negative carry on account of CRR;
3. Operating costs;
4. Tenor premium
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.
But 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.
How does MCLR work?
If you plan to take a floating rate home loan, your loan will now be linked to MCLR. Most banks have announced five to seven rates. For home loans, banks will either use the six-month MCLR or the one-year MCLR as the benchmark rate.
Therefore, from now, all floating rate loan agreements will have a reset clause at a pre-specified interval. “Banks can decide on the tenor that they want to use to reset for longer-term loans such as home loans. We have decided to reset home loan interest rates at a six-month frequency. Hence, the six-month MCLR will be applicable for home loans,” said Manian. Kotak Mahindra Bank has announced 9.40% as its six-month MCLR and the home loan will be reset every six months in case of any changes in MCLR. If you have a home loan, the bank will reset the rate automatically at a pre-specified date.
However, banks such as SBI and ICICI Bank Ltd have set one-year MCLR as the benchmark for home loans. For instance, for salaried individuals, ICICI Bank has set a floating rate home loan at one-year MCLR of 9.20% with a spread of 25 bps for loans of up to Rs.5 crore. So, the interest rate will be 9.45%. The bank’s website stated that this will be valid till 30 April 2016.
Though the MCLR is reviewed monthly, your home loan will be reset every year automatically, depending on the agreement with the bank.
For instance, if you take a Rs.30-lakh loan on 1 April this year, one-year MCLR is at 9.20% and spread on it is 25 bps, your home loan will be 9.45%. You will pay instalments at this rate for the next one year. If on 1 April 2017, one-year MCLR gets revised to 9.15%, your home loan interest rate will get reset at 9.40% (MCLR of 9.15% plus spread of 25 bps). Accordingly, your instalment or loan tenor may change.
According to a report by Ambit Capital Pvt. Ltd, RBI gave banks the provision of a reset period to partly smoothen the impact of changing rates on banks’ margins (as deposits re-price with a lag, reset periods allow bank to adjust the timing of loan pricing). As the concept of reset period contravenes with the RBI’s objective of quick transmission of monetary policy, the RBI has capped reset period at one year.
Though retail loans are likely to be set at six months to one-year MCLR tenors, corporate loans may be set at shorter tenors. “Due to complexity in the retail product, a pre-specified reset has been decided. When it comes to corporate loans, there is a possibility to negotiate across the multiple sets of rates that are available,” said Manian.
Can an existing borrower who is on a base rate regime move to MCLR? According to RBI, existing loans and credit limits linked to base rate will continue till repayment or renewal, and banks will have to continue publishing base rates as well. Existing borrowers can move to MCLR-linked loans at mutually acceptable terms and these loans will not be treated as foreclosure of existing facility.
What you should know
The MCLR-linked home loan rate is currently marginally lower than a base rate-linked loan. For instance, SBI was offering home loans between 9.50% and 9.55% till 31 March. From 1 April, the rate is lower by 10 bps and ranges between 9.40% and 9.45%.
According to the Ambit report, new MCLRs are not so different from base rates: “...even if benchmark rates would have fallen, the effective loan pricing for borrowers might not have changed much. This is because banks could change spreads over benchmark rates,” the report noted.
Home loan rates will now depend on the bank’s choice of reset period—six-month or one-year MCLR rate and spread rather than one common base rate and spread. According to a Centrum Broking Ltd report, while MCLR is intended to ensure effective policy transmission, past studies, including references to global banks, suggest limited rate transmission to end-user. Hence, its effectiveness in the longer run will need to be assessed, the report noted.
The Reserve Bank of India has announced a new methodology of setting lending rate by commercial banks under the name Marginal Cost of Funds based Lending Rate (MCLR). It will modify the existing base rate system from April 2016 onwards.
As per the new guidelines by the RBI, banks have to prepare Marginal Cost of Funds based Lending Rate (MCLR) which will be the internal benchmark lending rates. Based upon this MCLR, interest rate for different types of customers should be fixed in accordance with their risk assessment.
The MCLR should be revised monthly by considering some new factors including the repo rate and other borrowing rates. Specifically the repo rate and other borrowing rate that were not explicitly considered under the base rate system.
As per the new guidelines, banks have to set five benchmark rates for different tenure or time periods ranging from overnight (one day) rates to one year.
The new methodology uses the marginal cost or latest cost conditions reflected in the interest rate given by the banks for obtaining funds (from deposits and while borrowing from RBI) while setting their lending rate.
This means that the interest rate given by a bank for deposits and the repo rate (for obtaining funds from the RBI) are the decisive factors in the calculation of MCLR.
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.
The RBI calls the effective passing of repo rate change into interest rate change by the banking system as an important part of monetary transmission. Monetary transmission in complete sense is the way in which a monetary policy signal (like a repo rate cut) is passed into the economy in producing the set objectives.
We may take the case of a repo rate reduction by the RBI. It is aimed to reduce overall interest rate in the economy and thus promoting loans for consumption and investment. This consumption and investment boost will be realized only if banks are cutting interest rate in response to the reduced repo rate.
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.
Negative carry on account of CRR: It 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
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.
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%.
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.
According to the RBI guideline, actual lending rates will be determined by adding the components of spread to the MCLR. Spread means that banks can charge higher interest rate depending upon the riskiness of the borrower.
Powerful element of the MCLR system form the monetary policy angle is that banks have to revise their marginal cost on a monthly basis.
According to the RBI guideline, “Banks will review and publish their MCLR of different maturities every month on a pre-announced date.” Such a monthly revision will compel the banks to consider the change in repo rate change if any made by the RBI during the month.
Regarding the status-quo of base rate, the initial guidelines from the RBI indicate that the Base rate will be replaced by the MCLR. “Existing loans and credit limits linked to the Base Rate may continue till repayment or renewal, as the case may be. Existing borrowers will also have the option to move to the Marginal Cost of Funds based Lending Rate (MCLR) linked loan at mutually acceptable terms.”
How MCLR is different from base rate?
The base rate or the standard lending rate by a bank is calculated on the basis of the following factors:
1. Cost for the funds (interest rate given for deposits),
2. Operating expenses,
3. Minimum rate of return (profit), and
4. Cost for the CRR (for the four percent CRR, the RBI is not giving any interest to the banks)
On the other hand, the MCLR is comprised of the following are the main components.
1. Marginal cost of funds;
2. Negative carry on account of CRR;
3. Operating costs;
4. Tenor premium
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.
But 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.
News On MCLR
The new methodology will come into effect from 1 April 2016 and is expected to curtail banks' ability to hold on to higher base rates despite the RBI slashing rates.
How it works
So far, banks followed diverse methodologies for computing the minimum rate at which they could lend—the base rate.
Now, the RBI has asked all banks to follow the marginal cost of funds method to arrive at their benchmark lending rate. MCLR will be calculated after factoring in banks' marginal cost of funds (largely, the interest at which banks borrow money), return on equity (a measure of bank's profitability), negative carry on account of cash reserve ratio (the cost that banks incur on account of keeping reserves with the RBI), operating costs and tenure premium (longer the loan term, higher the interest/premium).
The actual lending rate will be MCLR plus the spread determined by banks after taking into account their business strategy and credit risk of the borrower, among other parameters.
Banks can review MCLR once a quarter till March 2017, after which they will have have to publish the MCLR on a monthly basis. Lenders will also have to specify the interest reset dates on their floating rate loans. They can either grant loans with reset dates linked to the date of sanction, or the date of MCLR review.
The interest rate charged to a borrower will be applicable until the next reset date. The gap between two reset dates cannot be longer than a year
How it works
So far, banks followed diverse methodologies for computing the minimum rate at which they could lend—the base rate.
Now, the RBI has asked all banks to follow the marginal cost of funds method to arrive at their benchmark lending rate. MCLR will be calculated after factoring in banks' marginal cost of funds (largely, the interest at which banks borrow money), return on equity (a measure of bank's profitability), negative carry on account of cash reserve ratio (the cost that banks incur on account of keeping reserves with the RBI), operating costs and tenure premium (longer the loan term, higher the interest/premium).
The actual lending rate will be MCLR plus the spread determined by banks after taking into account their business strategy and credit risk of the borrower, among other parameters.
Banks can review MCLR once a quarter till March 2017, after which they will have have to publish the MCLR on a monthly basis. Lenders will also have to specify the interest reset dates on their floating rate loans. They can either grant loans with reset dates linked to the date of sanction, or the date of MCLR review.
The interest rate charged to a borrower will be applicable until the next reset date. The gap between two reset dates cannot be longer than a year
State Bank of India (SBI), India’s largest lender, was the first to announce the new marginal cost-based lending rate (MCLR), on 1 April 2016. This is the new benchmark lending rate and it replaces the base rate for new borrowers. SBI has introduced seven MCLRs for periods ranging between overnight and three years. While MCLR will be the benchmark rate for new borrowers, for existing borrowers, the base rate regime will continue.
Marginal cost of funds is the marginal cost of borrowing and return on net worth for banks. The operating cost includes cost of providing the loan product including cost of raising funds. Tenor premium arises from loan commitments with longer tenors
According to brokerage and investment group CLSA, the source of funding for a bank is based on actual domestic funding mix. MCLR is closely linked to the actual deposit rates.
“If one-year term deposit is at 7.50%. Then one-year MCLR will be 7.50% plus CRR, operation cost and tenor premium,” said Ashutosh Khajuria, executive director, Federal Bank Ltd.
The Reserve Bank of India (RBI) has asked banks to set at least five MCLR rates—overnight, one month, three month, six month and one year. Besides these, banks are free to set rates for longer durations as well. The rates have to be reviewed on a monthly basis, but banks that don’t have the capacity to do monthly reviews on can do so quarterly till March 2017.
MCLR-linked loans will be reset for a maximum of one year. So, you will have a new interest rate on your home loan at a pre-decided time and for a maximum period of one year.
Marginal cost of funds is the marginal cost of borrowing and return on net worth for banks. The operating cost includes cost of providing the loan product including cost of raising funds. Tenor premium arises from loan commitments with longer tenors
According to brokerage and investment group CLSA, the source of funding for a bank is based on actual domestic funding mix. MCLR is closely linked to the actual deposit rates.
“If one-year term deposit is at 7.50%. Then one-year MCLR will be 7.50% plus CRR, operation cost and tenor premium,” said Ashutosh Khajuria, executive director, Federal Bank Ltd.
The Reserve Bank of India (RBI) has asked banks to set at least five MCLR rates—overnight, one month, three month, six month and one year. Besides these, banks are free to set rates for longer durations as well. The rates have to be reviewed on a monthly basis, but banks that don’t have the capacity to do monthly reviews on can do so quarterly till March 2017.
MCLR-linked loans will be reset for a maximum of one year. So, you will have a new interest rate on your home loan at a pre-decided time and for a maximum period of one year.
How does MCLR work?
If you plan to take a floating rate home loan, your loan will now be linked to MCLR. Most banks have announced five to seven rates. For home loans, banks will either use the six-month MCLR or the one-year MCLR as the benchmark rate.
Therefore, from now, all floating rate loan agreements will have a reset clause at a pre-specified interval. “Banks can decide on the tenor that they want to use to reset for longer-term loans such as home loans. We have decided to reset home loan interest rates at a six-month frequency. Hence, the six-month MCLR will be applicable for home loans,” said Manian. Kotak Mahindra Bank has announced 9.40% as its six-month MCLR and the home loan will be reset every six months in case of any changes in MCLR. If you have a home loan, the bank will reset the rate automatically at a pre-specified date.
However, banks such as SBI and ICICI Bank Ltd have set one-year MCLR as the benchmark for home loans. For instance, for salaried individuals, ICICI Bank has set a floating rate home loan at one-year MCLR of 9.20% with a spread of 25 bps for loans of up to Rs.5 crore. So, the interest rate will be 9.45%. The bank’s website stated that this will be valid till 30 April 2016.
Though the MCLR is reviewed monthly, your home loan will be reset every year automatically, depending on the agreement with the bank.
For instance, if you take a Rs.30-lakh loan on 1 April this year, one-year MCLR is at 9.20% and spread on it is 25 bps, your home loan will be 9.45%. You will pay instalments at this rate for the next one year. If on 1 April 2017, one-year MCLR gets revised to 9.15%, your home loan interest rate will get reset at 9.40% (MCLR of 9.15% plus spread of 25 bps). Accordingly, your instalment or loan tenor may change.
According to a report by Ambit Capital Pvt. Ltd, RBI gave banks the provision of a reset period to partly smoothen the impact of changing rates on banks’ margins (as deposits re-price with a lag, reset periods allow bank to adjust the timing of loan pricing). As the concept of reset period contravenes with the RBI’s objective of quick transmission of monetary policy, the RBI has capped reset period at one year.
Though retail loans are likely to be set at six months to one-year MCLR tenors, corporate loans may be set at shorter tenors. “Due to complexity in the retail product, a pre-specified reset has been decided. When it comes to corporate loans, there is a possibility to negotiate across the multiple sets of rates that are available,” said Manian.
Can an existing borrower who is on a base rate regime move to MCLR? According to RBI, existing loans and credit limits linked to base rate will continue till repayment or renewal, and banks will have to continue publishing base rates as well. Existing borrowers can move to MCLR-linked loans at mutually acceptable terms and these loans will not be treated as foreclosure of existing facility.
What you should know
The MCLR-linked home loan rate is currently marginally lower than a base rate-linked loan. For instance, SBI was offering home loans between 9.50% and 9.55% till 31 March. From 1 April, the rate is lower by 10 bps and ranges between 9.40% and 9.45%.
According to the Ambit report, new MCLRs are not so different from base rates: “...even if benchmark rates would have fallen, the effective loan pricing for borrowers might not have changed much. This is because banks could change spreads over benchmark rates,” the report noted.
Home loan rates will now depend on the bank’s choice of reset period—six-month or one-year MCLR rate and spread rather than one common base rate and spread. According to a Centrum Broking Ltd report, while MCLR is intended to ensure effective policy transmission, past studies, including references to global banks, suggest limited rate transmission to end-user. Hence, its effectiveness in the longer run will need to be assessed, the report noted.
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