Marginal Cost of funds-based Lending Rate (MCLR)
On December 17, 2015, The Reserve Bank of India (RBI) had issued final guidelines on computing interest rates on advances based on the marginal cost of funds to come to effect on April 1, 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).
As per MCLR, 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.
Currently, 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 Liquidity Adjustment Facility (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.
An observation can be made that, RBI has cut interest rates to the tune of 150 basis points in this fiscal year. But, this has not been effectively transmitted to lending rates offered by banks. Banks has so far lowered their base rate by only 50 – 60 basis points.
The purpose of changing the repo rate is realised only if the banks are changing their individual lending and deposit rates.
The key element of the MCLR system is that it facilitates the 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.
Calculation of MCLR
‘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;
The marginal cost of funds will comprise of Marginal cost of borrowings and return on net worth. According to the RBI, the Marginal Cost should be charged on the basis of following factors:
a. Interest rate given for various types of deposits- savings, current, term deposit, foreign currency deposit
b. Borrowings – Short term interest rate or the Repo rate etc., Long term rupee borrowing rate
c. Return on net worth – in accordance with capital adequacy norms.
2. 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.
3. Operating costs;
It is the operating expenses incurred by the banks
4. Tenor premium.
It denotes that higher interest can be charged from long term loans.
The marginal cost of borrowings shall have a weightage of 92% of Marginal Cost of Funds while return on net worth will have the balance weightage of 8%.

RBI’s key guidelines on MCLR

• All loans sanctioned and credit limits renewed w.e.f April 1, 2016 will be priced based on the Marginal Cost of Funds based Lending Rate.
• MCLR will be a tenor-based benchmark instead of a single rate. This allows banks to more efficiently price loans at different tenors based on different MCLRs, according to their funding composition and strategies.
• Banks have to review and publish their MCLR of different maturities every month on a pre-announced date.
• The final lending rates offered by the banks will be based on by adding the ‘spread’ to the MCLR rate.
• Banks may specify interest reset dates on their floating rate loans. They will have the option to offer loans with reset dates linked either to the date of sanction of the loan/credit limits or to the date of review of MCLR.
• The periodicity of reset can be one year or lower.
• The MCLR prevailing on the day the loan is sanctioned will be applicable till the next reset date.
• Existing borrowers with loans linked to Base Rate can continue with base rate system till repayment of loan. An option to switch to new MCLR system will also be provided to the existing borrowers.
• Once a borrower of loan opts for MCLR, switching back to base rate system is not allowed.
• Loans covered by government schemes, where banks have to charge interest rates as per the scheme are exempted from being linked to MCLR.
• Like base rate, banks are not allowed to lend below MCLR, except for few categories like loans against deposits, loans to bank’s own employees.
• Fixed Rate home loans, personal loans, auto loans etc., will not be linked to MCLR.

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.

Disadvantages
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.

Conclusion
As per the guidelines, MCLR will be automatically applicable on fresh loans extended by the bank. Whereas, existing loan holders have a choice to either stay with original BPLR framework or convert into MCLR framework.
Since MCLR is directly regulated by RBI, it is more beneficial for existing loan holders to convert as they won’t have to be completely dependent upon workings of a banks base rate. Even, transmission of any rate cut announced by RBI will be easily accessible at the reset date. MCLR is a far more convenient and beneficial option.
References:
RBI Press Release – https://rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=35749
RBI Guidelines on December 17, 2016 – https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=10179&Mode=0