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Marginal Cost of Funds based Lending Rate (MCLR)- issues of concern
by Tilak Gulati

Reserve Bank of India has directed  banks to adopt  Marginal Cost of Funds based Lending Rate (MCLR) for determining their respective Base Rates. It is felt that banks are not passing the benefit of reduction in RBI policy rates  to  borrowers. During last one year, RBI has cut the repo rates by 125 basis points but banks reduced their base rates by an average of 60 basis points only. Reason:  bankers  are not dependent on market borrowings and their major portion of liabilities are deposits and a cut in repo rate does not automatically lead to decline in proportionate  cost of deposits.


Base Rate is the minimum lending rate below which banks are not allowed to lend  (exceptions:  DRI advances, loans to bank's own employees, loans to banks' depositors against their own deposits, working capital term loan & funded interest term loan granted under restructuring package). 




Benchmark Prime Lending Rate (BPLR) system was introduced in India in 2003 but it fell short of bringing transparency to lending rates since banks were allowed to lend below BPLR. It resulted in charging lower interest rates to big corporates where as the needy small borrowers were paying much higher  rates. The opaque nature of BPLR also bred  corruption.


To bring in more transparency in system, Base Rate system  was implemented on July 1, 2010 under which banks were allowed to calculate cost of funds either on the basis of average cost of funds or on marginal cost of funds or any other methodology  which was reasonable and transparent. However, banks started frequently changing the methodology as per their convenience.



Concept of MCLR


With effect from 1st April, 2016, all loans in India shall be priced with reference to Marginal Cost of Funds based Lending Rates (MCLR) which will comprise of :-


            a. Marginal Cost of Funds


            b. Negative carry on account of CRR


            c. Operating Costs


            d. Tenor of premium.


Banks shall review and publish their MCLR every month on a pre-announced date.


a. Marginal Cost of Funds


Marginal Cost of Funds will comprise of marginal cost of borrowings and return on net-worth.


i.     Marginal Cost of Borrowings will be calculated using latest interest rates payable on various deposits. Formula:  Rates offered on deposit on the date of Review/ rates at which funds raised  X  Balance outstanding as on the previous day of review as a percentage of total funds  =  Marginal cost of borrowings.


ii.    Return on Net-worth can be computed using any pricing model such as Capital Asset Pricing Model.


Marginal cost of Borrowings will carry 92% weightage whereas Return on Net-worth will carry 8% weightage while calculating Marginal Cost of Funds.



b. Negative carry on account of CRR

Banks have to keep mandatorily certain percentage of their deposits in Cash Reserve Ratio (4%) with RBI on which the return is nil. The cost incurred on securing this deposit is straight loss and banks have to provide for it. The marginal cost of funds arrived at as a. above will be used for arriving at negative carry on CRR.


 c. Operating Costs

All operating costs associated with providing loans  including cost of raising funds will be included under this head.


d. Tenor of premium

These costs arise from loan commitments with longer tenor. The longer the tenor, the higher the risk associated with loan sanctioned.  Since MCLR will be tenor linked benchmark, banks shall arrive at the MCLR of a particular maturity by adding the corresponding premium to the sum of Marginal cost of funds, Negative carry on account of CRR and Operating costs.


However, depending upon the risk profile of the borrower, actual lending rates will be determined by adding the components of spread to the Base Rate; this spread is called Credit Risk Premium and it varies for each customer. The credit risk premium represents the default risk arising from loan sanctioned based upon an appropriate credit risk rating/scoring model after  taking into consideration customer relationship, expected losses, collateral etc.


Cost of Funds is the major and only flexible portion in computation of interest rates. Other components do not provide  much maneuverability  as banks have to account for the loss incurred for keeping CRR with RBI, operating costs are inelastic in short term and the tenor premium is the cost of loan commitments for longer tenor.


Of course, with new approach, borrowers will be benefited as interest rates are declining, but there are certain issues which need to be addressed;-


1.      Against RBI’s rate cut of 125 basis points in the last one year, banks have pared their deposit rates by around 100 basis points and Base Rates by an average of 60 basis point. The reason? Decrease in deposit rates are applicable on future deposits only (immediately not impacting the average cost of deposits to banks) whereas change in Base Rate becomes applicable on existing loans as well. Since the latest card rates payable on deposits will be accounted for to calculate cost of deposits, it will put a strain over the profitability of banks in the short-term. In the present, falling-interest-rate scenario, the new approach suits the borrower, the regulator and the government. But what will happen after three-four years when average cost of deposits to the banks will be low (due to assimilation of present declining interest rate structure), but interest rates may start rising? This new approach may not be conducive to these stakeholders.


2.      RBI has given a cushion to bankers by allowing the reset clause in interest rates on all loan accounts for a period of one year. This way, the adverse impact of base rate reduction will be gradual on the interest income of banks. Why can’t we think of floating rates on deposits with inbuilt re-set clause? This will be a more level playing field. To take care of small depositors, floating rates may be implemented above a cut-off limit of deposits, say Rs one lac


3.      Banks have flexibility over interest rates on term deposits only. What about the savings deposits where rate is fixed at 4%, in spite of RBI deregulating it? Why is RBI not able to break this cartelisation or whatever it may be called, where weak banks are forced to toe the line drawn by big banks?


(Part of this blog was published in "The Financial Express" on 25.12.2015 under 'Letters to the Editor" link: http://www.financialexpress.com/article/india-news/letters-to-the-editor-324/183745/ )