What is 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.

• Marginal cost of funds.
• Negative carry on account of CRR.
• Operating costs.
• Tenor premium.

Negative carry on account of CRR: 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:

• Interest rate given for various types of deposits- savings, current, term deposit, foreign currency deposit.
• Borrowings – Short term interest rate or the Repo rate etc., Long term rupee borrowing rate.
• 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%.

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.”

The base rate or the standard lending rate by a bank is calculated on the basis of the following factors:

• Cost for the funds (interest rate given for deposits)
• Operating expenses,
• Minimum rate of return (profit), and
• 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.

• Marginal cost of funds
• Negative carry on account of CRR
• Operating costs
• 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:

• Costs that the bank is incurring to get funds (means deposit) is calculated on a marginal basis.
• The marginal costs include Repo rate; whereas this was not included under the base rate.
• Many other interest rates usually incurred by banks when mobilizing funds also to be carefully considered by banks when calculating the costs.
• The MCLR should be revised monthly.
• A tenor premium or higher interest rate for long term loans should be included.

1. Whether the tenor premium charged will be for contractual tenor or residual tenor?
   Since floating rate loans are subject to periodic resets, the tenor premium will be the appropriate premium for the residual period up to the next reset date.
2. What will be the denominator used for arriving at the operating cost for computing MCLR?
   Banks may calculate all operating costs as a percentage of marginal cost of funds for computing MCLR.
3. Clarify the definition of short term borrowings.
   A short term borrowing means borrowing of tenor up to but less than one year.
4. Can components of spread be negative?
   The components of the spread i.e. business strategy and Credit risk premium shall have either a positive value or be zero. In other words, the spread components cannot be negative.
5. Banks grant fixed rate loans to long term projects where initial debt facility consists of loan for a medium term say 5 to 7 years. These loans are then refinanced after the specified period. Will these types of loans be permitted under MCLR system?
   Banks can grant fixed rate loans to long term projects wherein the interest rate are fixed till the loan is due for refinancing. The loan, at the time of refinancing, will be treated as a fresh fixed rate loan with a maturity period equal to the period upto the next date of refinancing. Such fixed rate loans will fall under the directions contained in Section 13(d)(v) of Reserve Bank of India (Interest Rate on Advances) Directions, 2016.
6. Will the interest rates on fixed rate loans (or fixed portion of hybrid loans) be based on the date of sanction or disbursement?
   The interest charged on fixed rate loans as well as the fixed portion of hybrid loans will be the interest rate mentioned in the sanction letter.