RBI has introduced Marginal Cost of Funds based Lending Rate (MCLR) to improve transparency in the methodology used by banks computing interest rates on advances. MCLR is also expected to enhance the transmission of policy rates into the lending rates of banks.
The fact that credit risk premium is extremely high in the system due to the huge NPA’s being reported by banks (third quarter 2015-16 results of banks shows huge rise in NPA’s), RBI policy rates are not likely to result in lower lending rates.
At present banks are using average cost of funds or blended cost of funds to determine their base rate. Base Rates based on marginal cost of funds are more sensitive to changes in the policy rates, to improve the efficiency of monetary policy transmission, the Reserve Bank is encouraging banks to move to marginal cost of funds based base rates.
What is Marginal Cost of Funds based Lending Rate (MCLR)?
The MCLR is a tenor linked internal benchmark. It is a minimum lending rate of a particular maturity for all loans linked to that benchmark
It has four component Marginal cost of funds, Negative carry on account of CRR, Operating Costs, Tenor Premium.
Taking each one by turn.
The marginal cost of funds comprises of Marginal cost of borrowings and return on net worth.
Marginal cost of funds = 92% x Marginal cost of borrowings + 8% x Return on net worth
Negative carry on CRR arises due to the fact that return on CRR balances is nil, it is calculated as
Required CRR x (marginal cost) / (1- CRR)
All operating costs associated with providing the loan product including cost of raising funds is included in the MCLR
Tenor premium is uniform for all types of loans for a given residual tenor
Banks need to publish the internal benchmark for following maturities every month on a pre-announced date- overnight, one-month, three-months, six months, one year.
Actual lending rates is calculated by adding the components of spread to the MCLR. Business strategy spread (which considers the business strategy, market competition, embedded options in the loan product, market liquidity of the loan) and credit risk premium spread are considered.
On floating rate loans banks specify interest reset dates with the periodicity of reset being one year or lower.
For the new borrowers, on the day loan is sanctioned, MCLR is applicable till the next reset date, irrespective of the changes in the benchmarks during the interim period. Existing borrowers have the option to move to the MCLR linked loan at mutually acceptable terms.
Special loans covered under Government of India scheme, Working Capital Term Loan (WCTL), Funded Interest Term Loan (FITL), advances to banks’ depositors against their own deposits. advances to banks’ own employees including retired employees, advances granted to the Chief Executive Officer / Whole Time Directors, loans linked to a market determined external benchmark and fixed rate loans granted by banks.
Example of MCLR
Marginal cost of borrowings – 7%
Return on net worth – 10%
Marginal cost of funds = 92%*7% + 8%*10% = 7.24%
Negative carry = 4%*7.24%/(1-4%) = 0.30%
Operating cost – 0.50%
5 years loan tenor premium – 0.60%
Marginal Cost of Funds based Lending Rate (MCLR) = 7.24%+0.30%+0.50%+0.60% = 8.64%
Actual lending rate = Marginal Cost of Funds based Lending Rate (MCLR) + Business strategy spread + Credit risk premium spread
Assuming Business strategy spread = 1% and Credit risk premium spread = 2%
Then actual lending rate is = 7.24%+1%+2%= 10.24%