January 7, 2017 No Comment. Posted in Financial Literacy

The reference rate is a benchmark upon which interest rates for financial operations are set. On the basis of reference rates banks and financial institutions decided their lending rates for different financial products considering the credit worthiness of the customer.

The reference rates differ for every bank and financial institution and is directly relative to the repo rate which is governed by RBI. This is the rate at which Banks borrows money from RBI. It’s the lending rate of the central bank. So if central bank increases the Repo rate it is not good news for banks as they have to borrow money at high cost. This compels banks to increase their lending rates as they get money at high rates

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).

During different times banks and FI  have used different methodology benchmark reference rates,  In the year 2003 RBI introduced the concept of Benchmark Prime Lending Rate (BPLR) or commonly termed as Prime Lending Rate (PLR).

Benchmark Prime Lending Rate (BPLR) 

It is the rate at which commercial banks charge their customers who are most credit worthy. According to the Reserve Bank of India (RBI), banks can fix the BPLR with the approval of their Boards. However, the RBI stipulates the interest rates as BPLR is influenced by the Repo rate and Cash Reserve Ratio (CRR) apart from individual bank’s policy.

BPLR was calculated by taking into considerations

  • Cost of Funds
  • Operational expenses
  • A minimum margin to cover regulatory requirements like CRR.
  • Profit margin of banks.

Challenges with Benchmark Prime lending Rates

The BPLR system failed to bring transparency in the lending rates of the banks. The calculations of BPLR was not that transparent. BPLR was the rate at which a bank were willing to lend to its most trustworthy, low-risk customer. However, often banks lend at rates below BPLR. For example, most home loan rates are at sub-BPLR levels. Some large corporate also get loans at rates substantially lower than BPLR.

To improvise on the reference rate method and for better transparency in interest rates, RBI introduce the concept of Base Rate in July 2010 and directed Banks and FI to migrate to the new system of calculating the interest rates.

Base Rate

Base rate is the minimum rate set below which banks are not allowed to lend to its customers, except for loans to its own employees, its retired employees and against bank’s own deposits. The base rate system has replaced the BPLR from July 1, 2010. Since then the BPLR is gradually losing its importance except for the loans taken before July 1, 2010. In such cases, RBI has allowed to continue with BPLR at which the loans were approved. Customer were, however, given the option of switching to the base rate before the expiry of their loans. This switching of reference rate happens by paying a switch fee a percentage charged over the principal outstanding of the loan.

How is the base rate calculated?

A host of factors, like the cost of deposits, administrative costs, a bank’s profitability in the previous financial year and a few other parameters, with stipulated weights, are considered while calculating a lender’s base rate. The cost of deposits has the highest weight in calculating the new benchmark. Banks, however, have the leeway to take into account the cost of deposits of any tenure while calculating their Base rate.

Challenges with Base Rate

Base rate system was introduced by RBI in July 2010 to ensure that banks can not lend below a certain benchmark. Also, to ensure that the changes in interest rate policy is effectively transmitted to the bank customers. However, policy transmission could not become very effective as banks adopted various methods in calculating their cost of funds. At present, the banks are slightly slow to change their interest rate in accordance with Repo Rate change by the RBI.

RBI does not fix the base rate. Individual banks fix their own base rates and so each bank has its own base rate.

You might have observed that RBI has cut interest rates to the tune of 125 basis points in this fiscal year. But, this has not been effectively transmitted to lending rates offered by the banks. Banks have so far lowered their base rate by only 50-60 basis points. However, your home loan EMI has not gone down that quickly. Banks have been reluctant to pass on these rate cuts (in form of lower interest rates) to borrowers.

Banks have been giving one excuse or the other for not reducing lending rates. Since  lending rate was linked to the Base Rate. There was just one base rate for all the loans.  You were given loan at Base Rate + Spread. This Spread was constant during the term of the loan (could be changed only in case of default or breach of terms of the loan agreement).  If the bank reduced Base Rate, interest rate on both new loans and old loans will go down.

In case of rate cuts by the Reserve Bank, banks could always say that even though the cost of fresh borrowing has gone down, they have legacy deposits for which the interest rate remains high.

There was nothing beyond a point that RBI could do to ensure quick transmission of interest rate cuts.

To counter this, RBI has introduced MCLR so that banks link their lending rates to marginal funding costs (MCLR). RBI issued a notification that from 1st April 2016, the base rate of banks needs to be based on the Marginal cost of funds.

Marginal cost of Fund base lending rate(MCLR)

MCLR is the new benchmark lending rate at which banks will now lend to new borrowers. With MCLR, the RBI wants to ensure that the lending costs are in line with the cost of fresh (incremental) borrowing. Hence, if the bank cuts the rates on deposits, it will automatically have to transmit the cut in deposit rates to lending rates. By cutting the deposit rates, the bank brings down its marginal cost of funds because it can raise deposits at a lower interest rate.

So, the rationale is simple. If you can borrow at lower rates, lend at lower rates.

MCLR is built on four components—marginal cost of funds, negative carry on account of cash reserve ratio (CRR), operating costs and tenor premium.

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 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,”.

How is MCLR calculated?

You can expect MCLR to be linked to fresh (incremental) cost of borrowing. However, there is more to it. Borrowing is not just rates of fixed deposits. It includes current account balances, savings account balances, wholesale borrowings, borrowings from RBI.

Still, there is more to it. Let’s look at various components of MCLR.

  1. Marginal Cost of FundsThis is cost of fresh (incremental) borrowing to the bank. It takes into account interest rates of different types of deposits (current, savings, term deposits etc). Marginal cost of funds is not just the deposits (borrowings) that the bank has accepted. There is some equity too. Hence, cost of equity is also considered. This is as per the RBI guidelines.

Marginal cost of funds = Marginal cost of Borrowing X 92% + Return on Net worth X 8%.

2.Negative Carry on Cash Reserve Ratio: Banks have to keep a certain level (4% as on April 5, 2016) of their deposits with the Reserve Bank. This ratio is the Cash Reserve Ratio (CRR). Banks don’t earn any interest on the amount. Essentially, they can use 96% of the deposits for lending and the remaining 4% does not earn the bank anything. RBI has allowed some weightage to decide MCLR basis this adjustment.

3.Operating CostsBank’s operating costs are not limited to interest it pays on deposits . There are expenses on salaries, branch rent or other expenses that are not directly charged to the customers. Cost of raising funds is also included under this head.

4.Tenor Premium/DiscountHigher the loan tenor, higher the tenor premium. Tenor refers to the period of interest rate reset. Even though your loan tenor is 15 years but if the loan reset is done every year, 1-year MCLR will be applicable.

The Reserve Bank has directed banks to set at least 5 MCLR rates viz. overnight, 1 month, 3 months, 6 months and 1 year. The banks can choose to have more (for longer tenors).

MCLR is merely to assess the cost of funds to the banks. The banks will also charge a premium based on your credit worthiness. The spread may depend on your credit score or bank’s assessment of your repayment ability.

The banks can change the spread in MCLR linked loans (could not do so earlier in base rate regime). However, it is not so easy.

The spread charged to a customer can be increased only in case of deterioration of credit risk profile of the borrower such as default in repayment etc. Such decision must be supported by complete risk profile review of the borrower. Hence, increasing the spread may become operationally difficult for the banks.

Advantages of Linking MCLR with Base rate

The main differences between the two calculations are i) marginal cost of funds & ii) tenor premium.  Operating expense and CRR remains common for both the methodology and past profitability if banks nowhere considered in calculating the MCLR. The marginal cost of funds will have high weight age while calculating MCLR. So, any change in key rates like repo rate brings changes in marginal cost of funds and hence the MCLR should also be changed by the banks immediately.

Some Disadvantages of MCLR

  • Spread on MCLR– Though RBI has linked base rate to marginal cost of funds, further linking it to repo rate, the spread over the MCLR is still under the control of the Banks and FI.
  • Interest Reset dates- The change in MCLR will only be reviewed on the predefined reviewal dates irrespective of changes in Repo Rate at any point of time .
  • Switch Charges for MCLR- The borrower who has taken the loan in base rate regime have to pay a switch fee which is a percentage of principal outstanding to avail the benefits.
  • Not applicable to all class of borrower- MCLR is only applicable to floating rate of Interest. The concept will not be applicable for borrower on fixed rate as well as borrower availing personal loan or auto loans.

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 (irrespective of changes in the benchmark rates during the interim period). For example, if the bank has given you a one-year reset period in your loan agreement, and your base rate at the beginning of the year is say 10%, even if the interest rate comes to 9% in the middle of the year, you will continue at 10% till the reset date. Same will be the case even if the interest rate increases above 10%.
  • Existing borrowers with loans linked to Base Rate can continue with base rate system till repayment of loan (maturity). 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.
  • 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.