MCLR -Marginal Cost of funds based Lending rate(New lending rate calculation proposed by RBI)

The Reserve Bank of India has issued new guidelines for setting lending rate (interest rate on loans) by commercial banks under the name Marginal Cost of Funds based Lending Rate. Till 31 March 2016, banks used the base rate as the benchmark rate to lend. The marginal cost of funds based lending rate (MCLR) refers to the minimum interest rate of a bank below which it cannot lend, except in some cases allowed by the RBI. MCLR actually describes the method by which the minimum interest rate for loans is determined by a bank.

Reasons for introduction of MCLR(Marginal Cost of funds based Lending rate) by RBI

You might have noticed that RBI has cut interest rates to the tune of 125 basis points in last fiscal year(2015-16). 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. Same is the case when interest rates are increased by the RBI. If RBI increases rates by say 100 basis points, banks increase their benchmark rates by say 50 basis points. Benefits of  Interest rate cut by RBI has not reached common people. So, as a result  the ‘base rate system’ has become an ineffective method to determine lending rates.  

Prior to MCLR system, different banks were following different methodology for calculation of base rate /minimum rate – that is either on the basis of average cost of funds or marginal cost of funds or blended cost of funds. 

Calculation of base rate

Before going deep into the MCLR lets understand how ‘base rate is calculated’ so far.

The main components of base rate system are;

1. Cost of funds -interest rates offered by banks on deposits)
2. Operating expenses to run the bank.
3. Minimum Rate of return ie margin or profit
4. Cost of maintaining CRR (Cash Reserve Ratio).

Note:RBI does not pay any interest rate on CRR. By including cost of  maintaining CRR in base rate calculation RBI is indirectly allowing banks to  recover cost of CRR from their customers .

As you can see ‘repo rate’ is not considered in base rate calculation.This was the main drawback of base rate system followed by banks.

Calculation of MCLR

As per RBI guidelines The MCLR shall comprise of:

1. Marginal cost of funds;
2. Negative carry on account of CRR;
3. Operating costs;
4. Tenor premium.

1.Marginal Cost of funds
The marginal cost of funds shall comprise of Marginal cost of borrowings and return on networth. 

Definition of marginal cost: The increase or decrease in costs as a result of one more or one less unit of output.

Instead of cost of funds(used in base rate system) banks have to consider changed cost or marginal cost in calculating MCLR.

Banks should consider following factors while calculating marginal cost of funds

• Interest rates offered on savings / current / term deposit accounts/ Foreign currency deposits
• Marginal cost of borrowings: short term borrowing rate which is repo rate and rate on long-term borrowing rates.
• Return on Net-worth

You can see Repo rate is also considered while calculating Marginal cost of borrowings. 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%. 

Detailed explanation of Marginal cost of fund is tabulated below.

2.Negative Carry on CRR

Negative carry on the mandatory CRR which arises due to return on CRR balances being nil, will be calculated as under:(As we have seen above in base rate calculation, no interest is paid on CRR).
Negative Carry on CRR=Required CRR x (marginal cost) / (1- CRR).
The marginal cost of funds arrived at (1) above shall be used for arriving at negative carry on CRR.

3.Operating Costs
All operating costs associated with providing the loan product including cost of raising funds shall be included under this head. It shall be ensured that the costs of providing those services which are separately recovered by way of service charges do not form part of this component.

4.Tenor premium
These costs arise from loan commitments with longer tenor. The change in tenor premium should not be borrower specific or loan class specific. In other words, the tenor premium will be uniform for all types of loans for a given residual tenor.

Marginal Cost of funds calculation in details

Sl	Source of funds (excluding equity)	Rates offered on deposits on the date of review/ rates at which funds raised (1)	Balance outstanding as a percentage of total funds (other than equity) (2) (See note below)	Marginal cost (1) x (2)	Remarks
A	Marginal Cost of Borrowings
1	Deposits
a	Current Deposits				The core portion of current deposits identified based on the guidelines on Asset Liability Management issued vide circular dated October 24, 2007 should be reckoned for arriving at the balance outstanding.
b	Savings Deposits				The core portion of savings deposits identified based on the guidelines on Asset Liability Management issued vide circular dated October 24, 2007 should be reckoned for arriving at the balance outstanding.
c	Term deposits (Fixed Rate)				Term deposits of various maturities including those on which differential interest rates are payable should be included.
d	Term deposits (Floating Rate)				The rate should be arrived at based on the prevailing external benchmark rate on the date of review.
e	Foreign currency deposits				Foreign currency deposits, to the extent deployed for lending in rupees, should be included in computing marginal cost of funds. The swap cost and hedge cost of such deposits should be reckoned for computing marginal cost.
2	Borrowings
a	Short term Rupee Borrowings				Interest payable on each type of short term borrowing will be arrived at using the average rates at which such short term borrowings were raised in the last one month. For eg. Interest on borrowings from RBI under LAF will be the average interest rate at which a bank has borrowed from RBI under LAF during the last one month.
b	Long term Rupee Borrowings				Option 1: Interest payable on each type of long term borrowing will be arrived at using the average rates at which such long term borrowings were raised. Option 2: The appropriate benchmark yield for bank bonds published by FIMMDA for valuation purposes will be used as the proxy rate for calculating marginal cost.
c	Foreign Currency Borrowings including HO borrowings by foreign banks (other than those forming part of Tier-I capital)				Foreign currency borrowings, to the extent deployed for lending in rupees, should be included in computing marginal cost of funds. The all-in-cost of raising foreign currency borrowings including swap cost and hedge cost would be reckoned for computing marginal cost of funds.
	Marginal cost of borrowings				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%.

B

Return on networth

Amount of common equity Tier 1 capital required to be maintained for Risk Weighted Assets as per extant capital adequacy norms shall be included for computing marginal cost of funds. Since currently, the common equity Tier 1 capital is (5.5% +2.5%) 8% of RWA, the weightage given for this component in the marginal cost of funds will be 8%. In case of newly set up banks (either domestic or foreign banks operating as branches in India) where lending operations are mainly financed by capital, the weightage for this component may be higher ie in proportion to the extent of capital deployed for lending. This dispensation will be available for a period of three years from the date of commencing operations. The cost of equity will be the minimum desired rate of return on equity computed as a mark-up over the risk free rate. Banks could follow any pricing model such as Capital Asset Pricing Model (CAPM) to arrive at the cost of capital. This rate can be reviewed annually.

Marginal cost of funds = 92% x Marginal cost of borrowings + 8% x Return on networth

Calculation of actual lending rate

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.

Difference between MCLR and Base Rate

As we have seen already the base rate or the standard lending rate by a bank is calculated on the basis of the following factors:

1. Cost of funds -interest rates offered by banks on deposits)
2. Operating expenses to run the bank.
3. Minimum Rate of return ie margin or profit
4. Cost of maintaining CRR (Cash Reserve Ratio).

On the other hand, the MCLR is comprised of the following are the main components.

1. Marginal cost of funds;
2. Negative carry on account of CRR;
3. Operating costs;
4. Tenor premium.

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.

Transition to MCLR from Base Rate/ BPLR

According to RBI

(a) Banks shall continue to review and publish Base Rate as hitherto.
(b) Existing loans and credit limits linked to the Base Rate/ BPLR shall continue till repayment or renewal, as the case may be.

Provided that existing borrowers shall have the option to move to the Marginal Cost of Funds based Lending Rate (MCLR) linked loan at mutually acceptable terms.

This article is prepared based on the information available on official site of RBI.Here you can read it in details Master Direction - Reserve Bank of India (Interest Rate on Advances) Directions, 2016

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