Marginal Cost of Funds-based Lending Rates (MCLR) – Explained, pointwise

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Introduction

State Bank of India has raised the marginal cost of funds-based lending rates (MCLR) for the first time in three years. SBI raised the MCLR by 10 basis points (bps) across tenures to 7.1% (from 7% earlier). Other public sector and private banks are set to raise MCLRs in the coming days. It signals that the soft rates regime that has prevailed since 2019 may be over. As a result, borrowers who have taken home, vehicle, and personal loans will find their equated monthly instalments (EMIs) rising in the coming months.

What is MCLR?

It is the minimum interest rate that a bank can lend at. The final rate of lending also includes risk premium and spread charged by banks.

MCLR is a tenor-linked internal benchmark, which means the rate is determined internally by the bank depending on the period left for the repayment of a loan.

MCLR is closely linked to the actual deposit rates and calculated based on four components: (a) The marginal cost of funds; (b) Negative carry on account of cash reserve ratio; (c) Operating costs; (d) Tenor premium.

Under the MCLR regime, banks are free to offer all categories of loans on fixed or floating interest rates.

Fixed-rate loans with tenors of up to three years are also priced according to MCLR. Banks review and publish MCLR of different maturities, every month. 

Certain loan rates, like that of fixed-rate loans with tenors above three years and special loan schemes offered by the government, are not linked to MCLR.

Key Terminologies

Repo Rate: It is the rate at which the central bank of a country (Reserve Bank of India in case of India) lends money to commercial banks in the event of any shortfall of funds.

Reverse Repo Rate: It is the rate at which the central bank of a country (Reserve Bank of India in case of India) borrows money from commercial banks within the country.

Standing Deposit Facility: It allows banks to park their excess funds at a higher rate but without taking any collateral from the central bank.

Internal Benchmark Lending Rate (IBLR): These are a set of reference lending rates which are calculated after considering factors like the bank’s current financial overview, deposits and non performing assets (NPAs) etc. Some of IBLR include Base rate, MCLR etc..

External Benchmark Lending Rate (EBLR): Under this, lending rate is linked to a benchmark rate. RBI has offered banks the option to choose from 4 external benchmarking mechanisms: (a) The RBI repo rate; (b) The 91-day Treasury-bill yield; (c) The 182-day Treasury-bill yield; (d) Any other benchmark market interest rate as developed by the Financial Benchmarks India Pvt. Ltd.

What is the background of MCLR?

The Reserve Bank of India introduced the MCLR methodology for fixing interest rates from 1 April 2016. It replaced the base rate structure, which had been in place since July 2010.

What is the difference between MCLR and Base Rate?

  • MCLR is an advanced version of the base rate.
  • The base rate uses the average finance cost, but MCLR is based on the marginal or incremental cost of money.
  • When calculating the base rate, a minimum rate of return/profit margin is used, whereas, for MCLR, banks are required to include tenor premium into the calculation. Tenor is the amount of time left for repayment of the loan. Higher the duration of the loan, higher will be the risk. Thus banks charge a higher rate of interest for long-term loans.

MCLR is applicable to corporate loans and floating rate loans taken before October 2019. RBI had then switched to the external benchmark linked lending rate (EBLR) system where lending rate is linked to benchmark rates like repo or Treasury Bill rates.

The banks failed to reduce the interest rate in spite of lower repo rates under the IBLR regime. This impeded the monetary policy transmission and gave way to External Benchmark Lending Rates.

Banks linked their EBLR to the RBI’s repo rate, which declined from 5.40% to 4% since October 2019. When the RBI hikes the repo rate, EBLR goes up and vice versa. 

MCLR-linked loans had the largest share (53.1%) of the loan portfolio of banks as of December 2021. The share of EBLR loans in total advances was 39.2% in December 2021, according to the RBI.

Why was MCLR introduced?

It ensures that banks must adjust their Interest Rates as soon as the repo rate changes.

It is implemented to bring transparency and uniformity in the interest rate on advances given by banks. 

It ensures that the interest rate on loans is equally fair and beneficial for the banks and the borrowers. As a result, it helps banks improve their long-run value and become more competitive using marginal cost pricing of loans.

Why has MCLR been hiked?

First, the ‘extraordinary’ liquidity measures undertaken in the wake of the pandemic, combined with the liquidity injected through various other operations of the RBI have left a liquidity overhang of the order of Rs 8.5 lakh crore in the system. 

Banks expected the repo rate — the main policy rate — to go up from June onwards as the RBI seeks to suck out liquidity from the system to rein in inflation. Therefore banks were apprehensive of an interest rate hike.

Second, the yield on 10-year benchmark government bonds has reached 7.15%, rising 24 bps in less than 2 weeks. This indicated an upward pressure on interest rates as a rising yield increases the cost of funds.

Third, On April 8, the RBI’s Monetary Policy Committee restored the policy rate corridor under the liquidity adjustment facility to the pre-pandemic width of 50 bps. It introduced the Standing Deposit Facility (SDF) at 3.75 as the floor of this corridor.

SDF is an additional tool employed by the RBI to absorb excess liquidity. In essence, overnight rates were hiked to 3.75% and SDF made the reverse repo rate redundant for now.

What impact does an increase in MCLR have?

First, borrowers who have taken home, vehicle, and personal loans will find their equated monthly installments (EMIs) rising in the coming months.

Second, it would be more costlier to procure loans as people would now have to pay higher interest rates than the past levels. This may lead to crowding out of various potential loan seekers.

Third, according to the SBI research report, deposit rates are likely to “increase meaningfully” over the next one-two months. SBI now offers 5.10% interest in the 1-2-year bucket. 

This means a fixed deposit holder is sitting on a negative return of 185 basis points, as inflation is now at 6.95%.  However, rising MCLR will help increase deposit rates.

What lies ahead?

First, the RBI is set to withdraw the accommodative policy (the willingness to expand money supply to boost economic growth) as retail retail inflation was at 6.95% in March and wholesale inflation at 14.55%. This will increase the lending rates in the coming months.

Second, the US Federal Reserve recently announced a tightening of the policy and raised interest rates. This will create pressure on Indian banks to raise interest rates. 

Third, given that the spread between bond yields and repo rate jumps in an increasing interest rate cycle, bond yields could touch 7.75% by September.

Fourth, people who have sufficient savings can prepay their loans or atleast enhance their EMI amount in order to reduce the burden of rising MCLR in future.

Conclusion

The next round of rate hikes is expected around May-June 2022. However, the rise in rates is likely to be gradual. The rise in rate is imperative to control the inflation and move up from the historic low levels as both policy rates were last reduced in May 2020, with repo at 4% and reverse repo at 3.35%, and have since been kept at these historic lows.

Source: Indian Express, Indian Express, Mint

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