Marginal Cost of Funds based Lending Rate (MCLR) - Indian Economy Notes

The Marginal Cost of Funds based Lending Rate (MCLR) is the minimum lending rate below which a bank is not allowed to lend. The MCLR system superseded the previous base rate mechanism in determining commercial bank lending rates. The MCLR system uses the marginal cost of funds, tenor premium, operating costs, and cost of carry in CRR (Cash Reserve Ratio) to determine the lending rate.

In this article, let us see the meaning of MCLR, how is it calculated, and the differences between base rate and MCLR.

Table of Contents

MCLR
Illustration
MCLR Calculation
Reasons
Difference Between Base Rate and MCLR
Conclusion
FAQs
MCQs

MCLR

What is MCLR?

The Marginal Cost of Funds based Lending Rate (MCLR) is the minimum lending rate below which a bank is not allowed to lend.
On April 1, 2016, the RBI implemented the MCLR to set lending interest rates.
It's an internal reference rate that banks use to figure out how much interest they can charge on loans.
Following the installation of MCLR, interest rates are calculated based on each customer's relative risk factor (creditworthiness).
When the RBI cut the repo rate in the past, banks took a long time to reflect the change in lending rates for borrowers.
Banks must modify their interest rates as soon as the repo rate changes under the MCLR regime.

Other Relevant Links
Base Rate	External Benchmarking
Banking Sector in India	Function of RBI
Narrow Money	Broad Money

Illustration

The below table illustrates lending by both Bank A and Bank B for the Agriculture sector for customers of different CIBIL scores or creditworthiness.

Customer 1 - Low credit risk

Parameter	MCLR	Credit Risk (Agri)	Custom Credit Risk	Total lending rate
Bank A	6	0.2	0.2	6.4%
Bank B	6.2	0.2	0.25	6.65%

Customer 2 - High credit risk

Parameter	MCLR	Credit Risk (Agri)	Custom Credit Risk	Total lending rate
Bank A	6	0.2	0.7	6.9%
Bank B	6.2	0.2	0.85	7.25%

calculated

How is MCLR Calculated?

The MCLR considers the current cost of funds as well as the incremental cost of funds. Let's look at the things that influence the MCLR based on this approach.

Marginal Cost of Funds: The marginal cost of borrowings, as well as the return on net worth, make up the marginal cost of funds.
- The marginal cost of borrowings has 92% of the influence, whereas the other factor has only 8%.
- It is also affected by the repo rate and bank interest rates.
Operating Costs: These are the costs of issuing the loan, obtaining capital, and running the business on a day-to-day basis.
Cost of Carry in Cash Reserve Ratio (CRR): Banks must take into account the cash deposits they must maintain with the Reserve Bank of India.
Tenor Premium: This is the premium that will be charged for long-term loans in order to minimize the risk of long-term lending.
Banks are allowed to publish the internal benchmark rate (MCLR) for overnight, one-month, three-month, six-month, and one-year maturities once a month.

Reasons

Reasons for Introducing MCLR

To promote the lending rates of banks.
For making the calculation of interest rates on bank advances more transparent.
To make bank lending available at rates that are fair to both lenders and banks.
To assist banks in becoming more efficient and profitable in the long run, as well as to contribute to economic development.

Difference

Difference Between Base Rate and MCLR

Base Rate	MCLR
Uses the average cost of financing as a guide.	Based on the incremental/marginal cost of money.
Calculated by taking into account the minimum rate of return/profit margin.	Tenor premium is factored into the calculation.
Operating expenses and expenses required to maintain the cash reserve ratio also affect the base.	The MCLR is calculated by taking into account deposit and repo rates, as well as operating costs and the cost of maintaining a cash reserve ratio.

Conclusion

The MCLR was introduced for quick and efficient transmission of the change in repo rate and to benefit the customers. However, the banks failed to reduce the interest rate in spite of lower repo rates giving way to External Benchmark Lending Rates.

Other Relevant Links
Indian Economics Notes	Monetary Policy
Monetary Policy Tools	Types of Monetary Policy
Money Supply	RBI Act 1935
Reserve Bank of India	Monetary Policy Transmission

FAQs

Question: What is the Marginal Cost of Funds Based Lending Rate (MCLR)?

Answer: The Marginal Cost of Funds Based Lending Rate (MCLR) is the minimum interest rate at which banks lend to their most creditworthy borrowers. This rate is determined based on the marginal cost of funds, which includes the interest rates on deposits and other borrowing costs. Introduced by the Reserve Bank of India (RBI) in April 2016, MCLR aims to enhance the transparency of lending processes and ensure that changes in policy rates are more effectively passed on to borrowers.

Question: How is MCLR calculated?

Answer: MCLR is calculated using several components, primarily focusing on the marginal cost of funds that a bank incurs for its incremental borrowing. This includes the costs associated with acquiring deposits and other forms of borrowing. Additionally, it factors in operating costs related to loan servicing, the cost of equity reflecting the returns expected by the bank’s investors, and a risk premium that accounts for the potential risks associated with lending. The MCLR may vary depending on the tenure of the loan, with different rates applicable for overnight, one-month, three-month, and one-year loans.

Question: What are the benefits of MCLR for borrowers?

Answer: MCLR offers several benefits to borrowers. It enhances transparency in the lending process, allowing borrowers to better understand how interest rates are determined. Additionally, MCLR allows for more timely adjustments to interest rates in response to market changes, which can lead to reduced borrowing costs when the cost of funds decreases. The structure of MCLR can ultimately make loans more affordable, providing borrowers with the opportunity to benefit from lower interest rates more readily.

Question: What challenges are associated with MCLR?

Answer: Despite its advantages, MCLR also presents challenges. The calculation process can be complex and may vary between banks, leading to potential confusion among borrowers regarding their interest rates. Additionally, if banks do not compete effectively, MCLR rates may remain high, limiting the benefits to consumers. Furthermore, there can be delays in how quickly changes in MCLR are passed on to borrowers, which may not align promptly with changes in the RBI's policy rates, thus affecting the intended benefits of MCLR.

Question: How does MCLR impact the overall economy?

Answer: MCLR significantly impacts the overall economy as it influences lending rates across various sectors. By providing a transparent and responsive framework for determining lending rates, MCLR encourages borrowing for investment and consumption, which can stimulate economic growth. When MCLR is aligned with market conditions, it enhances monetary policy transmission, allowing the RBI to manage inflation and liquidity more effectively. However, if MCLR rates are not responsive to changes in the economic environment, it could dampen borrowing and investment, potentially slowing economic growth.

MCQs

1. What does MCLR stand for?

A) Maximum Cost of Lending Rate
B) Marginal Cost of Funds Based Lending Rate
C) Minimum Cost of Funds Based Lending Rate
D) Marginal Credit Lending Rate