Marginal Cost Of Funds Based Lending Rate - MCLR VS Base Rate

Marginal Cost Of Funds Based Lending Rate (MCLR)

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. It is an internal benchmark or reference rate for the bank.

Important Point About MCLR

MCLR is a method by which the minimum interest rate for loans is determined by a bank - on the basis of Marginal Cost or the additional or incremental cost..
  • The MCLR was introduced by the Reserve Bank of India with effect from April 1, 2016. This new methodology replaces the base rate system introduced in July 2010.
  • All rupee loans sanctioned and credit limits renewed w.e.f. April 1, 2016, would be priced with reference to the Marginal Cost of Funds based Lending Rate.
  • Based upon this MCLR, interest rate for different types of customers should be fixed in accordance with their riskiness. 
  • Banks may publish the MCLR for following Duration on Monthly basis: Overnight, 1 Month, 3 Month, 6 Month MCLR, 1 year MCLR

Base Rate

Base Rate is the minimum rate of interest that a bank is allowed to charge from its customers. No Bank can offer loans at a rate lower than Base Rate to any of its customers. It is effective from, July 1, 2010.

Reasons To Introduce MCLR

RBI decided to shift from base rate to MCLR because the rates based on marginal cost of funds are more sensitive to changes in the policy rates. This is very essential for the effective implementation of monetary policy. 

Prior to MCLR system, different banks were following the 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. Thus, MCLR aims

  1. To improve the transmission of policy rates into the lending rates of banks.
  2. To bring transparency in the methodology followed by banks for determining interest rates on advances.
  3. To ensure availability of bank credit at interest rates which are fair to borrowers as well as banks.
  4. To enable banks to become more competitive and enhance their long run value and contribution to economic growth.

How MCLR is different from Base Rate?

About Base Rate :-

The base rate or the standard lending rate by a bank is calculated on the basis of the following factors:
  1. Cost for the funds (interest rate given for deposits),
  2. Operating expenses,
  3. Minimum rate of return (profit), and
  4. Cost for the CRR (CRR means cash reserve ratio, Under CRR a certain percentage of the total bank deposits has to be kept in the current account with RBI which means banks do not have access to that much amount for any economic activity or commercial activity. RBI doesnot give interest on the CRR because it is a cash reserve ratio. The amount is reserved and not used to generate income by RBI.)

About Marginal Cost Of Funds :-

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
1. Marginal cost of funds - The marginal cost of funds will comprise of Marginal cost of borrowings and return on net worth.  According to the RBI, the Marginal Cost should be charged on the basis of following factors:
  • Interest Rate given for various types of Deposits -  Savings, Current, Term Deposit (FDs or RDs), Foreign Currency Deposit.
  • Borrowings – Repo Rate (The Rate charged by RBI for amount borrowed from it by Banks) and etc.
  • Return on Net Worth – In accordance with Capital Adequacy Norms.
Marginal Cost of Funds = (92% x Marginal cost of borrowings) + (8% x Return on networth)

2. Negative carry on account of Cash Reserve Ratio - It is the cost that the banks have to incur while keeping reserves with the RBI. The RBI is not giving an interest for CRR held by the banks. This liquid amount cannot be used for day to day operations in the business of banks. In other words, the cost of funds blocked due to maintenance of CRR is also to be considered.

3. Operating Cost - It is associated with providing the loan product, including cost of raising funds, but excluding those costs which are separately recovered by way of service charges.

4. Tenor premium - Tenor premium means, longer the loan, higher can be the premium for the same. It is the profit margin of the bank. It means 1 year rate is higher than 6 month rate.