How to Compute Marginal Cost of Lending Rate (MCLR)

[The article explains the method of determining Lending rate of a bank under MCLR regime, method of  calculating  MCLR  and the position of existing loans etc. Updated till 01.04.2016)].

The banks in India set their lending rates on loans and advances with reference to ‘Base Rate’ which is computed on the basis of the cost of funds to the bank. The Base rate system was introduced by the banks on July 1, 2010. However, the method of computing Base Rate was followed by different banks in different methods like ‘Average Cost Funds’, ‘Marginal Cost Funds’, ‘Blended cost of funds (liabilities)’.

The Reserve Bank on September 1, 2015 proposed a uniform marginal cost of funds methodology for all the banks, for calculation of their base lending rates. The apex bank has shown its faith in marginal cost of funds as it appears to be more sensitive to changes in policy rates compared to other methods. The new guideline now proposed by RBI is in line with the monetary policy announced on July 1, 2015, and renewed on August 4, 2015. The banking regulator said that for effective transmission of its policy rates, the lending rates should be sensitive to the policy rates and linked to the policy rates.  Hence, with effect from April 1, 2016, all the commercial banks in India shall implement Marginal Cost of Funds Based Lending Rate (MCLR) for all rupee loans/ credit limits sanctioned or renewed by them. The existing loans and credit limits linked to the Base Rate may continue till repayment or renewal as the case may be. Existing borrowers will also have the option to move to the Marginal Cost of Funds based Lending Rate (MCLR) linked loan at mutually acceptable terms. Banks will continue to review and publish Base Rate as hitherto.

Method of determining Lending rate  MCLR regime:

Unlike ‘Base Rate’ which was constant for all loans, MCLR is different for loans with different tenors. The banks would finalize actual lending rates for different maturities by adding the components of spread to the MCLR. Every commercial bank defines the components of spread finalized by it with the approval of its board.  However, to introduce uniformity in deciding the components of spread, RBI has directed the banks to adopt the broad components of spread finalized by IBA. 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 Method of computing MCLR:

The MCLR is a tenor linked internal benchmark of an individual bank. The MCLR varies for different maturities of loans and advances.The important components are taken into account for calculating the MCLR are (A). Marginal Cost of funds. (B).Operating Expenses. (C). Negative carry on CRR and SLR (D).Average Return on return.

(A). Marginal Cost of Funds:

The marginal cost of funds is arrived at by taking into consideration of all  sources of the fund other than the equity and same is calculated using the latest interest rate/card rate payable on current and savings deposits and the term deposits of various maturities.  The cost of borrowings thus arrived at using the average rates at which funds were raised in the last one month preceding the date of review. Each of these rates is weighted by the proportionate balance outstanding on the date of review. Hence, based on interest/Premium paid to raise long- term funds, the cost of funds will change along with the tenor of the Deposits. Consequently, the lending rates under MCLR is different for loans with different tenors.The majority of the banks have therefore introduced the Overnight MCLR, One- month MCLR, Three months MCLR, Six months MCLR, and One year MCLR. Unlike in the Base Rate regime where Repo Rate was not considered for determining the rate, reduction, and increase of Repo Rate by RBI will be immediately factored in the cost of funds under MCLR rules.

(B). Negative carry on CRR and SLR

Negative carry on the mandatory CRR arises because the return on CRR balances is nil. Negative carry on SLR balances may arise if the actual return thereon is less than the cost of funds.

(C).Un-allocable Operating Expenses:

The Cost of deposits is not just restricted to interest paid on deposits for various tenors. There are other expenses like salaries, premises rent,  stationery, electricity bills, telephone bills etc. that are not directly charged to the customers. These operating costs will be taken into account while determining the lending rate. However, as per RBI guidance, the  un-allocable overhead expenses cannot be allocable to any particular business activity/unit, therefore, the costs should comprise solely of costs incurred to the bank as a whole. The  components of un-allocable overhead expenses would be fixed for 3 years, subject to review thereafter.

(D) Average Return on net worth:

The average return on net worth is the hurdle rate of return on equity determined by the Board or management of the bank. The component representing ‘return on net worth’ shall remain fairly constant. If the bank wishes to make any change, it would be made only in case of a major shift in the business strategy of the bank.

RBI Governor Dr. Raghuram Rajan had criticised the banks for not passing on the entire benefits of its  rate cuts to the customers. The lenders had cited  higher cost of funds for not reducing the rate proportionate to rate cuts declared by RBI.