How do banks determine ‘Spread’ in respect of interest on advances?

The interest rate on advance levied by banks comprises the BPLR, Base rate, MCLR rate, or external benchmarks like Repo-linked lending of the respective bank, and the ‘Spread’ over the cost of lending is decided by the bank’s Board. The determination of ‘Spread’  varies on each category of advance depending upon the tenure of the loan, and the risk profile attached to the type of advance.

The minimum rate of interest charged by commercial Banks in India on their advances cannot be less than their MCLR rate. This condition of a minimum rate of interest is not applicable to the following type of loans.

1. DIR loans where all the banks uniformly charge at 4% p.a, keeping in view the social objective.
2. In case of advance made against customer’s own deposit in the same bank.
3. Loans and advances are made under the Interest Subvention Scheme’ where the banks claim the subsidy from the Government.

Determination of ‘Spread’ charged to a customer:

Interest rate spread is the interest rate charged by banks on loans to customers minus the interest rate paid by banks for demand, time, or savings deposits. Thus, the net interest rate spread refers to the difference in the borrowing and lending interest rates for banks and other financial institutions. Hence, the net interest rate spread is a profit margin decided by a bank on its lending.  In the other words, Spread can be called the ‘profit margin’ decided by the bank on the specific type of advance based on loan pricing policy, credit risk, and tenor of advance. The decision of increasing the spread on account of the credit risk profile should be supported by a full-fledged risk profile review of the borrower. The change in tenor premium should not be borrower specific. Every bank has the right to adopt its own policy on deciding components of spread. The range of spread decided on different categories of advances shall be approved by the Board of the bank. It is mandatory on the part of the concerned bank to spell out the rationale for and range of the spread for various categories of borrowers. It is also mandatory on the part of the banks that the pricing policy should reveal the delegation of power of powers in respect of loan pricing. The spread decided by the bank must be consistent with its internal pricing policy and the same should be made available for supervisory review/scrutiny of RBI as and when required.

Based on the recommendations of Mr.Anand Sinha’s working group on ‘pricing of Credit’ RBI has revised guidelines on ‘Interest Rates on Advances’. The following additional guidelines of the central bank on interest rates are expected to force commercial banks to pass on the repo-rate cut benefit to the borrowers.

1. The spread charged to an existing borrower should not be increased except on account of deterioration in the credit risk profile of the customers or a change in the tenor premium.
2. The decision of increasing the spread on account of the credit risk profile should be supported by a full-fledged risk profile review of the borrower.
3. The change in tenor premium should not be borrower-specific or loan-class-specific. In the other words, the change in tenor premium will be uniform for all types of loans for a given residual tenor.
4. The spread norm iii is not applicable for consortium advances where participant banks need to maintain a uniform rate in line with other lenders of consortium advances.

The above norms under additional guidelines on the interest rate on advance are effective from one month after RBI Circular dated 19.01.2015

Originally posted on January 20, 2015, edited and reposted on February 20, 2023

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