Banks & Financial Institutions are generally free to determine the lending rates on loans and advances. The method to arrive at Lending Rate has changed drastically over the last decade. The Lending Rate like BPLR, Base Rate, and MCLR internal benchmark rates are used by individual banks to determine the interest rates on their credits. When a bank links its Lending Rate to an external benchmark like Repo Rate, it is known as Repo Linked Lending Rate.
BPLR (Benchmark Prime Lending Rate): The Benchmark Prime Lending Rate was introduced by the Reserve Bank of India in the year 2003 with the aim of introducing transparency and ensuring appropriate pricing of loans, wherein the lending rates truly reflect the actual costs. As per the Reserve Bank of India (RBI) guidelines, banks could fix the BPLR with the approval of their Boards. However, the calculation of BPLR was rigid, not that transparent, and inflexible in relation to the overall direction of interest rates in the economy. Many times the banks could lend to customers below BPLR. The bulk of wholesale credit (loans to corporate customers) was sanctioned sub-BPL rates and it comprised nearly 70% of all bank credit. Therefore, banks were actually subsidizing corporate loans by charging high-interest rates to retail and small and medium enterprise customers. In view of the above drawbacks in the BPLR regime, the Reserve bank asked banks to switch to the Base rate method with effect from July 1, 2010. RBI allowed banks to continue with BPLR at which loans were approved prior to the introduction of the Base rate arrangement. The customers are however given the option of switching to the base rate before the expiry of their loan.
Base rate: Banks were allowed to use any method to calculate their base rates consistent with RBI guidelines (RBI provided an ‘illustrative’ formula for reference of commercial banks). Under the base rate system banks were not permitted to lend below the base rate fixed by them. The base rate method to arrive at Lending Rate has the following components.
- Cost of funds (interest rates offered by banks on deposits)
- Operating expenses to run the bank.
- Minimum Rate of return i.e. margin or profit
- Cost of maintaining CRR (Cash Reserve Ratio).
However, the method of computing Base Rate was followed by different banks in different methods like ‘Average Cost Funds’, ‘Marginal Cost Funds’, and ‘Blended cost of funds (liabilities)’. Thus, any cut or increase in rates (especially key rates like Repo Rate) by the RBI was not getting transmitted to the bank customers immediately.
The Reserve Bank on September 1, 2015, proposed a uniform marginal cost of funds methodology for all the banks, for the calculation of their base lending rates.
MCLR – Marginal Cost of Fund-based Lending Rate: MCLR has been in effect since April 1, 2016. The important components taken into account for calculating the MCLR are;
- Marginal Cost of funds.
- Operating Expenses.
- Negative carry on CRR and SLR
- Average Return on return.
The marginal cost of funds is arrived at by taking into consideration all sources of the fund other than the equity and the same is calculated using the latest interest rate/card rate payable on current and savings deposits and the term deposits of various maturities. Reduction and increase of Repo Rate by RBI will be immediately factored in the cost of funds under MCLR rules.
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 are 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. For example, if a housing loan MCLR is linked to a six-month MCLR, the interest rate will get reset only after the completion of six months in case there is a change in the rate at the time of the reset. In case it is linked to a one-year MCLR, the loan gets reset after a year.
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.
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 guidelines, the unallocable 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 unallocable overhead expenses would be fixed for 3 years, subject to review thereafter.
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.
Under the MCLR system, 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.
External benchmark regime:
RBI had criticized the banks for not passing on the entire benefits of its rate cuts (Repo rate) to the customers. The lenders have cited higher cost of funds for not reducing the rate proportionate to rate cuts declared by RBI. The Reserve Bank, in late 2018, had mandated that the banks link all floating rate loans offered after April 1, 2019, to an external benchmark, however, Reserve Bank has since put this direction on hold.
The banks were given options to use any of the following for the external benchmark.
- Reserve Bank of India policy repo rate, or
- Government of India 91 days Treasury Bill yield produced by the Financial Benchmarks India Private Ltd (FBIL), or
- Government of India 182 days Treasury Bill yield produced by the Financial Benchmark India Private Ltd (FBIL) or
- Any other benchmark market interest rate produced by the Financial Benchmark India Private Ltd (FBIL).
Much before RBI guidelines, Citibank had linked the loan interest rate to a 3-month Treasury bill rate. RLLR is a nomenclature used by SBI to define Repo linked lending rate benchmark. The RLLR is launched by SBI on July 1, 2019. Commercial Banks may add spread to the Repo rate to fix RLLR. SBI adds the spread of 2.25% over the Repo Rate. Other banks that link to the Repo rate or any other external benchmark rate may choose a spread different than SBI.
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