The Reserve Bank of India establishes the MCLR, or marginal cost of funds-based lending rate, as an internal reference rate for banks. It is aimed to facilitate the calculation of the minimal interest rate for various types of loans that banks offer. MCLR, to put it simply, is the lowest rate at which banks are permitted to give loans to their customers.
The base rate system, which had been in use up until that point, was basically replaced by the RBI through the introduction of MCLR rates in 2016. Its principal goal was to preserve equilibrium between the interests of the banking sector on the one hand and the transfer of interest rate advantages from the RBI's monetary policy to borrowers on the other hand through the use of a benchmark rate that can assure profitability.
How is MCLR calculated?
Calculation of MCLR is done through the following four components-
Tenure premium: The cost of borrowing is dependent on the length of the loan. The risk will increase as the tenure of the loan stretches. The bank will charge a sum in the form of a premium in order to cover the risk, shifting the burden to the borrowers. This is referred to as the Tenure Premium.
Negative carry on CRR: When the return on the CRR balance is zero, there is a negative carry on the cash reserve ratio. This will have an effect on the required statutory liquidity ratio balance , a reserve that each commercial bank is required to keep. The bank cannot use the cash to generate any income or interest, thus it is recorded negatively.
Marginal costs of funds: The average rate at which deposits with comparable maturities were raised over a specified time period before the review date is the marginal cost of funds. This expense will appear as an outstanding balance in the bank's books.
Operating costs: The cost of raising funds is included in operational expenditures, with the exception of costs that are recovered independently through service fees. As a result, it is related to offering the loan product in its current form.
What are the benefits of MCLR?
The MCLR allows RBI interest rate modifications to be notified to borrowers relatively fast, with monthly updates to the MCLR. In other words, it enables borrowers to benefit from the rate reduction implemented by the RBI in a comparatively shorter amount of time.
Banks maintain the confidence of borrowers and companies in the banking industry with the current MCLR rate. More people and enterprises are turning to banks for their credit needs as a result of the transparency kept in lending rates through calculations based on the minimum loan rate.
Why is MCLR preferred over the traditional base rate?
Before MCLR, banks computed the base rate in a variety of ways with a lack of standardisation. Because of this, the base rate mechanism, which is connected to a bank's cost of funds, was unable to provide the desired level of transparency. This is because banks frequently argued that they were unable to pass along the lower interest rates to borrowers since, despite RBI policy reductions, their cost of capital had not decreased. Additionally, these standards fluctuated from time to time and from bank to bank.
The RBI has improved the process for pricing credit by standardising the benchmark rates across all tenors with the MCLR and so providing a consistent interest rate structure. As a result, the odds are not entirely stacked against the borrower who benefits from greater certainty and transparency.