CONCEPT – MCLR V/S BASE RATE SYSTEMS

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 CONCEPT – MCLR V/S BASE RATE SYSTEMS

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• What is MCLR? It is the minimum interest rate a bank must charge for lending. The bank cannot grant any loan below that rate (RBI-allowed exceptions exist).
• Since when? MCLR is a benchmark now since 2016, and was introduced to counter the Base Rate system. So, from April 2016, interest rates for every single loan, irrespective of the category, are governed by the MCLR.
• How is it determined? MCLR is determined by the current cost of funds, in contrast to the base rate, which is governed by the average cost of funds.
• Better system: Rates based on MCLR are more receptive to the changes in the RBI's policy rates. So better monetary policy transmission can happen.

• Factors determining the MCLR: ‘Marginal’ refers to a specific change in quantity in its current state. Hence, MCLR takes into account the current cost or incremental cost of funds.

1. "Marginal Cost of Funds" : It comprises marginal cost of borrowings (92% influence), along with return on net worth (8%). It also depends on repo rate and the interest rates charged by banks.
2. Operating Costs: These are costs associated with providing the loan, raising funds, and running operations
3. Cost of Carry in the Cash Reserve Ratio (CRR) : The banks have to take into consideration the cash deposits they need to keep with the RBI.
4. Tenor Premium : This is the premium that will be charged for long-term loans to mitigate the risk associated with long-term lending.

• Base Rate
• Base Rate: Before MCLR came about in 2016, loans fell under the purview of the base rate, since 2011. Before that banks used the "benchmark prime lending rate (BPLR)". So Base Rate replaced the BPLR, and MCLR replaced the Base Rate.
• What is it? Base Rate is the minimum interest rate below which a bank cannot lend (RBI-allowed exceptions exist).
• Why have it? Base Rate came about to improve the transmission of monetary policy and to make lending rates selection more transparent. Base Rate is determined by the "average cost of funds". But MCLR depends on the current cost of funds.

• Base Rate Calculation: Each bank is free to determine their own base rate, based on the RBI norms.

1. Average Cost of Funds: This is the interest rate given on the deposits.
2. Operating costs/Unallocatable Overhead Costs: Expenses that go into running operations and includes components like legal expenses, depreciation, administrative costs, stationery cost etc.
3. Negative Carry in the Cash Reserve Ratio: This is the cost that the banks need to incur in order to keep a specific amount of cash reserves with the RBI.
4. Margin of Profit/Average Return on Net Worth: This figure indicates the profitability and net amount obtained.

• Marginal Cost of Fund Based Lending Rate (MCLR) & Base Rate 

1. Base Rate is based on average cost of funds, while MCLR is based on marginal (incremental) cost of funds.
2. Base Rate is calculated considering minimum rate of return needed, while MCLR uses tenor premium.
3. Base Rate also considers operating expenses, and cost of maintaining the CRR. But MCLR also considers deposit rates and repo rates, in addition. 

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