Banking Awareness Study Notes:

Base Rate vs MCLR

 Base Rate 

• It is defined as the minimum interest rate of a bank below which it is not viable to lend (Loans).
• It was introduced on 1 July 2010 by the RBI.
• It replaced the benchmark prime lending rate (BPLR), the interest rate which commercial banks charged their most credit worthy customer.

 MCLR 

The marginal cost of funds based lending rate (MCLR) refers to the minimum interest rate of a bank below which it cannot lend, except in some cases allowed by the RBI. It is an internal benchmark or reference rate for the bank.

The MCLR methodology for fixing interest rates for advances was introduced by the Reserve Bank of India with effect from April 1, 2016. This new methodology replaces the base rate system introduced in July 2010. In other words, all rupee loans sanctioned and credit limits renewed w.e.f. April 1, 2016 would be priced with reference to the Marginal Cost of Funds based Lending Rate (MCLR) which will be the internal benchmark (means a reference rate determined internally by the bank) for such purposes.

 Calculation Of MCLR 

Following are the main components of MCLR.

1. Marginal cost of funds;
2. Negative carry on account of CRR;
3. Operating costs;
4. Tenor premium.

 Negative carry on account of CRR:  is the cost that the banks have to incur while keeping reserves with the RBI. The RBI is not giving an interest for CRR held by the banks. The cost of such funds kept idle can be charged from loans given to the people.

 Operating cost:  is the operating expenses incurred by the banks

 Tenor premium:  denotes that higher interest can be charged from long term loans.

 Marginal Cost:  The marginal cost that is the novel element of the MCLR. The marginal cost of funds will comprise of Marginal cost of borrowings and return on net worth.  According to the RBI, the Marginal Cost should be charged on the basis of following factors:

1. Interest rate given for various types of deposits – savings, current, term deposit, foreign currency deposit.
2. Borrowings – Short term interest rate or the Repo rate etc.,Long term rupee borrowing rate.
3. Return on net worth – in accordance with capital adequacy norms.

The marginal cost of borrowings shall have a weightage of 92% of Marginal Cost of Funds while return on net worth will have the balance weightage of 8%.

In essence, the MCLR is determined largely by the marginal cost for funds and especially by the deposit rate and by the repo rate. Any change in repo rate brings changes in marginal cost and hence the MCLR should also be changed.

 MCLR Vs Base Rate 

The base rate or the standard lending rate by a bank is calculated on the basis of the following factors:

1. Cost for the funds (interest rate given for deposits),
2. Operating expenses,
3. Minimum rate of return (profit), and
4. Cost for the CRR (for the four percent CRR, the RBI is not giving any interest to the banks)

It is very clear that the CRR costs and operating expenses are the common factors for both base rate and the MCLR. The factor minimum rate of return is explicitly excluded under MCLR.

But the most important difference is the careful calculation of Marginal costs under MCLR. On the other hand under base rate, the cost is calculated on an average basis by simply averaging the interest rate incurred for deposits. The requirement that MCLR should be revised monthly makes the MCLR very dynamic compared to the base rate.

Under MCLR:

1. Costs that the bank is incurring to get funds (means deposit) is calculated on a marginal basis.
2. The marginal costs include Repo rate; whereas this was not included under the base rate.
3. Many other interest rates usually incurred by banks when mobilizing funds also to be carefully considered by banks when calculating the costs.
4. The MCLR should be revised monthly.

A tenor premium or higher interest rate for long term loans should be included.