MintGenie explains: What is MCLR and why is it preferred over prime rate?

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The Reserve Bank of India establishes the MCLR, or Marginal Cost of Funds Based Lending Rate, as an internal benchmark rate for banks. It aims to facilitate the calculation of the minimum interest rate for the different types of loans offered by banks. The MCLR, to put it simply, is the lowest rate at which banks are allowed to lend to their customers.

The base rate system, which was in effect until then, was essentially replaced by the RBI through the introduction of MCLR rates in 2016. Its main purpose was to preserve the balance between the interests of the banking industry one hand and transfers the interest rate benefits of the RBI’s monetary policy to borrowers on the other hand through the use of a benchmark rate that can ensure profitability.

How is MCLR calculated?

The calculation of MCLR is done through the following four components –

Seniority bonus : The cost of borrowing depends on the term of the loan. The risk will increase as the term of the loan extends. The bank will charge a sum as a premium to cover the risk, shifting the burden onto the borrowers. This is called the occupancy bonus.

Negative report on CRR: When the return on the CRR balance is zero, there is a negative carry over to the cash reserve ratio. This will have an effect on the mandatory balance of the statutory liquidity ratio, a reserve that every commercial bank is required to maintain. The bank cannot use the cash to generate income or interest, so it is recorded negatively.

Marginal costs of funds: The average rate at which deposits of comparable maturities were raised over a given period before the review date is the incremental cost of funds. This expense will appear as an outstanding balance on the bank’s books.

Operating costs: The cost of fundraising is included in operating expenses, except for costs that are independently recovered through service fees. Therefore, it is tied to the offering of the loan product in its current form.

What are the benefits of MCLR?

The MCLR allows RBI interest rate changes to be notified to borrowers relatively quickly, with monthly updates from the MCLR. In other words, it allows borrowers to avail the rate reduction put in place by the RBI within a relatively shorter period of time.

Banks are maintaining the confidence of borrowers and businesses in the banking sector with the current MCLR rate. More and more people and businesses are turning to banks for their credit needs because of the transparency maintained in lending rates through calculations based on the minimum lending rate.

Why is MCLR preferred over traditional base rate?

Prior to MCLR, banks calculated the base rate in various ways without standardization. For this reason, the base rate mechanism, which is tied to a bank’s cost of funds, has not been able to provide the desired level of transparency. Indeed, banks have often argued that they were unable to pass on lower interest rates to borrowers since, despite RBI policy cuts, their cost of capital had not fallen. Moreover, these standards fluctuated from time to time and from bank to bank.

The RBI has improved the credit pricing process by standardizing benchmark rates across all tenors with the MCLR and thus providing a consistent interest rate structure. As a result, the odds are not entirely against the borrower who benefits from greater certainty and transparency.

This story was first published on MintGenie and accessible here.

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