Prime Lending Rate, MCLR (Marginal Cost of Funds-based Lending Rate) and RBI Base Rate are three internal benchmarks that financial institutions adhere to while deciding on interest rates. Read on to know more about these internal benchmarking rates in detail and how these can impact rates offered by lenders.
In April 2003, the Benchmark Prime Lending Rate (BPLR) policy was introduced. BPLR or prime rate of interest, is an interest charged by commercial banks to their most creditworthy customers. Thus, the bank would charge the lowest interest rate to the customers who had a good credit profile. However, this policy’s primary issue was the unavailability of a fixed formula to estimate the prime rate of interest, which created other problems such as lack of transparency (banks would charge different interest rates from different customers).
Consequently, the RBI’s BPLR policy or prime rate of interest could not link the repo rates with the interest rates of the loans given by commercial banks. The repo rate did not affect the interest rates needed to maintain the balance between growth and inflation.
Due to the Prime Lending Rate policy’s failure, RBI in July 2010 launched the Base Rate Policy. The concept was similar to the prime rate of interest, i.e., the interest rate charged to the customer was based on his creditworthiness. This policy’s additional feature was a suggestive formula prescribed by the RBI to calculate the Base Rate, which wasn’t there earlier.
Nevertheless, the lack of transparency still existed as there was no permanent formula given to these banks. RBI’s Base rate showed no impact of changing repo rates on the interest rates of the commercial banks.
Once again, a new policy was introduced in April 2016, known as MCLR. Marginal Cost of Funds Based Lending or MCLR. Here too, the fundamental concept is the same; the difference is in terms of calculation. The RBI prescribes a fixed formula to calculate MCLR. MCLR is only limited to commercial banks; thus, the rate does not apply to the NBFCs (as they follow the Prime lending rate). Apart from that, it’s applicable to floating interest rates (floating rates are usually related to home loans and loans against property) and fixed interest rates (up to 3 years). MCLR was introduced to increase transparency and overcome the limitations of the RBI’s Base rate and Prime Lending rate.
Banks publish MCLR for five tenors, i.e., one-day MCLR (if the bank’s MCLR is changing in one day), 1-month MCLR, 3-month MCLR, half-yearly MCLR, and yearly MCLR. The Repo rate cut is not reflected in the EMIs right away due to these reset periods.
The RBI Base Rate components are the Cost of Funds (deposits, borrowings from RBI, bonds), low SLR returns, and expected rate on the equity (average return on the net worth). However, no standard percentage was fixed concerning the weightage to the cost of funds and other components. Hence, some banks were using the average cost of funds, while others took into account the marginal cost of funds, blended cost of funds, etc. The base rate calculation of every bank was different and unsystematic, due to which repo rates had no impact on these rates.
In MCLR, it was defined that the banks could only take the marginal cost of funds for calculating the MCLR. The marginal cost of funds means the cost of all the banks’ new loans and the cost of new deposits. It was also made clear that the banks could only take 92% of their marginal cost of borrowing and 8% of their net worth. No SLR returns are considered under MCLR calculation; banks can only account for the negative carry-on CRR (no interest rate is received from the RBI). The operating cost or the expenses incurred on the regular operations of the banks are also allowed. Some banks may charge a premium on long-term loans, and these premiums may increase with the increase in the loan term. Therefore, the tenure premium is included, as well. When compared to the Base Rate, interest rates under MCLR are slightly lower. So if you took a loan at a base rate, you could convert it to MCLR.
Change in the bank’s MCLR is directly proportional to the EMI (and even the loan tenure). Therefore, MCLR charged by the banks is usually high in the initial years, and in the later stages, the interest charged is low. However, the borrower cannot witness immediate benefits with the fall in banks’ MCLR. The MCLR is related to the bank’s internal finance and the rest periods mentioned above. So suppose if the RBI decreased the repo rate in December 2020 and the borrower took the loan in July 2020 which is linked to the one-year reset period. In this case, the effect on the EMI will be visible only in July 2021. Thus, the impact that MCLR has on the borrower will depend upon the tenure/reset period, loan amount, and changes in the MCLR by the banks.
The Reserve Bank of India sets the base rate for the banks by taking into account their cost of funding. These include the cost of deposits, the administrative costs borne by the bank, the profitability of the bank, overhead costs, etc.
The difference between RBI’s base rate and the interest rate offered by banks is the profit earned by banks. If interest offered to depositors is high, the base rate will also be high and vice versa.
All financial institutions incur an operating cost for carrying out their day to day activities. These costs have a direct bearing on the base rate of RBI. Whenever banks face high operating expenses, RBI raises the base rates so as to maintain the profitability of the banks.
Inflation is an increase in the general price level of the economy. To curb increasing inflation, RBI aims to restrict the money supply and, as a result, resorts to increasing base rates. The base rate is set at a higher level which discourages investors from taking loans, and hence money supply is curbed. RBI may reduce these rates once inflation comes under control.
RBI periodically reviews the base rate and changes it according to the functioning of the economy. When the economy is in recession, RBI cuts the interest rate so as to provide a boost to business activities. It helps to bring the country back on a growth path.
On the other hand, when the Indian economy is in a boom phase, RBI may leave the base rates unchanged or may increase it if economic growth leads to inflation.
There are different variables that RBI considers while computing its base rates. These include cost of funds i.e. interest on deposits, average profits earned by banks in past years, the unallocated overhead cost and administrative expenses.
RBI attach different weights to each factor and compute the base rate accordingly. The highest weight is given to the cost of funds. However, banks are provided with the freedom to categorise the deposits of various tenures while computing their own base rates.
The NBFCs come under the Companies Act, 1956. NBFCs don’t have a full banking license. It’s a company that deals with loans and advances. And since it falls under the company act of 1956, it is not regulated by the RBI. All the other banks are regulated by The Banking Regulation Act of 1949. Another act, called the RBI Act of 1934, provides a framework for banking firms only, and for NBFCs, the framework is set under the companies act.
Banks and NBFCs are required to follow the benchmark set by RBI. With RBI hiking the repo rate to 4.90%, banks have increased their home loan interest rates.
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Ans. To curb the rising inflation in the country, the Reserve Bank of India hiked the base rate from 4% to 4.4% on May 4 2022. It was again hiked to 4.9% on June 8 2022. RBI might also plan to go for a third hike towards the end of the year, depending on the financial situation of the country.
Ans. A change in RBI’s base rate may affect the EMI of your existing loan if you have opted for a floating interest rate system. Under this system, an increase in base rate will increase the rate of interest on your loan; hence, you will be paying more. On the other hand, if you have opted for a fixed rate system, any change in RBI’s base rate will not affect your monthly payments.
Ans. A bank will have to stay aligned to the base rate fixed by the RBI. They will have to change their interest rates as and when RBI changes its base rate. An individual bank’s base rate cannot be lower than RBI’s mandated base rate, so banks will have to make the necessary adjustments in that regard.
Ans. MCLR loans are decided by considering the current incremental cost of a fund. On the other hand, base rate loans consider the average cost of funds. Therefore, many borrowers prefer MCLR as it is more inclined to the current market conditions than a base rate.
Ans. No, the MCLR is not the same for every bank in India. Different banks consider their cost of funding and net worth before finalising MCLR. As the cost of funding and net worth of every bank can vary, MCLR cannot be the same for all.
Ans: The current repo rate stands at 4.90%.
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Disclaimer: This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information, and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
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