Prime Lending Rate 

In April 2003, the BPLR policy was introduced. BPLR(Benchmark Prime Lending Rate), or prime rate of interest, is an interest charged by commercial banks to its 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 

MCLR 

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 the commercial banks; thus, the rate does not apply to the NBFCs (as they follow the Prime lending rate). Apart from that, it’s applicable on 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. 

How do these rates work?

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. 

  • Under MCLR, costs of only new deposits are taken into account. As specified by the RBI, 92%of the marginal cost of borrowings + 8% return on net worth equals the marginal cost of funds. 
  • The marginal cost of borrowings: In the case of borrowings, marginal rates on short-term, long-term, and foreign currency borrowings will be considered. 
  • Negative Carry on CRR- The banks don’t get any interest on CRR. Therefore, negative carry on CRR can be included here. The reason for negative carry is due to  – return < cost of funds. 

What is the Difference – Base Rate vs. MCLR?

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% on their net worth. No SLR returns are considered under MCLR calculation; banks can only account for the negative carry on the 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 the 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.

Impact of MCLR on Loans 

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. 

How RBI Base rates don’t apply to NBFCs?

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.

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