RBI Links Lending Rates To Loan Tenor

•  The Reserve Bank of India released the final guidelines on computing interest rates on advances based on the marginal cost of funds. The guidelines come into effect from April 1, 2016.
•  The new method — Marginal Cost of funds based Lending Rate (MCLR) — will replace the present base rate system.

The highlights of the guidelines are as under:

•   All rupee loans sanctioned and credit limits renewed w.e.f. April 1, 2016 will be priced with reference to the Marginal Cost of Funds based Lending Rate (MCLR) which will be the internal benchmark for such purposes.
•  According to the new rules, every bank will be required to calculate its marginal cost of funds across different tenors. To this, the banks will add other components including operating cost and a tenor premium. (A tenor premium is the compensation for the risk associated with lending for a longer time)
•  Taking all these components into account, banks will then publish an MCLR for overnight loans, one-month, three-months, six-months and one-year loans. This MCLR will act as the minimum or base lending rate for that tenor of loans irrespective of the borrower.
•  The final lending rate will be MCLR plus the spread that banks will charge for individual categories of borrowers.
•  Banks may specify interest reset dates on their floating rate loans. They will have the option to offer loans with reset dates linked either to the date of sanction of the loan/credit limits or to the date of review of MCLR.
•   The periodicity of reset shall be one year or lower.
•  The MCLR prevailing on the day the loan is sanctioned will be applicable till the next reset date, irrespective of the changes in the benchmark during the interim period.
•  Existing loans and credit limits linked to the Base Rate may continue till repayment or renewal, as the case may be. Existing borrowers will also have the option to move to the Marginal Cost of Funds based Lending Rate (MCLR) linked loan at mutually acceptable terms.
•  Banks will continue to review and publish Base Rate as hitherto.

How it is different from base rate system:

• The base rate or the standard lending rate by a bank is calculated on the basis of the following factors:  a) Cost for the funds (interest rate given for deposits), b)  Operating expenses, c)  Minimum rate of return (profit),  d) Cost for the CRR (for the four percent CRR, the RBI is not giving any interest to the banks). So under this system bank don’t consider repo rate, bank rate to calculate the base rate, which is there minimum lending rate. So, when RBI performs its LAF , bank don’t change it on its interest , which dilute the whole concept of monetary policy.
• On the other hand, the MCLR is comprised of the following are the main components. a) Marginal cost of funds; b)  Negative carry on account of CRR; C)   Operating costs; d) Tenor premium
•  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, Costs that the bank is incurring to get funds (means deposit) is calculated on a marginal basis and the marginal costs include Repo rate. So, whenever RBI change repo rate, bank have to change its lending rate, which is the main objective of monetary policy.
• (marginal cost depends upon a lot of things like interest paid by the bank on savings accounts, term deposits etc. + the REPO RATE)

Analysis:

•  The differentiation based on tenor will be a big positive for banks as now we would be able to price their loans based on the deposits of the corresponding tenor, rather than the older practice of considering 3-6 month deposit rate for computing base rates for all loans.
•  The new rules will reduce the cost of borrowing for companies.
•  At present, the banks are slightly slow to change their interest rate in accordance with repo rate change by the RBI. Commercial banks are significantly depending upon the RBI’s LAF repo to get short term funds. But they are reluctant to change their individual lending rates and deposit rates with periodic changes in repo rate.
•  Whenever the RBI is changing the repo rate, it was verbally compelling banks to make changes in their lending rate. The purpose of changing the repo is realized only if the banks are changing their individual lending and deposit rates.
•  Now, the novel element of the MCLR system is that it facilitates the so called monetary transmission. It is mandatory for banks to consider the repo rate while calculating their MCLR.
•  Apart from helping improve the transmission of policy rates into the lending rates of banks, these measures are expected to improve transparency in the methodology followed by banks for determining interest rates on advances.
•  The guidelines are also expected to ensure availability of bank credit at interest rates which are fair to the borrowers as well as the banks.
•  Further, marginal cost pricing of loans will help the banks become more competitive and enhance their long run value and contribution to economic growth.

By: Vishal