MCLR - a new tool for Monetary Policy Transmission

The Monetary Transmission Mechanism is the process by which asset prices and general economic conditions are affected as a result of monetary policy decisions. Such decisions are intended to influence the aggregate demand, interest rates, and amounts of money and credit in order to affect overall economic performance.

By changing the short-term interest rate—like the repo rate in India or the federal funds rate in the US—a central bank signals other banks to change their lending and deposit rates. But it can’t force them to make the change, and so the actual efficiency of monetary policy transmission depends on commercial banks.

The Reserve Bank of India had stated in its First Bi-monthly Monetary Policy Statement 2015-16 announced on April 7, 2015 that ‘for monetary transmission to occur, lending rates have to be sensitive to the policy rate. With the introduction of the Base Rate on July 1, 2010 banks could set their actual lending rates on loans and advances with reference to the Base Rate. At present, banks are following different methodologies in computing their Base Rate – on the basis of average cost of funds, marginal cost of funds or blended cost of funds (liabilities). Base Rates based on marginal cost of funds should be more sensitive to changes in the policy rates. In order to improve the efficiency of monetary policy transmission, the Reserve Bank will encourage banks to move in a time-bound manner to marginal-cost-of-funds-based determination of their Base Rate’.

Accordingly, the Reserve Bank of India had brought out the draft guidelines on banks adopting marginal cost of funds methodology for calculating Base Rates on September 1, 2015. Based on the feedback received from all stakeholders, as well as extensive discussions held with banks, the final guidelines have now been released.

What is MCLR?
Marginal Cost of Funds based Lending rate has been made applicable w.e.f 1st April 2016. It has replaced the previous 'base rate' that was being used previously. MCLR is the rate comprising 4 Factors that contribute to its making:

1. Marginal Cost of Funds
2. Operational Costs of bank
3. Negative carry in maintaining CRR
4. Tenor Premium

Why MCLR?
RBI cut out Repo Rates in the previous fiscal thinking that the banks would pass on the benefits of Rate cuts to their customers (the borrowers) but a few banks put the benefit of rate cuts into their pockets and did not reduce the base rate. The banks that had been demanding rate cuts to make the loans cheaper were actually not doing so when Repo rates got reduced. Therefore MCLR was brought in to attach the effects of REPO Rate to the base rate of banks.

How to Calculate MCLR?

As mentioned above, 4 factors have to be properly understood.

1. Marginal Cost of Funds: It comprises 3 parts:
The interest rates on deposits given by the banks to its customers
The Rate charged by RBI for amount borrowed from it. (REPO)
The rate of return on Net Worth (in accordance with capital adequacy norms)
Weights assigned to each of the 3 above are as follows:

92% weightage to be given to (a) + (b)
8% weightage to (c)

2. Bank's Operating Cost: the everyday operating cost of the bank.

3. Negative carry in maintaining CRR with RBI: CRR is the amount kept as reserve by the banks in accordance with the guidelines and monetory policy of RBI. This liquid amount cannot be used for day to day operations in the business of banks. In other words, the cost of funds blocked due to maintenance of CRR is also to be considered.

4. Tenor Premium: Tenor premium means, longer the loan, higher can be the premium for the same. This, in other words, is the profit margin of the bank.

The basic difference is easily visible in the form of tenor premium and Marginal Cost of Funds that would be used.
Example: Suppose SBI's marginal cost of funds comes out to 6%, operating costs 1% , CRR maintenance: 1% and tenor premium 1% for one year. Therefore if you take a loan for one year then the MCLR comes out to 9% + spread (if any). Now suppose if any cut in the REPO rate happens, then this would cut the rate of marginal cost of funds.

By: Abhishek Sharma