Marginal Cost of Funds based Lending Rate (MCLR): Banking Awareness Special Series

Team Adda247 and Bankers Adda have introduced a Special Banking Awareness series for SBI and IBPS Interviews 2021. In this series, we will introduce the candidates to some banking awareness topics Daily that will improve their general awareness and ensure that the candidates do not lack in any banking term when it comes to the interview round. Today the topic of our Banking Awareness Series is Marginal Cost of Funds based Lending Rate (MCLR).

Marginal Cost of Funds based Lending Rate (MCLR)

Intention to introduce The Marginal Cost of Funds Based Lending Rate (MCLR) was introduced in April 2016 to help borrowers for availing various loans (including home loans) benefit from the Reserve Bank of India’s (RBI) rate cut. It has changed the base rate structure, which had been in place since July 2010. This new rate system ensuring that your lender could not charge you interest rates above the margin defined by RBI. So, understanding the workings of the MCLR will help you for repaying your loans affordably. 

Understanding about MCLR: MCLR is the minimum interest rate on which a bank can lend. Under the MCLR structure, banks can offer all categories of loans on fixed or floating interest rates. The actual lending rates for different categories of loans and tenors are determined by adding the components of spread to MCLR. Therefore, the bank can’t offer loans at a rate lower than the MCLR of a particular maturity for all loans linked to that benchmark. However, certain defined exceptions can be made if allowed by the RBI. 

Calculation of MCLR: MCLR is an internal benchmark that is linked with tenor, which means the rate is determined internally by the bank depending on the period left for the repayment of a loan. The MCLR is based on factors ranging from the usage of this tool in a broad structure. The four main elements of MCLR are as follows:

1.) Tenor premium: When the bank charged a premium for the risk associated with lending of higher tenors is called a ‘Tenor premium’. Tenor is calculated on time left for repayment of the loan. The higher the period of time for the loan, the risk will be the higher. In order to cover the risk, the bank will shift the load to the borrowers by charging an amount in the form of a premium.  Tenor premium is in a uniform structure on all types of loans which is not specific to a loan class of borrower.

2.) Marginal Cost of Funds: Marginal cost of funds (MCF) is calculated on account of all the borrowings of a bank taking into consideration. The various sources of funds to borrow for banks are; fixed deposits (FD), savings accounts, current accounts, equity (retained earnings), RBI loans, etc. MCF is calculated on the rate of interest on these borrowings. MCF contains the Marginal cost of borrowing and return on net worth. Marginal Cost of Borrowings covers 92% and the Return on Net Worth accounts for 8%. This 8% is almost the same as the risk of weighted assets as identified by the Tier I capital for banks.

3.) Negative Carry on CRR: CRR or Cash Reserve Ratio is a proportion of the bank’s fund that banks in India are supposed to submit to the RBI in form of liquid cash, mandatorily. It is considered negative because this money cannot be used by the bank to make any income and it does not earn interest on it. Under MCLR, certain allowances are given to banks are given which are known as Negative Carry on CRR, which is calculated as under:

                                          Requirement of CRR × [marginal cost ÷ (1 – CRR)]

4.) Operating cost: Banks incurred various expenses for raising funds, opening branches, paying salaries, and so on. Operating costs include all costs which are associated with providing loan products. However, the cost of providing services is not included because it is recovered by service charges.