Marginal Cost of funds based Lending rate (MCLR)

The Marginal Cost of Funds Based Lending Rate (MCLR) is a benchmark interest rate system introduced by the Reserve Bank of India (RBI) with effect from 1 April 2016. It replaced the earlier Base Rate system as the standard for determining the minimum interest rate that commercial banks can charge on loans. The MCLR mechanism was designed to improve the transmission of monetary policy, enhance transparency in lending rates, and ensure that the benefits of policy rate cuts by the RBI are passed on more effectively to borrowers.

Background and Rationale

Prior to MCLR, Indian banks followed two main lending benchmarks—the Benchmark Prime Lending Rate (BPLR) system (introduced in 2003) and the Base Rate system (introduced in 2010). Both systems faced significant limitations in ensuring quick and full transmission of RBI’s monetary policy actions to lending rates.
Under the Base Rate regime, banks’ lending rates were determined primarily by the average cost of funds, which changed slowly over time and was less sensitive to changes in policy repo rates. Consequently, when the RBI reduced policy rates, banks often delayed reducing their lending rates, weakening the monetary transmission process.
To address these inefficiencies, the RBI introduced the MCLR framework, linking loan rates more directly to the marginal cost of funds—that is, the cost a bank incurs in raising an additional unit of fund. This ensured a more responsive and market-linked mechanism for determining lending rates.

Concept and Definition

The Marginal Cost of Funds Based Lending Rate represents the minimum internal lending rate below which a bank is not permitted to lend, except in certain specified cases such as loans against deposits or government schemes.
In essence, MCLR reflects the incremental cost of borrowing funds, taking into account the latest cost of deposits, borrowings, and other funding sources, along with operational expenses and a profit margin.
It provides a dynamic and forward-looking benchmark that adjusts more frequently in response to changes in funding costs or monetary policy decisions by the RBI.

Components of MCLR

The MCLR of a bank is calculated based on four key components:

1. Marginal Cost of Funds:
   • This includes the marginal cost of borrowings (such as interest rates on new deposits or borrowings) and the return on net worth that banks are required to earn.
   • The weighted average cost of deposits (especially term deposits) forms a major portion of this component.
2. Negative Carry on Cash Reserve Ratio (CRR):
   • Banks are required to maintain a portion of their deposits as CRR with the RBI, on which they earn no interest.
   • The cost incurred due to this non-interest-bearing reserve is included as a negative carry.
3. Operating Costs:
   • These are the administrative and operational expenses incurred in running the lending business, excluding costs already recovered through service charges.
4. Tenor Premium:
   • A premium added to reflect the higher interest rate risk associated with longer-term loans.
   • It ensures that loans of longer maturities carry slightly higher rates than short-term loans.

Calculation and Tenor-Based Structure

Banks are required to compute and publish MCLR for different maturities (tenors) such as overnight, one month, three months, six months, and one year. Each tenor has its own MCLR, which serves as the benchmark for determining loan interest rates.
For example:

• A short-term loan might be linked to the 3-month MCLR, while
• A long-term home loan may be linked to the 1-year MCLR.

The interest rate on a floating rate loan is then determined by adding a spread (margin) to the relevant MCLR.
Formula:Lending Rate = MCLR (of the relevant tenor) + Spread (markup for credit risk, operating cost, etc.)
Banks are required to review and reset their MCLR rates monthly, ensuring that lending rates reflect recent changes in funding costs.

Advantages of the MCLR System

The introduction of the MCLR framework brought several significant benefits:

• Improved Monetary Transmission:Lending rates became more responsive to changes in the RBI’s repo rate, allowing borrowers to benefit more quickly from policy rate cuts.
• Enhanced Transparency:Banks were required to publicly disclose their MCLR and the methodology for its calculation, making the process more transparent.
• Better Pricing Efficiency:Since MCLR is based on the marginal cost of funds rather than the average cost, it reflects real-time market conditions more accurately.
• Fair Competition:By standardising calculation methods, the system ensured a level playing field among banks.

Limitations and Criticisms

Despite its advantages, the MCLR system faced several operational and structural challenges:

• Incomplete Transmission:Although more responsive than the Base Rate system, banks still showed a lag in passing on the full benefits of repo rate cuts, mainly due to high deposit costs and asset–liability mismatches.
• Complexity for Borrowers:Frequent revisions in MCLR and the presence of multiple tenors created confusion for borrowers in understanding effective loan rates.
• Stickiness of Deposit Rates:Banks were reluctant to lower deposit rates quickly due to competition and liability considerations, which affected the marginal cost of funds.
• Reset Periods:Many loans had interest rate reset periods of 6 or 12 months, delaying the reflection of lower MCLR rates in borrower EMIs.

Transition to External Benchmark Lending Rate (EBLR)

In order to further strengthen monetary transmission, the RBI introduced the External Benchmark Lending Rate (EBLR) framework in October 2019. Under this system, banks are required to link new floating-rate retail and small business loans to an external benchmark such as:

• The RBI repo rate,
• The 3-month or 6-month Treasury Bill yield, or
• Any other market-determined benchmark approved by the RBI.

While the EBLR is now the dominant benchmark for new loans, the MCLR system continues to apply to loans sanctioned before October 2019 and for certain other categories of borrowers.

Comparison with Previous Systems

Impact on Borrowers and the Banking Sector

The introduction of MCLR has had several implications:

• Borrowers: Benefited from relatively faster rate reductions during periods of monetary easing, though benefits were not always immediate.
• Banks: Became more competitive and efficient in managing their funding strategies. The need to review MCLR monthly also encouraged better asset–liability management.
• Financial System: The MCLR framework strengthened market discipline and improved transparency in credit pricing.

Significance in India’s Monetary Policy Framework

MCLR represents a critical link in India’s monetary transmission chain. It bridges the gap between policy rates determined by the RBI and lending rates charged by banks to customers. Although now complemented by external benchmark systems, MCLR continues to play an important role in ensuring that changes in monetary policy are effectively transmitted across the banking sector.