Borrowing: The new rate regime - MCLR

Borrowing: The new rate regime-MCLR

Banks will decide the interest rate based on marginal cost of fund where they have to regularly calculate their cost of funds and the change has to be passed on to the borrowers by revising their benchmark. The earlier benchmark was base rate, which was calculated to reflect the average cost of funds. The base rate did not change if banks lowered deposit rates as existing deposits continued to earn interest on old rates. In marginal cost of lending rate (MCLR), if a bank cuts its one-year deposit rate, its one-year MCLR will decline and lending rates will also drop.

Home loans, term loans to small and medium enterprises and middle-level corporates will largely fall into this category. However, fixed rate home loans, personal loans and auto loans will not be linked to MCLR. The Reserve Bank of India had issued guidelines on MCLR in December last year which have come into effect on April 1.

The central bank has underlined that the actual lending rates will be determined by adding the components of spread to the MCLR. Accordingly, there will be no lending below the MCLR of a particular maturity for all loans linked to that benchmark. The reference benchmark rate used for pricing the loans should form part of the terms of the loan contract.

As a result, the country’s largest lender, State Bank of India has reduced its lending rates. Home loan EMIs will fall by Rs300 for those who avail of Rs50 lakh for 15 years as the bank reduced its home loan rate to 9.45% from 9.55%. Current borrowers of SBI will also have the option to switch to the new rates, but will have to pay a small switching fee. Under the MCLR regime, SBI’s benchmark rate would range between 8.85% (for overnight) and 9.35% (for three years). Similarly, ICICI Bank and HDFC Bank have also made one-year MCLR of 9.2%.

Analysts say MCLR is more transparent and beneficial for borrowers as they do not have to wait for the average cost of deposits for a bank to come down. The MCLR will be determined by the marginal cost for funds, especially by the deposit rate and by the repo rate. Any change in repo rate will change the marginal cost and the MCLR would also change.

The MCLR will be reviewed based on the prevailing costs of funds. As MCLR will be tenor-based benchmark instead of a single rate, it will enable banks to efficiently price loans at different tenors based on different MCLR and their funding composition. The final lending rates offered by the banks will include the spread to the MCLR.

However, existing borrowers with loans linked to the base rate will have to continue with base rate till repayment of the entire loan. Banks may provide an option to the existing borrower to switch to MCLR by paying a conversion fee which will be determined by the banks. If the existing borrower switches to MCLR, then he will not be able to go back to the base rate system again.

Analysts say if the interest rates tend to fall, then it benefits borrowers of home loan to be on MCLR. However, if the rates move up, then the hike in MCLR will be much swifter. Moreover, banks will still set a spread on loans depending on the type of loan and the credit history of the borrower. Spread means that banks can charge higher interest rate depending upon the riskiness of the borrower.

In 2010, the central bank had introduced the base rate system to ensure that banks do not lend below a certain rate and that the changes in interest rate policy is effectively transmitted to the borrower. However, that did not happen. While the central bank has reduced the repo rate by 125 basis points (bps) since January 2015, banks have reduced their base rate by only 66 bps, and in contrast, deposit rate by 118 bps.

The base rate was calculated on the basis of a host of factors such as the cost for the funds or the interest given for deposits, operating expenses of the bank, minimum rate of return or profit, and the cost for the cash reserve ratio. Banks have pointed out that one of the reasons for weak monetary policy transmission was because a bulk of their borrowing was through deposits rather through the market.

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Home loans, term loans to small and medium enterprises and middle-level corporates will largely fall into the marginal cost of lending rate (MCLR) category.

Analysts say MCLR is more transparent and beneficial for borrowers as they do not have to wait for the average cost of deposits for a bank to come down.

The MCLR will be determined by the marginal cost for funds, especially by the deposit rate and by the repo rate. Any change in repo rate will change the marginal cost and the MCLR would also change.

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