Marginal Cost of Funds based Lending Rate (MCLR) Explained

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) in April 2016, replacing the earlier base rate system to determine the lending rates for commercial banks. The MCLR aims to ensure fair interest rates to borrowers as well as banks. It ensures that the rates offered by banks are closely related to the actual cost of funds, making the banking system more transparent and efficient.

Components of MCLR

The MCLR is calculated based on four components:

1. Marginal Cost of Funds: This is the main component and refers to the cost incurred on new deposits. It is a blend of the cost of borrowings and return on net worth. The marginal cost is the cost of the last rupee lent by the bank and is more sensitive to changes in policy rates compared to the average cost of funds.
2. Operating Costs: These are the expenses incurred by banks to provide loan services, including costs of raising funds but excluding costs recovered directly through service charges.
3. Tenor Premium: This accounts for the risk associated with the loan duration. Longer loan durations have a higher tenor premium due to the increased risk over time.
4. Negative Carry on Account of CRR: Banks are required to keep a certain percentage of their deposits as cash reserve ratio with the RBI, on which they earn no interest. The cost associated with maintaining this reserve is factored into the MCLR as a negative carry.

Banks are required to review and publish their MCLR of different maturities every month. The actual lending rates for loans are determined by adding a spread to the MCLR, which covers credit risk and other factors specific to a borrower or a loan category.

Importance of MCLR

The introduction of MCLR was aimed at improving the transmission of policy rates into the lending rates of banks, thereby making the credit market more responsive to monetary policy changes. This system ensures that when the RBI changes its policy rates, it has a more direct and immediate impact on the lending rates offered to customers, promoting economic growth and financial stability.