What is MCLR?

The marginal cost of funds-based lending rate, or MCLR, is a benchmark interest rate that is the lowest rate at which banks can lend. MCLR went into effect in 2016, basically replacing the base rate structure that had been in place previously.

The Reserve Bank of India (RBI) originally implemented MCLR rates to ensure better pricing of variable rate loans by banks to end customers. Its principal goal was to strike a compromise between the transfer of interest rate advantages from the RBI's monetary policy to borrowers on the one hand, and the banking system's interests through a benchmark rate that ensured profitability on the other. Another thing to remember is that MCLR is a bank's "internal benchmark" and is connected to tenure, or the amount of time left to repay a loan. Commercial banks are currently using it as the lending rate for certain loans, and it is established by each bank separately.

Why was MCLR implemented?

By increasing openness in the loan process, MCLR aims to create a win-win situation for both lenders and borrowers.

For example, banks were not obligated to drop their interest rates as soon as the RBI announced a rate cut during its regular policy meetings in the past. When the RBI raised policy rates, on the other hand, the prevailing complaint was that lenders were ready to raise their rates. Even with the base rate scheme, which was implemented in 2010, there was still a delay in the transmission of interest rate decreases from the RBI to borrowers.

With monthly adjustments to the MCLR, RBI interest rate revisions can be notified to the borrower rapidly. In other words, it allows borrowers to profit from the RBI's rate drop in a shorter period of time.

The goal of bringing MCLR was to increase transparency as well as speed of communication. Previously, a bank might charge customers a "spread" above the base rate based on a variety of parameters such as loan category, customer type, and so on, the determination of which was not always consistent or scientific.

For example, if a bank's base rate is 9%, client A will be charged 9.5 percent (base rate + 0.5 percent spread), whereas customer B will be charged 9.75 percent (base rate + 0.75 percent spread). The MCLR stipulates that the spread be fixed based on the customer's riskiness and the loan's duration, with modifications permissible only as per the sanction document and major changes in the borrower's risk profile.

The MCLR implementation's outcome

Following the installation of MCLR, interest rates are calculated based on each customer's relative risk factor. When the RBI cut the repo rate in the past, banks took a long time to reflect the change in lending rates for borrowers. 

Banks must modify their interest rates as soon as the repo rate changes under the MCLR regime. The implementation intends to increase the transparency of the system used by banks to calculate advance interest rates.

It also ensures the availability of bank credits at rates that are fair to both consumers and banks.

Repo rate and its effect on MCLR

The repo rate is the rate at which a country's central bank (in India, the Reserve Bank of India) loans money to commercial banks in the event of a cash shortage. Monetary authorities utilise the repo rate to limit inflation. 

Borrowers who use the MCLR method receive a lower repo rate. However, if the RBI raises the repo rate, interest rates may rise. The MCLR has an impact on loans that are only borrowed at floating interest rates. The modification in the MCLR has no impact on loans with fixed rates. Borrowers who want to move to an MCLR-based loan have to consider the amount charged by the bank as a fee for making the switch. 

To benefit their customers, a few banks have waived changeover fees, while others charge a defined sum as conversion fees, with some banks calculating the fees as a fixed percentage ranging from 0.5 percent to 2 percent of the loan sanction amount. As a result, these fees, as well as the associated costs, should be considered when calculating the cost of switching.

Conclusion

The main goal of MCLR is to ensure that banks charge their borrowers fairly for their loans, based on actual market conditions rather than opaque internal computations. It has a lot of advantages. However, while MCLR was better than the base rate system, it still did not maintain pace of external benchmark rates, which meant that commercial banks were charging higher interest rates than what was required for good credit development in India's fast-growing economy.

This has altered with the implementation of the external benchmark lending rates (EBLR) in 2019. EBLR is an external benchmark that lenders can now use to price their loans, as the name implies. Interest rates must now be matched to market rates, in keeping with the adage that the market knows best. What are the current market rates? According to the RBI, this might be the repo rate or Treasury Bill rates (at which the Government of India raises cash for its purposes), which are issued on a regular basis by Financial Benchmarks India Pvt. Ltd. (FBIL), an RBI-appointed entity.

Banks should also adjust their interest rates at least once every three months. Borrowers will be able to observe quick changes in interest rates connected to external standards, as opposed to internal benchmarks like MCLR, pushing transmission and transparency to the next level.