Context
- India’s largest private sector lender, HDFC Bank, hiked its Marginal Cost of Funds-Based Lending Rate (MCLR) by up to 10 basis points across various tenors. This rate hike directly increases the Equated Monthly Instalments (EMIs) for existing borrowers whose floating-rate retail and corporate loans are linked to the bank’s internal benchmarks.
Core Economic Concept: Understanding MCLR
1. What is MCLR?
- It is the minimum interest rate below which a bank cannot ordinarily lend money (except in certain cases permitted by the Reserve Bank of India). It was introduced by the RBI in April 2016 to ensure faster transmission of policy rate changes to borrowers.
- Example:
- If a bank’s 1-year MCLR is 8.5%, a home loan may be offered at: 8.5% + spread (e.g., 0.5%) = 9.0%.
2. How Does an MCLR Hike Affect Borrowers?
- When MCLR rises, the interest rate on linked floating-rate loans also increases.
- As a result:
- EMIs may increase, or
- Loan tenure may extend (depending on the bank’s policy).
3. Why was it introduced?
- To replace the Base Rate System.
- To make lending rates more transparent.
- To ensure RBI policy rate changes are reflected more quickly in loan interest rates.
4. How is MCLR Calculated?
- Unlike older systems that relied on average costs, MCLR is calculated based on the incremental (marginal) cost of raising new funds. It comprises four critical components:
- MCLR = Marginal Cost of Funds + Negative Carry on CRR + Operating Costs + Tenor Premium
- Marginal Cost of Funds (90% weightage): The interest rate the bank pays to raise fresh deposits or borrowings (e.g., current deposit rates, repo borrowings), alongside its return on net worth.
- Negative Carry on CRR (Cash Reserve Ratio): Banks do not earn any interest on the cash they keep locked with the RBI as CRR. The cost of these locked, zero-earning funds is factored in here.
- Operating Costs: The operational expenses of running the bank (salaries, branches, infrastructure).
- Tenor Premium: The additional risk premium charged based on the length of the loan commitment (e.g., a 2-year loan carries a higher tenor premium than an overnight loan).
5. The Evolution of Lending Rate Frameworks in India
To evaluate monetary transmission, the RBI has progressively changed benchmarks. For Prelims, understand this chronological evolution:
- Prime Lending Rate (PLR) / Benchmark PLR (BPLR): High degree of bank discretion; banks frequently lent to AAA-rated corporates below the officially declared BPLR, hiding true pricing from retail consumers.
- Base Rate (2010): Introduced a minimum floor rate below which banks could not lend. Calculated using the average cost of funds. It failed to transmit RBI rate cuts quickly because older, expensive long-term deposits kept the average cost high.
- MCLR (2016): Shifted the formula to marginal (incremental) cost of funds. While better than the Base Rate, it still suffered from a transmission lag because banks delayed updating their internal deposit rates or reset periods were long (typically 6 to 12 months).
- External Benchmark Lending Rate – EBLR (October 1, 2019): To eliminate bank discretion entirely, the RBI mandated that all new floating-rate retail loans (home, auto) and MSME loans must be linked to an external market benchmark rather than internal calculations.
6. Key Differences: MCLR vs. EBLR
| Feature | Marginal Cost of Funds-Based Lending Rate (MCLR) | External Benchmark Lending Rate (EBLR) |
| Type of Benchmark | Internal (calculated uniquely by each bank based on its own financial health). | External (linked to public, market-determined or RBI-determined rates). |
| Reset Frequency | Typically once every 6 to 12 months. | Mandatory reset at least once every 3 months. |
| Policy Transmission | Slow & lagged. Banks take months to pass on RBI repo rate cuts. | Immediate & dynamic. A change in the repo rate triggers an automatic shift in loan rates. |
MCQ
Consider the following statements regarding the Marginal Cost of Funds-Based Lending Rate (MCLR):
1. MCLR was introduced by the Reserve Bank of India in 2016 to improve the transmission of monetary policy.
2. MCLR is calculated based on the average cost of funds raised by banks.
3. The cost associated with maintaining the Cash Reserve Ratio (CRR) is a component of MCLR.
4. Under the External Benchmark Lending Rate (EBLR) system, floating-rate retail loans are linked to an external benchmark such as the RBI's repo rate.
Which of the statements given above are correct?
(a) 1, 3 and 4 only
(b) 1 and 2 only
(c) 2, 3 and 4 only
(d) 1, 2, 3 and 4
Answer: (a) 1, 3 and 4 only
Explanation:
• Statement 1 is correct: MCLR was introduced in April 2016 to improve monetary policy transmission.
• Statement 2 is incorrect: MCLR is based on the marginal (incremental) cost of funds, not the average cost.
• Statement 3 is correct: Negative carry on CRR is a component of MCLR.
• Statement 4 is correct: EBLR links loans to external benchmarks such as the RBI repo rate, enabling faster policy transmission.