MCLR

MCLR (Marginal Cost of Funds based Lending Rate) is the internal benchmark used by banks in India to determine the minimum interest rate at which they can lend money. It was introduced by the RBI in 2016 to replace the Base Rate system and make lending rates more responsive to changes in the cost of funds.

How MCLR is Determined?

Banks calculate MCLR monthly (or as per their policy) for different tenors (loan durations, e.g., overnight, 1-month, 3-month, 6-month, 1-year, etc.). It is tenor-linked, meaning different MCLR rates apply for different loan periods.

The standard formula is:

MCLR = Marginal Cost of Funds (MCOF) + Negative Carry on CRR + Operating Costs + Tenor Premium

1. Marginal Cost of Funds (MCOF) — Largest Component

• This is the incremental cost of raising fresh funds.

• It includes:

  • Cost of deposits (savings, current, fixed deposits) with similar maturities.

  • Cost of borrowings from RBI (e.g., repo rate) or market.

  • Return on Net Worth (usually 8% weightage for equity capital).

• Typically, 92% weight is given to marginal cost of borrowings and 8% to return on net worth.

2. Negative Carry on CRR (Cash Reserve Ratio)

• Banks must keep a portion of deposits (currently around 4%) with the RBI, on which they earn no interest.

• This represents the opportunity cost or loss due to idle funds.

3. Operating Costs

• Day-to-day expenses of the bank (salaries, rent, technology, etc.), excluding costs recovered via service charges.

• Usually expressed as a percentage of the marginal cost of funds.

4. Tenor Premium

• Extra charge for longer-duration loans to cover higher risk and liquidity issues.

• Longer the loan tenor → higher the premium.

After calculating MCLR, banks add a spread (which includes business strategy premium + credit risk premium) to arrive at the final lending rate for a borrower.

Example (simplified): If MCOF = 7.5%, Negative CRR carry = 0.2%, Operating cost = 0.3%, Tenor premium = 0.1% → MCLR ≈ 8.1%. Final loan rate = MCLR + Spread (e.g., 0.5%–2% depending on your credit profile).

This system ensures that when RBI changes policy rates (like repo rate), banks quickly pass on the benefit (or cost) to borrowers through MCLR resets.

External Benchmark-based Lending Rate (EBR)

External Benchmark-based Lending Rate (EBR) refers to a lending rate that is linked to an external benchmark, which is determined by factors beyond the control of the lending institution. 

1. In the context of banking and finance, this concept gained significance due to regulatory changes in various countries, including India. Key points related to External Benchmark Based Lending Rate:

2. Regulatory Context (India): In India, the Reserve Bank of India (RBI) introduced guidelines to link the interest rates on certain loans to external benchmarks, effective from October 1, 2019. This was done to improve the transmission of policy rates and ensure that changes in the policy rates were passed on to borrowers more effectively.

3. External Benchmarks: The external benchmarks can include market-determined interest rates, such as the Repo Rate (the rate at which the central bank lends to commercial banks), Government of India 3-Month Treasury Bill Yield, or any other benchmark published by Financial Benchmarks India Private Ltd. (FBIL).

4. Transmission Mechanism: When the external benchmark rate changes, the lending rates for loans linked to that benchmark also change. This is expected to make the transmission of changes in the policy rate more direct and faster.

5. Loans Linked to EBR: Home loans, auto loans, and personal loans are examples of retail loans that may be linked to the External Benchmark-based Lending Rate.

6. Periodic Review: The interest rates linked to external benchmarks are typically reset at regular intervals, providing borrowers and lenders with transparency and responsiveness to changes in market conditions.

7. Spread or Margin: In addition to the external benchmark rate, banks may charge a spread or margin over the benchmark to determine the final lending rate. The spread covers the bank's operating costs and risk premium.

8. Risk Management: Lenders may incorporate risk premium in the spread to account for credit risk, operational risk, and other factors.

9. EBLR replaced the previous benchmark rates, such as the Base Rate and Marginal Cost of Funds-based Lending Rate (MCLR), to address the issue of slower-than-expected rate transmission under the MCLR regime. The EBLR system has been found to be more effective in transmitting policy rate changes compared to the previous systems.

BASE RATE

Base Rate is the oldest of the three major lending benchmarks in India.

What is Base Rate?

• Introduced by RBI in July 2010.
• It replaced the even older BPLR (Benchmark Prime Lending Rate) system.
• Base Rate is the minimum interest rate below which a bank cannot lend (with few exceptions).
• It was designed to bring more transparency than BPLR.

How Base Rate is Determined?

Banks calculate Base Rate using the average cost of funds method. The main components are:

Final Base Rate = Average Cost of Funds + Operating Cost + Profit Margin + Other adjustments

• Banks review and publish Base Rate at least quarterly.

• It is not tenor-specific (unlike MCLR).

Now No new loans are sanctioned on Base Rate after 2016.

Comparison: Base Rate vs MCLR vs EBLR