In 2015-16, the Reserve Bank of India (RBI) reduced its policy rate (i.e. repo rate) several times, but it hardly reflected in my home loan EMIs. Perhaps the RBI sensed my disappointment, and that of numerous other borrowers like me, and introduced the Marginal Cost of Funds based Lending Rate (MCLR). Effective from April 2016, this policy mandates banks to pass on the rate change advantage to customers, by default. The adoption of the MCLR seems to be a step in the right direction. To appreciate its merits, let us look at how the Indian banking sector has evolved.
Taking a look back at Indias interest rate regimes
Introduced in 2003, the BPLR was a reference rate at which banks would lend to their most creditworthy customers. Ideally, loans below BPLR were not to be extended. However, since this rate was merely for reference, and not necessarily the minimum lending rate, banks gradually resorted to sub-BPLR lending to stay competitive. By 2007, sub-BPLR lending across the banking system was more than 70%, raising serious questions on its efficacy. Moreover, when the RBI reduced policy rates, banks would merely adjust the spread across new loans and not really lower the BPLR itself. Existing borrowers therefore continued at higher rates even when rates were actually falling!
To bring in transparency, in 2010 the RBI introduced the Base Rate System. This was the lowest rate at which a bank could lend, with the cost of funds being calculated based on the banks entire deposit portfolio. However, in this system, changes in policy rates did not reflect in ongoing loans as the rates on existing deposits seldom came down significantly. This is evident from the fact that in the last one year, the RBI has reduced the repo rate by nearly 125 basis points but banks base rates have come down by merely an average 60 basis points.
What is the MCLR?
To overcome the shortcomings of these previous methods, the RBI has introduced the MCLR under which banks are expected to fix their benchmark rates based on the cost of fresh borrowings. In essence, the MCLR is based on the marginal cost of funds, which primarily includes the latest interest rate on various deposits and the rate of short-term borrowing (the repo rate). It has to be calculated for different tenures daily, monthly, quarterly, bi-annually, and annually and must be published on banks websites regularly. So, any change in the repo rate will be reflected in the revised MCLR, making it more responsive to policy rate changes.
Banks are not allowed to lend below the MCLR and a credit risk spread is added as per the risk-rating of the borrower. Banks can individually decide the reset frequency for loans, subject to a maximum of one year. Lets say a borrower avails a home loan on one-year MCLR of 9% with a reset time period of six months and a credit spread of 2%, making the final rate 11%. At the next reset (i.e. after six months), if the one-year MCLR is 8%, the lending rate will fall to 10%.
The MCLR will be applicable to new loans immediately, while existing loans will continue on the base rate system until the next renewal. The RBI has exempted certain loans, such as fixed rate loans and restructured loans, from the MCLR. However, it has linked the fixed rate loans with a tenure of up to three years to the MCLR, as otherwise banks would prefer fixed, rather than floating, rate loans.
So, is MCLR the answer?
In the past, the RBI had to nudge banks to reduce lending rates when policy rates fell, and even then, banks would comply only partially. Under the MCLR, the rates will automatically get adjusted as per the latest cost of funds, ensuring transmission of the benefit to borrowers.
Having said that, allowing banks to adjust the reset clause can hinder the responsiveness of the system. For example, when rates are falling, the benefit will be passed on to new borrowers only; existing loans with a one-year reset clause will not stand to gain immediately. In the longer run, competitive pressures are likely to result in banks setting shorter reset periods, as borrowers will be aware of market lending rates (since MCLRs will be published on banks websites).
In the immediate future, the MCLR may also put some pressure on the Net Interest Margin (NIM) of some banks, as their existing deposit bases (particularly with longer maturities) may be on higher rates, whereas new loans will be disbursed on floating rates linked to the latest deposit base. However, over time, older deposits will mature eventually, providing a more level playing field, as the rates for both lending and deposits will reflect in the current policy rates.
We have observed that banks dont seem to mind this marginal impact as long as volumes are increasing. They have already begun aligning their strategy to attract high-rated corporates by offering them short-tenure loans (say, three-month MCLRs as opposed to one-year MCLRs), with a rollover facility, thus providing a lower interest rate.
Unlike developed countries, where the money market is the primary source of funds, India relies on deposits as the key source of funding. There is no model external benchmark rate like LIBOR, which Indian banks can use to base their loans on. The MCLR is definitely an effort toward establishing an ideal policy rate regime. In the event that the new system delivers the expected results, existing home loan borrowers like me would benefit.
Do you think the MCLR is going to drive a change for the good? Which recent banking reforms in your country do you think will benefit the borrower?