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The Reserve Bank of India has brought a new methodology for setting lending rate by

commercial banks: Marginal Cost of Funds based Lending Rate (MCLR). It is applicable
from April 2016 onwards.
The new methodology uses the marginal cost or latest cost conditions reflected in the interest
rate given by the banks for obtaining funds (from deposits and while borrowing from RBI)
while setting their lending rate
Why the MCLR reform?
At present, the banks are slightly slow to change their interest rate in accordance with repo
rate change by the RBI. Commercial banks are significantly depending upon the RBIs LAF
repo to get short term funds. But they are reluctant to change their individual lending rates
and deposit rates with periodic changes in repo rate.
Whenever the RBI is changing the repo rate, it was verbally compelling banks to make
changes in their lending rate. The purpose of changing the repo is realized only if the banks
are changing their individual lending and deposit rates.
Implication on monetary policy
Now, the novel element of the MCLR system is that it facilitates the so called monetary
transmission. It is mandatory for banks to consider the repo rate while calculating their
The RBI calls the effective passing of repo rate change into interest rate change by the
banking system as an important part of monetary transmission. Monetary transmission in
complete sense is the way in which a monetary policy signal (like a repo rate cut) is passed
into the economy in producing the set objectives.
Take the case of a repo rate reduction by the RBI. It is aimed to reduce overall interest rate in
the economy and thus promoting loans for consumption and investment. This consumption
and investment boost will be realized only if banks are cutting interest rate in response to the
reduced repo rate.
Previously under the base rate system, banks were changing the base rate, only occasionally.
They waited for long time or waited for large repo cuts to bring corresponding reduction in
their base rate. Now with MCLR, banks are obliged to readjust interest rate monthly. This
means that such quick revision will encourage them to consider the repo rate changes.
The concept of marginal is important to understand MCLR. In economics sense, marginal
means the additional or changed situation. While calculating the lending rate, banks have to
consider the changed cost conditions or the marginal cost conditions. For banks, what are the
costs for obtaining funds? It is basically the interest rate given to the depositors (often
referred as cost for the funds). The MCLR norm describes different components of marginal

costs. A novel factor is the inclusion of interest rate given to the RBI for getting short term
funds the repo rate in the calculation of lending rate.
Following are the main components of MCLR.
1. Marginal cost of funds;
2. Negative carry on account of CRR;
3. Operating costs;
4. Tenor premium.
Negative carry on account of CRR: is the cost that the banks have to incur while keeping
reserves with the RBI. The RBI is not giving an interest for CRR held by the banks. The cost
of such funds kept idle can be charged from loans given to the people.
Operating cost: is the operating expenses incurred by the banks
Tenor premium: denotes that higher interest can be charged from long term loans
Marginal Cost: The marginal cost that is the novel element of the MCLR. The marginal cost
of funds will comprise of Marginal cost of borrowings and return on networth. According to
the RBI, the Marginal Cost should be charged on the basis of following factors:
1. Interest rate given for various types of deposits- savings, current, term deposit,
foreign currency deposit
2. Borrowings Short term interest rate or the Repo rate etc., Long term rupee
borrowing rate
3. Return on networth in accordance with capital adequacy norms.
The marginal cost of borrowings shall have a weightage of 92% of Marginal Cost of
Funds while return on networth will have the balance weightage of 8%.
In essence, the MCLR is determined largely by the marginal cost for funds and
especially by the deposit rate and by the repo rate. Any change in repo rate brings
changes in marginal cost and hence the MCLR should also be changed.
According to the RBI guideline, actual lending rates will be determined by adding the
components of spread to the MCLR. Spread means that banks can charge higher interest rate
depending upon the riskiness of the borrower.
Powerful element of the MCLR system form the monetary policy angle is that banks have to
revise their marginal cost on a monthly basis. According to the RBI guideline, Banks will
review and publish their MCLR of different maturities every month on a pre-announced
date. Such a monthly revision will compel the banks to consider the change in repo rate
change if any made by the RBI during the month.

Regarding the status-quo of base rate, the initial guidelines from the RBI indicate that the
Base rate will be replaced by the MCLR. Existing loans and credit limits linked to the Base
Rate may continue till repayment or renewal, as the case may be. Existing borrowers will also
have the option to move to the Marginal Cost of Funds based Lending Rate (MCLR) linked
loan at mutually acceptable terms.
How MCLR is different from base rate?
The base rate or the standard lending rate by a bank is calculated on the basis of the following
1. Cost for the funds (interest rate given for deposits),
2. Operating expenses,
3. Minimum rate of return (profit), and
4. Cost for the CRR (for the four percent CRR, the RBI is not giving any interest to the
On the other hand, the MCLR is comprised of the following are the main components.
1. Marginal cost of funds;
2. Negative carry on account of CRR;
3. Operating costs;
4. Tenor premium
It is very clear that the CRR costs and operating expenses are the common factors for both
base rate and the MCLR. The factor minimum rate of return is explicitly excluded under
But the most important difference is the careful calculation of Marginal costs under MCLR.
On the other hand under base rate, the cost is calculated on an average basis by simply
averaging the interest rate incurred for deposits. The requirement that MCLR should be
revised monthly makes the MCLR very dynamic compared to the base rate.
Under MCLR:
1. Costs that the bank is incurring to get funds (means deposit) is calculated on a
marginal basis
2. The marginal costs include Repo rate; whereas this was not included under the base
3. Many other interest rates usually incurred by banks when mobilizing funds also to be
carefully considered by banks when calculating the costs.

4. The MCLR should be revised monthly.

5. A tenor premium or higher interest rate for long term loans should be included.
It expects banks margins in FY17 to face downward pressure on the back of this
transition; the impact, however, will be different across banks, based on the variances in
their Asset Liability Management (ALM) gaps, floating rate book, current account
savings account (CASA) ratios, share of borrowing in the funding profile and differences
in their operating cost structure.
Banks will set their lending rates under the marginal cost of funds (deposits) every month,
which will be based on the rate offered on new deposits, which would reflect the market