Explained: Why there is better policy transmission in the MCLR regime vs base rate regime

Rate hikes by the Reserve Bank of India (RBI) are better transmitted under the Marginal Cost of Funds-based Lending Rate (MCLR) regime than in the base rate regime, according to a recent paper by the RBI. Under the MCLR regime, a formula has been prescribed to banks to calculate the cost of funds. This reduces the scope for discretion with banks which existed under the base rate regime, leading to better transmission, say economists.

MCLR is the minimum interest rate below which financial institutions like banks and other lenders cannot lend, barring a few exceptions. Earlier, this minimum rate was the base rate. While the base rate was based on the average cost of funds, the MCLR is based on marginal/incremental cost of funds.

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The paper published on August 12 suggests that during the MCLR regime, a 100-basis-point (bps) change in repo rate would lead to 26-47 bps change in the weighted average lending rate on fresh rupee loans sanctioned by banks over the long run, while under the base rate regime this would have been 11-19 bps.

The central bank introduced the MCLR system on April 1, 2016. Under this system, banks are expected to determine their benchmark lending rate based on the formula prescribed for the calculation of the marginal cost of funds. This helps reduce the scope for discretion that existed during the base rate regime.

Difference between MCLR and Base Rate

The base rate is calculated on the average cost of funds, while the MCLR is calculated on the marginal cost of funds. Base rate calculation includes the minimum returns or profit margins, but MCLR is calculated based on the tenor premium, i.e., the amount of time a borrower has to repay the loan. This tenor-linked benchmark is internal in nature. The bank determines the actual lending rates by adding the elements used in this tool.

The formula prescribed by the RBI for MCLR calculation is:

MCLR = Marginal borrowing cost X 92% + net worth returns X 8%

Banks just need to maintain a 4 percent cash reserve ratio (CRR) under the MCLR regime.

Base rate calculation is done by taking a number of factors into consideration. These include the cost of deposits, administrative costs borne by the bank, profitability of the bank in the previous financial year, and the unallocated overhead costs, among other things. The components of Base Rate will include the cost of funds, negative carry on CRR/SLR, un-allocable overhead costs, and average return on net worth.

Thus, in MCLR, the rate is independent of factors like administrative costs borne by the bank, the profitability of the bank in the previous etc. So, the rate will go up or down as per the RBI monetary policy rate.

Reasons for better policy rate transmission

Experts say the rate of transmission to the end customers is maximised under the MCLR regime. And so, despite higher rates, MCLR is the preferred regime, they contend.

“The MCLR regime has reduced the extent of discretion, which was present during the base rate regime. During the base rate regime, price discrimination was pervasive between old and new customers, which hindered transmission of policy rate changes. The MCLR regime is relatively more transparent, leading to better transmission,” says Shashank Mendiratta, an economist from Delhi.

Economists also identified various other factors that led to higher rate under the MCLR regime. According to them, rates under the MCLR regime is largely decided by the marginal cost of funds of the banks, which varies from banks to banks. This was not the case under the base rate regime. “Majority of the MCLR regime (period) (from April 2016) was marked by rate cuts with the exception of the eight-month period (June 2018 to January 2019) where policy tightening took place. Banking system liquidity is higher during the MCLR regime, which enabled better transmission of policy rate changes, especially in periods of rate cuts,” added Gaura Sen Gupta, economist, IDFC First Bank.

The transmission of monetary policy initiatives is expected to improve further under the external benchmark system, which came into effect from October 2019 for retail loans, and industry credit, say the economists.

Impact on banking

Under MCLR, policy transmission is effective during rate-hike times, similarly, it will be effective during the easing cycle to a certain extent. Various other factors like CRAR, bank recapitalisation and operating cost contribute significantly to the level of lending rates.

“The impact will be better transmission of monetary policy rate changes under the MCLR, which is expected to improve further under the external benchmark regime. Currently, we are in a rate-hike cycle and the improved transmission on lending rates coincides with the pick-up in bank credit growth. At the same time, the focus on monetary policy is on normalising banking system liquidity, which will further aid transmission of rate hikes,” added Sen Gupta.

Moreover, the MCLR regime allows the bank to transfer most of the rate change (read, rate-cuts) to the end customers. “Under the base rate regime banks were not able to transfer the rate-cuts fully. So, customers would complain when the benefit on rate-cut was not passed on to them,” said Dr Sriharsha Reddy, economist and director, IMT, Hyderabad. But under the MCLR regime, there is little room for such complaints.