RBI announces Marginal Cost of Funds Methodology for Interest Rate on Advances

Understanding Base Rate

The BPLR system, introduced in 2003, fell short of its original objective of bringing transparency to lending rates. This was mainly because under the BPLR system, banks could lend below BPLR. The bulk of wholesale credit (loans to corporate customers) was contracted at sub-BPL rates and it comprised nearly 70% of all bank credit. Under this system, banks were subsidising corporate loans by charging high interest rates from retail and small and medium enterprise customers.

This system defeated the purpose of having a prime lending rate, or the rate that banks charge from its best customers. It also resulted in another problem: bank interest rates ceased to respond to monetary policy changes that the RBI introduced periodically.

Subsequently, in October 2009, the central bank decided to move all banks to a new interest rate system, which would not only be transparent, but also transmit monetary policy signals to the economy. Six months later, in April 2010, after a series of circulars, discussion groups and a rigorous consultative process, the RBI announced its decision to implement the base rate from 1 July 2010. 

The Base Rate system was aimed at enhancing transparency in lending rates of banks and enabling better assessment of transmission of monetary policy. Accordingly, the following guidelines are issued for implementation by banks.

Base Rate

1. The Base Rate system replaced the BPLR system with effect from July 1, 2010. Base Rate included all those elements of the lending rates that were common across all categories of borrowers. Banks chose any benchmark to arrive at the Base Rate for a specific tenor that may be disclosed transparently.Banks were free to use any other methodology, as considered appropriate, provided it was consistent and made available for supervisory review/scrutiny, as and when required.
2. Banks determined their actual lending rates on loans and advances with reference to the Base Rate and by including such other customer specific charges as considered appropriate.
3. In order to give banks some time to stabilize the system of Base Rate calculation, banks were permitted to change the benchmark and methodology any time during the initial six month period i.e. end-December 2010.
4. The actual lending rates charged may be transparent and consistent and be made available for supervisory review/scrutiny, as and when required.

Applicability of Base Rate

5. All categories of loans henceforth were to be priced only with reference to the Base Rate. However, the following categories of loans could be priced without reference to the Base Rate: (a) DRI advances (b) loans to banks’ own employees (c) loans to banks’ depositors against their own deposits.
6. The Base Rate could also serve as the reference benchmark rate for floating rate loan products, apart from external market benchmark rates. The floating interest rate based on external benchmarks should, however, be equal to or above the Base Rate at the time of sanction or renewal.
7. Changes in the Base Rate shall be applicable in respect of all existing loans linked to the Base Rate, in a transparent and non-discriminatory manner.
8. Since the Base Rate will be the minimum rate for all loans, Banks were not permitted to resort to any lending below the Base Rate. Accordingly, the stipulation of BPLR as the ceiling rate for loans up to Rs. 2 lakh stood withdrawn. It was expected that the above deregulation of lending rate will increase the credit flow to small borrowers at reasonable rate and  direct bank finance will provide effective competition to other forms of high cost credit.
9. Reserve Bank of India separately announced the stipulation for   export credit.

Review of Base Rate

10. Banks were required to review the Base Rate at least once in a quarter with the approval of the Board or the Asset Liability Management Committees (ALCOs) as per the bank’s practice. Since transparency in the pricing of lending products has been a key objective, banks were required to exhibit the information on their Base Rate at all branches and also on their websites. Changes in the Base Rate should also be conveyed to the general public from time to time through appropriate channels. Banks were required to provide information on the actual minimum and maximum lending rates to the Reserve Bank on a quarterly basis, as hitherto.

Transitional issues

11. The Base Rate system would be applicable for all new loans and for those old loans that come up for renewal. Existing loans based on the BPLR system may run till their maturity. In case existing borrowers want to switch to the new system, before expiry of the existing contracts, an option may be given to them, on mutually agreed terms. Banks, however, should not charge any fee for such switch-over.

12. In line with the above Guidelines, banks may announce their Base Rates after seeking approval from their respective ALCOs/ Boards.

Effective date

13. The above guidelines on the Base Rate system will became effective fron July 1, 2010.

The constituents of the Base Rate  included:

 (i) the card interest rate on retail deposit (deposits below Rs. 15 lakh) with one year maturity (adjusted for CASA deposits);

(ii) adjustment for the negative carry in respect of CRR and SLR;

(iii) unallocatable overhead cost for banks which would comprise a minimum set of overhead cost elements; and

(iv) average return on net   

Now with the introduction of RBI's Marginal Cost of Funds Methodology for Interest Rate on Advances it is essential to know the following facts:

Background

The Reserve Bank of India had stated in its First Bi-monthly Monetary Policy Statement 2015-16 announced on April 7, 2015 that ‘for monetary transmission to occur, lending rates have to be sensitive to the policy rate. With the introduction of the Base Rate on July 1, 2010 banks could set their actual lending rates on loans and advances with reference to the Base Rate. At present, banks are following different methodologies in computing their Base Rate – on the basis of average cost of funds, marginal cost of funds or blended cost of funds (liabilities). Base Rates based on marginal cost of funds should be more sensitive to changes in the policy rates. In order to improve the efficiency of monetary policy transmission, the Reserve Bank will encourage banks to move in a time-bound manner to marginal-cost-of-funds-based determination of their Base Rate’.

Accordingly, the Reserve Bank of India had brought out the draft guidelines on banks adopting marginal cost of funds methodology for calculating Base Rates on September 1, 2015. Based on the feedback received from all stakeholders, as well as extensive discussions held with banks, the final guidelines have now been released.

The highlights of the guidelines are as under :

1. All rupee loans sanctioned and credit limits renewed w.e.f. April 1, 2016 will be priced with reference to the Marginal Cost of Funds based Lending Rate (MCLR) which will be the internal benchmark for such purposes.
2. The MCLR will be a tenor linked internal benchmark.
3. Actual lending rates will be determined by adding the components of spread to the MCLR.
4. Banks will review and publish their MCLR of different maturities every month on a pre-announced date.
5. Banks may specify interest reset dates on their floating rate loans. They will have the option to offer loans with reset dates linked either to the date of sanction of the loan/credit limits or to the date of review of MCLR.
6. The periodicity of reset shall be one year or lower.
7. The MCLR prevailing on the day the loan is sanctioned will be applicable till the next reset date, irrespective of the changes in the benchmark during the interim period.
8. 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.
9. Banks will continue to review and publish Base Rate as hitherto.

RBI HAS PRESCRIBED THAT:

Banks shall follow the following guidelines for pricing their advances: a) Internal Benchmark i. All rupee loans sanctioned and credit limits renewed w.e.f. April 1, 2016 will be priced with reference to the Marginal Cost of Funds based Lending Rate (MCLR) which will be the internal benchmark for such purposes. ii. The MCLR will comprise of: Marginal cost of funds; Negative carry on account of CRR; Operating costs; Tenor premium. iii. Marginal Cost of funds The marginal cost of funds will comprise of Marginal cost of borrowings and return on networth. The detailed methodology for computing marginal cost of funds is given in the Annex. iv. Negative Carry on CRR Negative carry on the mandatory CRR which arises due to return on CRR balances being nil, will be calculated as under: Required CRR x (marginal cost) / (1- CRR) The marginal cost of funds arrived at (iii) above will be used for arriving at negative carry on CRR. v. Operating Costs All operating costs associated with providing the loan product including cost of raising funds will be included under this head. It should be ensured that the costs of providing those services which are separately recovered by way of service charges do not form part of this component. vi. Tenor premium These costs arise from loan commitments with longer tenor. The change in tenor premium should not be borrower specific or loan class specific. In other words, the tenor premium will be uniform for all types of loans for a given residual tenor. vii. Since MCLR will be a tenor linked benchmark, banks shall arrive at the MCLR of a particular maturity by adding the corresponding tenor premium to the sum of Marginal cost of funds, Negative carry on account of CRR and Operating costs. viii. Accordingly, banks shall publish the internal benchmark for the following maturities: overnight MCLR, one-month MCLR, three-month MCLR, six month MCLR, One year MCLR. In addition to the above, banks have the option of publishing MCLR of any other longer maturity. b) Spread i. Banks should have a Board approved policy delineating the components of spread charged to a customer. The policy shall include principles: To determine the quantum of each component of spread. To determine the range of spread for a given category of borrower / type of loan. To delegate powers in respect of loan pricing. ii. For the sake of uniformity in these components, all banks shall adopt the following broad components of spread: a. Business strategy The component will be arrived at taking into consideration the business strategy, market competition, embedded options in the loan product, market liquidity of the loan etc. b. Credit risk premium The credit risk premium charged to the customer representing the default risk arising from loan sanctioned should be arrived at based on an appropriate credit risk rating/scoring model and after taking into consideration customer relationship, expected losses, collaterals, etc. iii. The spread charged to an existing borrower should not be increased except on account of deterioration in the credit risk profile of the customer. Any such decision regarding change in spread on account of change in credit risk profile should be supported by a full-fledged risk profile review of the customer. iv. The stipulation contained in sub-paragraph (iii) above is, however, not applicable to loans under consortium / multiple banking arrangements. c) Interest Rates on Loans i. Actual lending rates will be determined by adding the components of spread to the MCLR. Accordingly, there will be no lending below the MCLR of a particular maturity for all loans linked to that benchmark ii. The reference benchmark rate used for pricing the loans should form part of the terms of the loan contract. d) Exemptions from MCLR i. Loans covered by schemes specially formulated by Government of India wherein banks have to charge interest rates as per the scheme, are exempted from being linked to MCLR as the benchmark for determining interest rate. ii. Working Capital Term Loan (WCTL), Funded Interest Term Loan (FITL), etc. granted as part of the rectification/restructuring package, are exempted from being linked to MCLR as the benchmark for determining interest rate. iii. Loans granted under various refinance schemes formulated by Government of India or any Government Undertakings wherein banks charge interest at the rates prescribed under the schemes to the extent refinance is available are exempted from being linked to MCLR as the benchmark for determining interest rate. Interest rate charged on the part not covered under refinance should adhere to the MCLR guidelines. iv. The following categories of loans can be priced without being linked to MCLR as the benchmark for determining interest rate: (a) Advances to banks’ depositors against their own deposits. (b) Advances to banks’ own employees including retired employees. (c) Advances granted to the Chief Executive Officer / Whole Time Directors. (d) Loans linked to a market determined external benchmark. (e) Fixed rate loans granted by banks. However, in case of hybrid loans where the interest rates are partly fixed and partly floating, interest rate on the floating portion should adhere to the MCLR guidelines. e) Review of MCLR i. Banks shall review and publish their Marginal Cost of Funds based Lending Rate (MCLR) of different maturities every month on a pre-announced date with the approval of the Board or any other committee to which powers have been delegated. ii. However, banks which do not have adequate systems to carry out the review of MCLR on a monthly basis, may review their rates once a quarter on a pre-announced date for the first one year i.e. upto March 31, 2017. Thereafter, such banks should adopt the monthly review of MCLR as mentioned in (i) above. f) Reset of interest rates i. Banks may specify interest reset dates on their floating rate loans. Banks will have the option to offer loans with reset dates linked either to the date of sanction of the loan/credit limits or to the date of review of MCLR. ii. The Marginal Cost of Funds based Lending Rate (MCLR) prevailing on the day the loan is sanctioned will be applicable till the next reset date, irrespective of the changes in the benchmark during the interim. iii. The periodicity of reset shall be one year or lower. The exact periodicity of reset shall form part of the terms of the loan contract. g) Treatment of interest rates linked to Base Rate charged to existing borrowers i. Existing loans and credit limits linked to the Base Rate may continue till repayment or renewal, as the case may be. ii. Banks will continue to review and publish Base Rate as hitherto. iii. 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. However, this should not be treated as a foreclosure of existing facility. h) Time frame for implementation In order to give sufficient time to all the banks to move to the MCLR based pricing, the effective date of these guidelines is April 1, 2016. Annex Sl Source of funds (excluding equity) Rates offered on deposits on the date of review/ rates at which funds raised (1) Balance outstanding as on the previous day of review as a percentage of total funds (other than equity) (2) Marginal cost (1) x(2) Remarks A Marginal Cost of Borrowings 1 Deposits a Current Deposits The core portion of current deposits identified based on the guidelines on Asset Liability Management issued vide circular dated October 24, 2007 should be reckoned for arriving at the balance outstanding. b Savings Deposits The core portion of savings deposits identified based on the guidelines on Asset Liability Management issued vide circular dated October 24, 2007 should be reckoned for arriving at the balance outstanding. c Term deposits (Fixed Rate) Term deposits of various maturities including those on which differential interest rates are payable should be included. d Term deposits (Floating Rate) The rate should be arrived at based on the prevailing external benchmark rate on the date of review. e Foreign currency deposits Foreign currency deposits, to the extent deployed for lending in rupees, should be included in computing marginal cost of funds. The swap cost and hedge cost of such deposits should be reckoned for computing marginal cost. 2 Borrowings a Short term Rupee Borrowings Interest payable on each type of short term borrowing will be arrived at using the average rates at which such short term borrowings were raised in the last one month. For eg. Interest on borrowings from RBI under LAF will be the average interest rate at which a bank has borrowed from RBI under LAF during the last one month. b Long term Rupee Borrowings Option 1: Interest payable on each type of long term borrowing will be arrived at using the average rates at which such long term borrowings were raised. Option2: The appropriate benchmark yield for bank bonds published by FIMMDA for valuation purposes will be used as the proxy rate for calculating marginal cost. c Foreign Currency Borrowings including HO borrowings by foreign banks (other than those forming part of Tier-I capital) Foreign currency borrowings, to the extent deployed for lending in rupees, should be included in computing marginal cost of funds. The all-in-cost of raising foreign currency borrowings including swap cost and hedge cost would be reckoned for computing marginal cost of funds. Marginal cost of borrowings 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%. B Return on networth Amount of common equity Tier 1 capital required to be maintained for Risk Weighted Assets as per extant capital adequacy norms shall be included for computing marginal cost of funds. Since currently, the common equity Tier 1 capital is (5.5% +2.5%) 8% of RWA, the weightage given for this component in the marginal cost of funds will be 8%. In case of newly set up banks (either domestic or foreign banks operating as branches in India) where lending operations are mainly financed by capital, the weightage for this component may be higher ie in proportion to the extent of capital deployed for lending. This dispensation will be available for a period of three years from the date of commencing operations. The cost of equity will be the minimum desired rate of return on equity computed as a mark-up over the risk free rate. Banks could follow any pricing model such as Capital Asset Pricing Model (CAPM) to arrive at the cost of capital. This rate can be reviewed annually. Marginal cost of funds = 92% x Marginal cost of borrowings + 8% x Return on networth

Source: RBI.org.in
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