Base rate and MCLR linking: harmful for the Indian borrower

By Sravya Vemuri

In order to enable customers to gain the benefits of interest rates movements of the Reserve Bank of India, it has ordered banks to synchronise the Marginal Cost of funds Lending Rate (MCLR) with the Base Rate from April 1.

MCLR and Base Rate

As a part of the financial sector reform Base Rate was introduced by the RBI in 2010 as a standard lending rate for commercial banks. Furthermore, the MCLR was introduced in April 2016 which was the minimum interest rate, below which the banks cannot lend, except in some cases already stipulated by the RBI.

The MCLR acts as an internal benchmark determined internally by the banks. This was introduced in place of Base Rate as MCLR is more sensitive to the changes in the policy rates, thereby, ensuring the effective implementation of the monetary policy.

The main difference between the calculation of base rate and MCLR is that the latter takes into account the marginal cost of funds. As marginal costs are charged on the basis of interest rates for various types of deposits, borrowings and return in net worth, it becomes sensitive to policy changes.

Impact on the economy

Banks charge customers on the basis of Base Rate for loans taken before April 2016, which is when MCLR was first implemented. Whereas, MCLR is now the latest benchmark, which has been mandated by the bank.

 Experts are of the opinion that the new norm will be beneficial to the borrowers. For those borrowers who are on the base rate, this will bring down the interest rates and trigger their savings. For instance, there is an average of 70 basis points(bps) difference between base rate and MCLR. Last year, there was a huge flush of funds which resulted in a sharp decline in MCLR. However, the MCLR remained unchanged, which implies that a large number of retail borrowers were paying higher interest rates to these banks.

Bridging this gap will have a significant impact on the existing borrowers as lending rates will also be brought down gradually. Harmonising the rates does not mean that the rates will be equal, but rather that there won’t be a significant difference between the two. The RBI has also said that this move will bring India’s monetary policy in line with the global bank loan pricing practices.

Adverse impacts on borrowers

However, certain market experts are criticising the bank for the timing of the introduction of the norm. They argue that the RBI should have intervened when the benefit of lower interest rates was not being transferred to the borrowers as now banks will charge interest rates based on their current cost of funds, translating to higher interest rates in the upcoming years.

There was a two-year low-interest rate cycle, which is now turning away. Borrowers have been deprived of the benefits of low-interest rates for years as the Base Rate was independent of the cost of funds. Announcing the norm is considered to be futile, as it does not serve a purpose when interest rates are deemed to go higher.

Rajiv Anand, head of retail banking at Axis Bank said in an interview with the Economic Times, “Borrowers should remember that interest rates are cyclical.” He said,” You will see a benign interest rate environment for 2-3 years and then it starts to turn.”

MCLR is also vulnerable to volatility, which raises further concern for the borrowers. As MCLR is calculated on the basis of marginal costs, it gets influenced by the short-term shift in rates.

Given that in Indian markets, the rates determined by the banks and those determined by the RBI never move in the same direction, while the move to harmonize rates might be a welcome step to impose norms to ensure conformity to monetary policy, it might ultimately harm borrowers.