Context-The Reserve Bank of India (RBI) has made it mandatory for banks to link loans to retail customers and micro, small and medium enterprises (MSMEs) to external interest rate benchmarks in a big push to make transmission of monetary policy more effective 

What is external benchmarking of loans?

• When you borrow money from a bank, be it for purchasing a house, car or for business purposes, interest is levied based on certain methodologies approved by the Reserve Bank of India (RBI). At present, banks use Marginal Cost-based Lending Rate (MCLR) to arrive at their lending rate. Prior to this, it was the Base Rate method and the Benchmark Prime Lending Rate (BPLR). These were all internal benchmarks. Banks have been allowed to use RBI’s policy rate among other market-driven options to calculate lending rates

What is Internal Benchmark Lending Rate?

RBI will give certain guidelines to banks and based on which the banks will decide their own lending rate. As banks have authority to decide the lending rate, such method of lending rate is called Internal Benchmark Lending Rate. Earlier there are three types of lending rates which banks used to follow and they are as below.

Primary Lending Rate (PLR)

• This was the oldest practice of lending rate. Banks were given freehand to fix their lending rate to their customers. Obviously, banks taking advantage of this, use to fix high lending rate for a borrower whose credit rating is not so trustworthy and at the same time used to offer a discount to a borrower whose credit rating is good.
• Hence, there was a big difference in lending rate which banks used to offer to the borrowers. To avoid this parity in lending rates, RBI introduced the Base Rate Regime or BRR.

Base Rate Regime (BRR)

• In the Base Rate Regime of lending rate, RBI instructed the banks to follow certain parameters before deciding the base rate lending rates. The lending rate at any cost should be below this base rate. This RBI felt that will remove the mismatch which is there in PLR based interest rate regime. The parameters set by RBI are as below.

1. Cost of Funds (COF)-Banks usually borrows money from RBI, Household Individuals and from the companies. Hence, once banks borrows the money from these entities, definitely bank has to give certain interest rate on these deposits right? Hence, assume your bank is giving you a 7% interest on your FD, then the bank has to consider this cost of 7% while deciding the lending rate.

2. Operational Expenses (OE)-When bank lend money to a borrower or collect money from depositors, the bank will incurre certain expenses. Obviously, such expenses should be part of the lending rate and have to incurred by the borrower.

3. Cost of CRR (Cash Reserve Ratio which Banks keeps with RBI)-Assume that Bank collected Rs.100 Crore from the bank. As per RBI guidelines, Bank has to keep certain portion of this with the RBI, which in finance world called as CRR or Cash Reserve Ratio. Assume that this is around 4%. Hence, if the bank collected Rs.100 Cr from the depositors, then bank has to keep Rs.4 Cr with RBI.

This Rs.4 Crore which is RBI will not earn a single interest to Bank. Because RBI will not give any interest on CRR. Hence, if the Bank collected Rs.100 Cr at the promise of giving an interest rate of 7% to individuals, then this cost of Rs.4 Cr which is IDLE with the RBI is also the cost of the Bank itself. Bank has to bear this 7% interest on Rs.4 Cr from its pocket and give to the depositor.

This is called as Cost of CRR. Hence, RBI guidelines included considering this Cost of CRR while deciding the lending rate.

4. The margin of Profit-After considering the above expenses, bank at the end of the day has to run it’s show as a business entity right? Hence, they have to consider what margin of profit they are looking at in their business. Such a margin of profit also is part of the lending rate.

Combined all the four parameters, banks used to fix their lending rate under the Base Rate Regime (BRR).

Hence, as per RBI guidelines, the lending should not be at any cost below this base rate. Do remember that banks were also allowed to charge certain additional interest rate over and above this base rate. Such additional rate is called as SPREAD or PREMIUM. This usually be lower to high creditworthy borrowers and obviously high for lower creditworthy borrowers.

The spread or premium is introduced because the bank giving a loan to an individual is entirely different than a loan to business entity. Hence, based on the risk in lending, banks can set their spread or premium to the borrower.

 Marginal Cost of Lending Rate (MCLR)

With the introduction of Base Rate based lending regime, RBI thought whenever there is a change in policy rate by RBI, the lending rate will also reduce in the same proportion. Such change is called a Monitory Policy Tranmission or MPT. Bank expected that if the rate has fallen, then the lending rate also must fall equally.

Assume that RBI reduced the interest rate for around 50 BPS (100 BPS-1%), then RBI expects banks will also reduce the lending rate by 50 BPS. If banks reduce it, then it is called as the efficient transmission of RBI policy. If not, then it is called inefficient transmission.

What RBI noticed is that such efficient transmission is not happening in the Base Rate pricing method of lending. Hence, RBI introduced the MCLR effective from 1st April 2016. 

MCLR is usually arrived at based on below mentioned four considerations.

1) Marginal Cost of Funds: This is the cost of CURRENT borrowing to the bank. You noticed in based rate system that banks used to arrive at the cost of the fund as per their comfort. Also, they used to consider the existing deposits rates as if the cost of fund. However, in the case of MCLR based loans, the last month deposit rates (current, savings, term deposits etc) will be considered to arrive the cost of funds.

Banks not only consider the current borrowing cost but also their margin of profit is also included in this Marginal Cost of Funds. This is called as the Return on Networth. The return on net worth is nothing but the bank’s profit they want to earn from their lending business.

You might be noticed that in the case of base rate system, the cost of fund and margin was used to calculate separately. However, in case of MCLR based loans, both cost of fund and margin (return on net worth) are together are called Marginal Cost of Funds.

The calculation of this Marginal Cost of Funds is as below.

Marginal cost of funds = Marginal cost of Borrowing X 92% + Return on Net worth X 8%

Notice the above formula, the stress or the higher priority to arrive at Marginal Cost of Funds is to cost of borrowings (the deposits banks accepted) than the return on net worth or margin.

2) Negative Carry on Cash Reserve Ratio-

As I pointed above, banks have to keep a certain level of their deposits with reserve bank. This is the safety measure and banks will not earn any interest on this amount. Banks have to keep a certain level (4% as on April 5, 2016) of their deposits with the Reserve Bank. This ratio is the Cash Reserve Ratio (CRR). Banks don’t earn any interest on the amount. Essentially, they can use 96% of the deposits for lending and the remaining 4% does not earn the bank anything. RBI allows some leeway for this with adjustment to the

Hence, such cost is also considered to arrive at MCLR calculation.

3) Operating Costs-

Apart from the cost of deposit and CRR, banks also have to incur some expenses. Such expenses are called as Operating costs. Such cost may include salaries, rent or other overhead expenses.

4) Tenor Premium/Discount- If the bank is lending for higher tensors (like home loans), then there are uncertainties associated which are not factored in the MCLR calculated based on (say) 1-year MCLR. Therefore, the banks will charge a premium to the borrower for the risk (uncertainty) associated with lending for higher tenor loans.

Hence, this tenor premium is usually higher for long tenure loans.

Considering all the above four factors, Banks arrive at the MCLR rate.

What is the concern with MCLR-based system?

• The biggest problem with the current system is the lack of required transmission of policy rates. 
• The internal benchmark is not influenced solely by the policy rate cut but depends on a variety of factors.
• So, policy rate cuts often do not reach the borrowers i.e. when the RBI cuts repo rate there is no guarantee a borrower will get the benefit of it.
• Also, the MCLR system is opaque since it is an internal benchmark that depends on the way a bank does its business.

All about External Benchmark Lending Rate in a layman terms

After the introduction of MCLR, RBI was skeptical about the implementation of MCLR by banks. Hence, RBI set up a committee which is known as Janak Raj Committee. Janak Raj Committee came out with certain interesting findings and they are as below.

• Shifting of loans from BRR to MCLR was not done by all Banks. There are certain loans which are still under BRR regime and banks are enjoying the higher profit.
• MCLR rate used to be recalculated frequently. However, many banks used to revise MCLR only either once in 6 months or 12 months.
• Assumed that RBI reduced its rate on Jan 2019 and banks following the revision of MCLR on a yearly basis, then Banks may revise their MCLR in December 2019. The reduction in MCLR in Jan 2019 will not be going to affect to the borrower immediately. Hence, there is a big lagging in policy implementation effectively.

Hence, considering all these aspects, the Committee recommended shifting to external benchmark lending rate rather than banks internally decide their benchmark. This is where the RBI acted now and introduced all loans be under external benchmark lending rate effective from 1st October 2019.

How will the new system work?

• The new system will come into effect from April 1, 2019.
• Banks will then have to link their lending rates charged on different categories of loans with an external benchmark instead of MCLR.
• The RBI has given the following options to banks:

1. RBI repo rate
2. the 91-day T-bill yield
3. the 182-day T-bill yield
4. any other benchmark market interest rate produced by the Financial Benchmarks India Pvt. Ltd

• One of these benchmarks will be used to decide the lending rate in addition to the spread.
• Banks will be free to decide their spread value but it will have to be fixed for the tenure of the loan.
• However, it can change if the credit score of the borrower changes.
• The interest rates under the new system will change every month. 

How will it benefit borrowers?

• It will help better transmission of policy rate cuts i.e. an RBI rate cut will immediately reach the borrower.
• It will make the system more transparent since every borrower will know the fixed interest rate and the spread value decided by the bank.
• It will help borrowers compare loans in a better way from different banks.
• Under the new system, a bank is required to adopt a uniform external benchmark within a loan category.
• This will ensure transparency, standardisation and ease of understanding for the borrowers.
• This would mean that same bank cannot adopt multiple benchmarks within a loan category.

By: Dr.Dharminder Singh