Context: Most commercial banks in India are likely to select RBI’s repo rate as the external benchmark to decide their lending rates, from April 1. The repo rate is the key policy rate of the Reserve Bank of India (RBI).

Current scenario:

The marginal cost of fund based lending rate (MCLR) is currently the benchmark for all loan rates. Banks typically add a spread to the MCLR while pricing loans for homes and automobiles.

Why repo?

The RBI has mandated that the spread over the benchmark rate to be decided by banks at the inception of the loan should remain unchanged through the life of the loan. It should remain unchanged unless the borrower’s credit assessment undergoes a substantial change and as agreed upon in the loan contract.

If the lending rates are linked to the repo rate, any change in the repo rate will immediately impact the home and auto loan rates, since RBI has mandated the spread to remain fixed over the life of the loan.

Benefits of setting Repo Rate as benchmark for lending:

• 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.
• There shall be standardisation and ease of understanding for the borrowers. This would mean that same bank cannot adopt multiple benchmarks within a loan category.

What is Repo Rate?

Repo stands for ‘Repurchasing Option’. It refers to the rate at which commercial banks borrow money from the RBI in case of shortage of funds.

It is one of the main tools of RBI to keep inflation under control.

What is MCLR?

The Marginal Cost of Funds based Lending Rate (MCLR) system was introduced by the Reserve Bank to provide loans on minimal rates as well as market rate fluctuation benefit to customers. This system has modified the existing base rate system of providing home loans. In this system, banks have to set various benchmark rates for specific time periods starting from an overnight to one month, quarterly, semi-annually and annually.

MCLR replaced the earlier base rate system to determine the lending rates for commercial banks. RBI implemented it on 1 April 2016 to determine rates of interests for loans.

MCLR aims:

• To improve the transmission of policy rates into the lending rates of banks.
• To bring transparency in the methodology followed by banks for determining interest rates on advances.
• To ensure availability of bank credit at interest rates which are fair to borrowers as well as banks.
• To enable banks to become more competitive and enhance their long run value and contribution to economic growth.