Category: Investment Management

MCLR vs Base Rate

Understanding the Base Rate in the Banking System

In the realm of banking, the Base Rate plays a pivotal role. It is the minimum lending rate set by our central bank, the RBI. This rate is a threshold below which banks are not permitted to lend funds. The introduction of the Base Rate aimed to provide customers with transparent and cost-effective access to funds.

Transition from Base Rate to MCLR

Up until April 1, 2016, banks employed the Base Rate, which replaced the earlier Benchmark Prime Lending Rate (BPLR) in 2010. The move was prompted by concerns that banks were charging retail customers high interest rates while favoring corporate borrowers. The new Marginal Cost of funds based Lending Rate (MCLR) outshines the Base Rate for several reasons:

  • MCLR offers greater transparency in interest rate calculation.
  • Unlike the Base Rate, MCLR ensures uniformity among banks in terms of interest rates.
  • MCLR considers Current and Savings deposit rates, enhancing its accuracy.
  • It accounts for the cost of borrowings from the RBI, ensuring a more comprehensive approach.
  • The Base Rate allowed banks to use various methods for calculation, while MCLR adheres to a standardized approach.
  • MCLR is more responsive to changes in the Repo rate, providing better monetary transmission.

How Banking Borrowing Works

The RBI serves as the apex institution in the Indian banking system. It oversees commercial banks, which encompass public and private sector banks, foreign banks, and local area banks, including rural and cooperative banks. To comprehend the banking business, we can analyze a typical bank's balance sheet, a financial statement that reflects the bank's assets and liabilities at a given point in time.

Bank capital funds are sourced from fixed deposits, savings accounts, and current accounts, as well as borrowings from the RBI and equity funds from shareholders. These liabilities constitute the funds banks use to grant loans, invest in securities, purchase equipment, and maintain cash reserves. On the asset side, we find cash, money at call, loans, investments, bills receivable, and other assets. Banks aim to maximize profits by managing these assets and liabilities effectively.

The Need for MCLR Over Base Rate

The introduction of MCLR on April 1, 2016, for home loan interest rates was driven by the need for enhanced monetary transmission, transparency, and equitable treatment. MCLR considers four key components: marginal cost of funds, negative carry on account of Cash Reserve Ratio (CRR), operating costs, and tenor premium. It factors in the cost of borrowings and return on net worth for banks, emphasizing transparency in interest rate determination.

Switching from Base Rate to MCLR: A Prudent Choice

Old borrowers, who secured loans with a Base Rate before April 1, 2016, stand to benefit from switching to MCLR, as recent rate cuts have reduced the MCLR considerably. It's crucial to assess your financial situation, consider any additional costs associated with the switch, and understand the interest rate reset risks associated with MCLR.

Ultimately, the decision to transition from the Base Rate to MCLR should be made thoughtfully, taking into account factors like spread, processing fees, transfer fees, and future interest rate changes in the context of India's dynamic market.

Rashmi Mahesh Senior Para Planner - Dilzer Consultants Pvt Ltd