Often while reading Economic/Financial news or listening to Business news, you must have come across the terms Base Rate and MCLR and often must have wondered what are these rates. Some of you might be aware of the terms while some others might not be. So in this blog post, we would discuss about these rates and the difference between MCLR and Base Rates. We would also know here who controls these rates and how these rates affect the lives of the common man. The MCLR is also determined by considering deposit rates and repo rates, along with operating costs and cost of maintaining the cash reserve ratio.
Difference between MCLR and Base Rates
1. The base rate is the minimum rate of interest that is set by a country’s central bank (RBI) for lending a loan. This rate is usually taken as the standard interest rate by all the banks functioning in the country.
2. Once the base rate is announced by the central bank (RBI), no bank is permitted to offer any type of loan to its customers at a rate that is lower than the base rate that has been set by the central bank of a nation.
3. To make the credit market more transparent & to ensure that the banks charge a lower interest rate (to improve the transmission of monetary policy), Reserve Bank of India, on July 1, 2010, introduced the concept of base rate across all banks in India.
Calculation of Base Rate
Each bank is free to determine its own base rate, based on the norms provided by the RBI. The Base Rate is determined by considering the following factors:
- Average Cost of Funds – This is the interest rate given on the deposits.
- Operating costs/Unallocatable Overhead Costs – These are the expenses that go into running the day to day operations and includes several components like legal expenses, depreciation, administrative costs, cost of stationery etc.
- Negative Carry in the Cash Reserve Ratio – This is the cost that the banks need to incur in order to keep a specific amount of cash reserves with the RBI.
- Margin of Profit/Average Return on Net Worth – This figure indicates the profitability and net amount obtained.
As a result, the Base Rates may vary from bank to bank, due to the differences in one of the factors given above. Mostly, it is the difference in the interest rates provided on deposits by different Banks.
MCLR (Marginal Cost of Fund Based Lending Rate)
1. The MCLR or Marginal Cost of Fund based Lending Rate refers to the minimum interest rate which a bank must charge for lending to its customers. Banks cannot grant any loan below this rate, except in certain cases permitted by the Reserve Bank of India (RBI).
2. MCLR replaced the Base Rate on 1 April 2016. It is an internal reference rate for banks to decide what interest they can levy/charge on loans. For this, they also take into account the additional or incremental cost of arranging additional rupee for a prospective buyer.
3. Under the MCLR regime, banks must adjust their interest rates as soon as the repo rate changes.
4. After MCLR implementation, the interest rates are determined as per the relative riskiness of individual customers. It is a risk-based approach to determine the final lending rate for borrowers. It considers unique factors like the marginal cost of funds instead of the overall cost of funds. Such marginal costs take into account the Repo Rate, which did not form part of the base rate.
5. In the case of MCLR, the banks should now include a tenor premium. This means they can charge a higher rate of interest for loans with long-term horizons.
Factors considered while calculating MCLR.
- Marginal/incremental cost of funds
- Calculated by taking into account the tenor premium
- The MCLR is also determined by considering Deposit Rates and Repo Rate,
- Also Operating Costs and Cost of maintaining Cash Reserve Ratio
So, this was all from us in this blog of “Difference between MCLR and Base Rates”. We hope that you understood both the terms and the difference between them.
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