InvestorQ : What is meant by MCLR in banking and how is it used and are the MCLR levels related to the NPA levels?
Aashna Tripathi made post

What is meant by MCLR in banking and how is it used and are the MCLR levels related to the NPA levels?

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Tisha Malhotra answered.
11 months ago

Before looking at the how the NPA level affects the MCLR, let us first what is meant by MCLR.

What is MCLR?

The MCLR is a replacement for the erstwhile Base Rate that was the benchmark for banks to set their lending rates. The Base Rate was based on the average cost of borrowings of the bank, which was a mix of the current rate and the historic cost of funds. The MCLR, on the other hand, is based on the incremental cost of funds of the bank.

That logically means that when the RBI cuts repo rates, the MCLR should fall in tandem, substantially if not partially. However, that is normally not the case. Here are the 4 key reasons:

· MCLR is linked to cost of deposits and borrowings of the banks and not to the Repo rate. If the repo rate is cut but banks do not cut deposit rates for fear of losing depositors, then the MCLR will not fall and thus these repo rate cuts will not be transmitted to the end borrower.

· MCLR only applies to floating rate loans only. In case of any fixed rate loan beyond tenure of 3 years, the MCLR is not applicable.

· There are different MCLRs for each bank e.g. there is an overnight MCLR, 1-month MCLR, 3-month MCLR, 6-month MCLR and a 12-month MCLR. Longer-term loans are normally linked to 1-year MCLR and hence the reset in such cases will only happen after a period of 1 year.

· That is the advantage of a Base rate methodology, wherein the rates get reset immediately whereas in case of MCLR the rates get reset only on the reset dates specified in the loan agreement.

Let us now look at how are NPAs relevant in setting the MCLR? There are 2 reasons why NPAs impact MCLR.

· Every bank is allowed to charge a spread over the MCLR, which has to be decided by the bank in question. Banks with higher level of NPAs will have more borrowers whose credit quality is suspect. Therefore the spread over the MCLR that is charged to these borrowers will also be higher and hence falling rates cannot be effectively passed on to the borrower.

· Secondly, when the MCLR calculation is done the numerator includes the incremental cost of borrowing, compensation for CRR as it earns no interest, operating expenses and tenor premium. Banks will higher NPAs will have to spend more on recovery which will inflate their overall cost and hence rate cuts cannot be fully passed on in case the NPAs are high.

However, it needs to be noted that effective October 2019; banks in India have shifted to the external benchmark based pricing which is linked either to the repo rate or the treasury bill rate. This is also applicable only in case of floating rate loans.