February 7, 2018

The Reserve Bank will link the base rate for loans given by banks to the MCLR starting April 1, 2018 i.e. from the new financial year. The Marginal Cost of Funds based Lending Rates (MCLR) system was introduced on April 1, 2016 to tackle the problems of the Base Rate regime.

With the introduction of the MCLR system, it was expected that the existing Base Rate linked loans and other credit exposures would also migrate to MCLR system. However, this has not happened.

"It is observed, however, that a large proportion of bank loans continue to be linked to the Base Rate despite the Reserve Bank highlighting this concern in earlier monetary policy statements. Since MCLR is more sensitive to policy rate signals, it has been decided to harmonize the methodology of determining benchmark rates by linking the Base Rate to the MCLR with effect from April 1, 2018", says an RBI press release here today.

While the impact of this on existing borrowers will become clear only when details of this 'harmonisation' are known, however, prima facie it appears that once base rate is linked to MCLR, the former will automatically increase or decrease in tandem with the latter without any specific action required for adjustment. This may benefit the existing borrowers whose loans are still linked to the base rate.

Earlier there had been a lot of complaints that whenever RBI reduced interest rates banks took a long time to pass on the benefit to borrowers and often the benefit was passed on only partially i.e. banks did not reduce their lending rates by as much as RBI cut the benchmark rates.

Following these complaints, RBI had introduced the MCLR system. Today's announcement appears to be a step in the same direction.

Under the base rate regime, the banks were either reluctant to cut their lending rates (post RBI repo rate cuts) or did so with a time lag. A new method of bank lending called marginal cost of funds based lending rate (MCLR) was therefore put in place for all loans, including home loans, given after April 1, 2016.

Under the MCLR mode, the banks have to review and declare overnight, one month, three months, six months, one year, two years, three years rates each month. However, when it came to lending, in the MCLR based lending, the interest rate of the home loan gets re-priced on a periodical basis. As per the RBI rules, "the periodicity of reset shall be one year or lower. The exact periodicity of reset shall form part of the terms of the loan contract."

Most borrowers shifted their loans from the base rate to the MCLR mode. The primary reason to switch from base rate to MCLR has to be the sluggishness seen in banks' passing on the benefits of RBI rate cuts to borrowers. The MCLR, on the other hand, takes into account the marginal cost of funds which includes the rate at which the bank raises deposits and other cost of borrowings. This largely helped banks in passing on the benefits to the customers unlike n the base rate era.

The RBI has made it clear that banks should allow base rate borrowers to switch to MCLR. The existing loans can run till maturity or borrowers can switch to MCLR on mutually agreed terms. The base rate borrowers have two options, either switch to MCLR based lending with the same bank or else transfer i.e. get the loan refinanced from another bank on MCLR mode. One may also continue the loan on base rate, especially if the loan term is nearing the end.

[The Economic Times]