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Introduction
Banks should charge interest on loans / advances / cash credits / overdrafts or any other
financial accommodation granted / provided / renewed by them or discount usance bills in
accordance with the directives on interest rates on advances issued by Reserve Bank of India
from time to time.
Reserve Bank of India began prescribing the rate of interest on advances granted by
Scheduled Commercial Banks .The structure of lending rates of Scheduled Commercial
Banks, as it had evolved over time, was characterised by an excessive proliferation of rates.
An objective of financial sector reform has been to ensure that the financial repression
inherent in administered interest rates is removed. Accordingly, in the context of granting
greater functional autonomy to banks, effective October 18, 1994, RBI decided to free the
lending rates of scheduled commercial banks for credit limits of over Rupees two lakh; for
loans up to Rupees two lakh, it was decided that it was necessary to continue to protect these
borrowers by prescribing the lending rates .
It was prescribed by RBI that for loans up to and inclusive of Rupees two lakh, the lending
rates of banks should not exceed the Benchmark Prime Lending Rate (BPLR) of the
respective banks. For credit limits of over Rupees two lakh, the prescription of minimum
lending rate was abolished and banks were given the freedom to fix the lending rates for such
credit limits subject to BPLR and spread guidelines. The BPLR system, introduced in 2003,
fell short of its original objective of bringing transparency to lending rates. This was mainly
because under the BPLR system, banks could lend below BPLR.
Base Rate
Accordingly, based on the recommendations of the Working Group on Benchmark Prime
Lending Rate, banks were advised to switch over to the system of Base Rate with effect from
July 1, 2010. Banks may determine their actual lending rates on loans and advances with
reference to the Base Rate and by including such other customer specific charges as
considered appropriate.
As per the calculations, Base rate = a+b+c+d where
a= cost of deposit/funds
b= Negative carry on CRR and SLR. (That is negative return to the bank due to maintaining CRR
and SLR as CRR will not fetch any interest and the return on SLR is minimum.)
c= Unallocatable overhead cost
d= Average return on net worth.
In effect banks will have to compute Base Rate by choosing a benchmark rate (for example,
banks cost of deposits/ funds) and arrive at the Base Rate taking into account all such
elements/ costs which are common to different types of lending. Banks will have to take into
account their negative carry on CRR and SLR, average return on net worth as also the
overhead costs/ establishment expenses, etc which cannot be specifically allocated to any
particular type of lending, while arriving at the Base Rate.
However, under Base Rate regime, though Banks could not lend below their internal
benchmark i.e. their respective Base Rate, policy transmission could not become very
effective as Banks adopted various methods in calculating their cost of funds. Banks were
found to be slow to change their interest rate in accordance with Repo Rate change by RBI.
Thus w.e.f April 1 2016, MCLR - Marginal Cost based Lending Rate (MCLR) has been
introduced aiming at enhancing transparency in lending rates of banks and enabling better
assessment of transmission of monetary policy.
Marginal Cost based Lending Rate (MCLR)
RBI vide its notification dated 17.12.2015 announced the introduction of Marginal Cost
based Lending Rate (MCLR) as the new internal benchmark for pricing loans sanctioned/
renewed from 01st April 2016.
As against cost of funds in Base Rate, MCLR is calculated based on marginal cost of funds.
his essentially means that changes in deposit rates and borrowing rates (increase or decrease)
may change the marginal cost of funds and hence the MCLR will also change. The change in
deposit rates will affect MCLR significantly.
Tenor premium was not a component of Base Rate. It formed part of spread over Base Rate.
Return on net worth forms part of marginal cost of funds for pricing loans under the MCLR
framework.
The key difference between Base Rate and MCLR are summarised below
Components of MCLR
Base Rate
Tenor premium
date would be 05.11.2016. Thereafter, the interest rate of that loan would be reset on
every 05th of May and November, till its repayment.
Banks Interest rate structure now consists of
(a) Floating interest rates linked to MCLR
(b) Fixed rates of interest under MCLR framework, for select types of loans.
It may be noted that interest rates for foreign currency denominated loans are not linked to
MCLR.
Different interest rate tables are prescribed generally in line with the different credit rating
models for rating borrowers (in case of models in Risk Assessment Model) or types of loan
(in case of models in CRESS), with a few exceptions that are specifically stated. Details of
MCLR will be published in Banks website for the information of all concerned. Branches
shall also display the information on MCLR as given in Annexure I, on the Notice Board.
The periodicity of reset of interest rates shall be one year, for all floating loans of one
year and above, and linked to MCLR. Those floating rate loans having an original
tenor of less than one year shall be linked to the applicable MCLR
Other general guidelines
Levying of Penal Rates of Interest
Banks are permitted to formulate a transparent policy for charging penal interest with the
approval of their Board of Directors. However, in the case of loans to borrowers under
priority sector, no penal interest should be charged for loans up to Rs 25,000. Penal interest is
levied for reasons such as default in repayment, non-submission of financial statements, etc.
However, the policy on penal interest should be governed by well-accepted principles of
transparency, fairness, incentive to service the debt and due regard to genuine difficulties of
customers.
Periodicity of Interest application
Banks were advised by RBI to charge interest on loans/advances at monthly rests with effect
from April 1st, 2002. The interest at the specified rates should be charged at monthly rests and
rounded off to the nearest rupee.