From April 1 2016, Banks have a new thing to tell you: Loans linked to the MCLR. The base rate will now no longer be the rate at which you get a loan.

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What is MCLR?

It’s the Marginal Cost of funds based Lending Rate. (See RBI Circular) I wish it could be called the Maclor or something that sounds cool but we will forever be stuck with stupid acronyms. It’s basically going to change how banks lend.

First, how do banks lend currently? It’s their Base Rate PLUS a spread, which is based on the amount of time you want the loan (the tenor) and the risk that your personal profile involves (a risk premium). The Base Rate is supposed to be changed when banks get reduced funding costs such as when RBI cuts rates. But banks always find excuses not to pass on lower rates to customers. Because if you change the base rate, it’s not just the new customers that get a lower rate, but it’s also old customers who see a lower rate (since their spread doesn’t change the overall rate = Base Rate + Spread, so if Base Rate falls, their loan rates fall).

The new concept is that banks HAVE to lend using rates linked to their funding costs. A bank raises money through deposits, bonds and wholesale borrowing. It has costs like salaries, rents, electricity costs etc. It also has to make a certain amount of profit at the very least. So the RBI has put all of this into a formula that banks can use to quantitatively determine how much their lending rate should be.

How is MCLR calculated?

Banks will have to use four concepts:

  • The Marginal Cost of Funds
  • How much it therefore costs to maintain CRR with RBI at zero interest rate
  • Operating costs
  • A premium for how much longer you borrow (so 1 year rate is higher than 6 month rate etc)

First, you calculate the marginal cost of funds. For this, the RBI requires banks to calculate this using a table based on: 

  • Cost of Deposits: You take the total amount of current account deposits as a percentage of the borrowed funds you have in total, and multiply that with the rate you offer on such current deposits. Then you do that with savings deposits, with term deposits (where you use the rates at which the money was initially deposited) , foreign currency borrowing etc. Add the resulting numbers.
  • Costs of other borrowing: the average rate at which you borrow money from the bond market or from the RBI, weighted to the total borrowed funds you have.
  • Add both the above for your marginal cost of borrowings.
  • Then, you want a certain amount of return on your equity. If you want an ROE of 12% and the risk free rate is 7%, then your “marginal” excess return you need is 5%. And then you need a certain amount of capital required to maintain Tier 1 capital ratios, which you add up to get the return on net worth.
  • The marginal cost of funds is simply = marginal cost of borrowings x 92% plus return on net worth x 8%.
  • The number you want is the marginal cost of funds (rupee amount) as a percentage of total borrowed funds.

Okay, then you get the CRR cost. CRR means that banks have to put 4% of all their deposits with the RBI at zero interest. Technically they have to get full return on their money but can only use 96% of what they borrow. The remaining 4% thus has a cost – and a simple formula, based on the same marginal cost of funds, is used to calculated this cost.

Then you have operating costs as a percentage of the marginal cost of funds. Everything including salaries, rents, marketing costs etc. which are not specifically charged from a customer are op-costs.

What is Tenor Bucket?

Take these and then find the “tenor bucket“. This is basically that all the above apply to what lending term? Is it one year, two years or 6 months? The answer: it’s the term that corresponds to where 30% of your borrowed money resides. So if you’ve got 55% money in current accounts, then the MCLR applies to the short term bucket. If you’ve got 30% in three year termloans, then the MCLR applies to that bucket. More on this later.

(See the FAQ here)

This is Boring!

Of course it is. No one cares about this other than the banks themselves. Whose only idea is: how can I trick customers into lending money at higher rates while continuing to borrow at much lower rates? Anyways, why you need to know is simple: How will banks get impacted?

The answer: Banks will have to publish these rates once a month.

They have to publish different MCLRs for:

  • overnight lending
  • one-month
  • three-months
  • six-months
  • one year

They can do more too. See a sample here by SBI.

MCLR SBI loans base rate - April 2016

As you can see, SBI has published rates beyond one year also. They don’t tell you how they got here – that’s too boring. But what they did was to find the MCLR and the “tenor bucket” of the MCLR – like we explained earlier. And then, for higher terms than the tenor bucket, they apply a higher “tenor premium” and for lower terms, a “tenor discount”. How much? That’s left to the bank’s discretion.

How Does This Affect Banks?

Banks could not lend earlier below their base rates. This allows banks to lend at shorter terms, for a much lower rate but for longer tenures they can keep higher rates. This allows them to capture a market that corporates have been flocking to the short term commercial paper market. However, this may still not be enough: for example, Power Finance Corporation today saw its 90 day commercial paper trade at a yield of 8.4% which is even lower than the lowest MCLR for SBI above. Meaning, PFC will continue to borrow from the commercial paper market which remains more attractive.

Banks cannot lend under the MCLR under any of the bucket rates above. So if you borrow for 6 months from SBI, your rate cannot be less than 9.15% (but of course SBI can charge you higher, based on your spread). This also means that their longer term loans – like housing loans, have to be higher than the 9.35% MCLR for the highest term above.

Maximum 1 year reset, Some Fixed Rate Loans Will Reset Too

All loans (floating rate) and all fixed rate loans up to three year terms (like a 2.5 year car loan) will be subject to a “reset” of interest rates, periodically. The reset can be maximum one year apart – but banks can offer smaller reset periods too.

Now imagine that SBI has made a ton of loans in the two year bucket at 9.3%. One year later, the MCLR falls by 0.5%, so after one year, automatically the loans gets reset by 0.5% lower. To SBI this means lower income from existing customers (though the cost of funds has fallen too). In general longer term bank loan customers will see the benefit of lower rates forcibly even if banks don’t cut their base rate. The downside? If rates fall now and your reset date is a year away, you have to wait for a year to see that lower rate.

Also, fixed rate loans aren’t exempt – they used to be in the earlier draft. Fixed rate loans can ignore MCLR only if they’re three years in term or more. (Nowadays most car loans are in the three year bucket, and they are fixed rate, so car loans won’t see any benefit) But the three year term hurts the banks who thought they could circumvent the regulation by making loans fixed rate instead.

Customer Specific Spread Changes Need Explanation

Imagine you borrowed at MCLR + 0.5% and the MCLR was 9.5%. Your effective rate is 10%.

Next year the MCLR drops to 9%. You think your loan rate should fall to 9.5% too – but no, the bank tells you your “spread has increase to 1%” so you continue to pay 10%.

This sucks for you and banks could earlier do this easily without any real explanation. Now, a change in the spread needs to be accompanied by a full-fledged risk profile review of the customer. Meaning: banks can’t easily get arbitrary with spread changes.

Bad for banks, good for everyone else.

The Others

Minor other things to care about:

  • MCLR applies to all loans made after 01 April 2016
  • Loans made earlier will continue to link to the base rate, which the bank will maintain until all such loans exist
  • You can request a transition to MCLR from the base rate for which the bank could charge you a fee. (A switch, though, is not a foreclosure)
  • There are exemptions to MCLR applicability – one is that if your loan is linked to a benchmark (like MIBOR). Or if a loan is given against a deposit. Or, for restructured accounts where a working capital loan is given.
  • Hybrid loans – where part of the loan is fixed and part is floating, like teaser loans – will see MCLR apply to each part separately. MCLR applies to the fixed portion if it’s less than three years in tenure, and to the entire floating rate portion.
  • MCLR has to be published monthly but for the first year, banks can choose to publish it quarterly.

There will be more nuances which unwind as the MCLR system kicks in, and RBI is expected to make minor changes based on feedback.

Our View: Loan Dynamics Will Change, Corporates To Benefit

Banks have, in general, refused to drop lending rates. Borrowing rates have dropped substantially – banks can borrow at just 6.75% from the RBI, and most banks have 1 year deposit rates at less than 8%. Banks at this point are simply enjoying the extra spread they earn.

They won’t be able to do that as easily under the MCLR system. With different rates for each bucket, and the only thing possible is to give a spread on a per-customer basis, banks will find it difficult to hide their lower borrowing costs from customers. Given that the MCLR has to be published regularly, you can easily see the loan levels that you can receive from other banks for the same tenure and shift your loan away. Banks will be forced to compete.

Bank interest margins are protected in part, because a lower MCLR is only applicable to a customer on his reset date. So if you borrow for two years, and your reset date is one year away, you see no change in your interest rate for the full one year, even if MCLR has dropped in the interim. (The only thing you can do is refinance the loan)

Corporate customers are also likely to look at shorter term loans to take advantage of falling rates. This will mean that banks which borrow for longer terms but have give term loans will face an asset-liability mismatch – though the only issue there is that bank earnings become volatile, they don’t usually face a crisis because of that.

Overall, we expect banks with the the largest spreads (between borrowing and lending rates) to hurt in the longer term. (But Indian Banking is super-inefficient, so you can expect that longer term to mean years, not months!)

Here’s a list of banks with their base rates and 1 year deposit rates:

banks with their base rates and 1 year deposit rates

As you can see – the banks with very high spreads are the likes of Indusind, Yes Bank and Karnataka Bank. ICICI Bank, HDFC Bank and SBI actually have low spread and much lower rates in comparison.

The corporate sector will benefit as they take advantage of lower loan rates. Competition within banks is important to help this happen, and currently they behave like a cartel – so even this will take time to trickle down. It is therefore important for RBI to push new banks into the system.

The retail borrower will benefit only for short term loans, and even personal loans will have to see resets if they are less than three years in term. Since most car loans are longer term (three years or more) they will not be impacted, as they are fixed rate loans. But two-wheeler loans have to see a reset benefit – and many such loans are taken for two years.

Housing loans don’t see a major impact, except that all loans will reset at least once a year rather than whenever the base-rate is changed. But since housing loans can be moved to other banks without prepayment penalties there should be no major impact here.

Hopefully, MCLR will form the basis of a lot more analysis in the future and we at Capital Mind will track it closely!

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Nothing in this newsletter is financial advice and should not be construed as such. Please do not take trading decisions based solely on the matter above; if you do, it is entirely at your own risk without any liability to Capital Mind. This is educational or informational matter only, and is provided as an opinion. 

Disclosure: The authors at Capital Mind have positions in the market and some of them may support or contradict the material given above, or may involve a direction derived from independent analysis.

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