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Base Rate Dead. Marginal Cost Lending Rate is Born.

Once upon a time, we were the poor and unfortunate victims of Benchmark Prime Lending Rate.

RBI tried to rescue us, by replacing it with the Base Rate. But banks continued to fleece us.

So, it now introduces another (possible) saviour... Marginal Cost Lending Rate.

New borrowers may not know this:

Few years back, banks used to lend floating rate loans that were linked to their Benchmark Prime Lending Rate (BPLR). As long as the RBI's policy rates were trending higher, banks were quick to raise the BPLR. So the interest rates for the existing borrowers too went up.

But when the rates started moving southwards, BPLR was (often) left untouched.

Hence, the existing borrowers did not benefit from the softening of interest rates in the economy. They were constrained to continue paying their EMIs at higher rates. Banks were clearly exploiting the fact that it was not easy to switch loans to other banks. Apart from the procedural inconveniences, there was also a cost involved... prepayment penalty.

To add insult to the injury, new borrowers were lent money at lower rates by reducing the margin or even lending below the BPLR (this was earlier permitted). And, to add more insult to the injury, rates on our fixed deposits were promptly cut.

Enter RBI:

From Benchmark Prime Lending Rate to Base Rate to Marginal Cost Lending Rate.

Firstly, it introduced the concept of Base Rate; and stipulated that no bank will lend below this Base Rate.

Any increase or decrease in the policy rates, was duly reflected in the Base Rate. Thus, the benefit of any fall in the interest, automatically passed on to the existing borrowers. Of course, now banks could not lure new customers with lower rates, as the margin between the Base Rate and Lending Rate was not significant (especially on the home loans).

Secondly, the prepayment penalty clause on floating rate loans was abolished. The logic was simple. In floating rate loans, the risk of interest rate movement was on the borrower. Lender was safe. So why should the borrower be penalized if he wished to prepay the loan?

So things were fine for some time.

Unfortunately, the story has a new twist this year:

Though RBI has repeatedly cut the policy interest rates since Jan this year, banks have been reluctant to bring down their Base Rates commensurately. As against a total reduction of 1.25% by RBI, average cut in the Base Rates by banks have been around 0.60% only. A major portion of cost saving by banks, has not been passed on to the hapless borrowers. Consequently, they continue to bear the higher EMI burden.

Again RBI enters:

Looking into this reluctance on the part of banks to transmit the full rate cut (or at least a major part) to the borrowers, RBI had floated the Draft Base Rate Guidelines in Sept. In this, it was proposed that the interest rates on loans should be linked to the bank's marginal cost of funds.

After extensive discussions with all the parties concerned, these guidelines have now been finalised. Accordingly, RBI has introduced the concept of 'Marginal Cost of Funds based Lending Rate'.

The idea behind all this is that the interest rates linked to marginal cost of funds, would be more sensitive to policy rate changes by the RBI, as compared to the Base Rate.

Listed below are the key features of this new concept of fixing the lending rates by banks.

a. RBI has prescribed a detailed formula for banks to arrive at their base rate, based on their marginal cost of funds. Hence, this new base rate will now be known as 'Marginal Cost of Funds based Lending Rate'.

b. This will be the internal benchmark for each bank.

c. Marginal Cost Lending Rate (MCLR) will be the reference for each bank to fix the interest rate on all (new and renewed) rupee loans and credit limits.

d. Earlier, there was just one Base Rate for each bank. However, now the MCLR would be linked to the tenor or period of the loan. In other words, henceforth there will be many interest rates viz. overnight MCLR, one-month MCLR, three-month MCLR, six-month MCLR, one-year MCLR and more.

e. Every month on a pre-decided date, all banks will have to publish their MCLRs for various maturities.

f. Actual lending rate will be arrived at by adding various components of spread to the MCLR.

g. For the floating rate loans, banks will have to specify the interest reset dates

h. Banks can decide and fix their reset period as one year or lower.

i. MCLR applicable on the date the loan is sanctioned, shall remain unchanged till the next reset date; even if there is any change in the MCLR in the interim period.

j. There would be an option to link the interest reset dates either (i) to date of sanction or (ii) to the date of review of MCLR.

k. All existing loan facilities shall continue to be linked to the Base Rate till the loan is repaid or renewed.

l. Banks will, therefore, have to continue with the practice of reviewing and publishing their Base Rate as earlier. However, the borrowers will have the option to switch to the Marginal Cost Lending Rate on mutually acceptable terms.

m. These new base rate guidelines will be effective from April 1, 2016.

Let us keep our fingers crossed and hope that banks become less predatory. Instead of making money at our expense, they should catch the big defaulters.

Here's wishing you all a reduced EMI burden in 2016.

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