What the increase in MCLR means for public and their loan

State Bank of India (SBI), India’s largest commercial bank, raised the marginal cost of funds-based lending rates (MCLR) for the first time in three years, signalling that the soft rates regime that has prevailed since 2019 may be over.

What is MCLR

• MCLR, which RBI instituted with effect from April 1, 2016, is the lowest interest rate that a bank or lender can offer or it is the minimum lending rate below which a bank is not allowed to lend.
• It's an internal reference rate that banks use to figure out how much interest they can charge on loans.
• Following the installation of MCLR, interest rates are calculated based on each customer's relative risk factor (creditworthiness).
• When the RBI cut the repo rate in the past, banks took a long time to reflect the change in lending rates for borrowers.
• Under MCLR regime banks must modify their interest rates as soon as the repo rate changes.
• It is applicable to fresh corporate loans and floating rate loans taken before October 2019.
• RBI then switched to the external benchmark linked lending rate (EBLR) system where lending rate is linked to benchmark rates like repo or Treasury Bill rates.

Effect of increasing MCLR

• Borrowers who have taken home, vehicle, and personal loans will find their equated monthly instalments (EMIs) rising in the coming months.
• With the RBI set to withdraw the accommodative policy (the willingness to expand money supply to boost economic growth), lending rates are expected to rise further in the coming months.
• MCLR-linked loans had the largest share (53.1%) of the loan portfolio of banks as of December 2021.
• The sustained decline in MCLRs in the last three years and periodic resetting of such loans at lower rates helped existing borrowers, as banks extended the benefits to them by reducing the WALR (weighted average lending rate) on outstanding rupee loans more than the policy repo rate cuts during the EBLR period.
• Banks linked their EBLR to the RBI’s repo rate, which declined from 5.40% to 4% since October 2019.
• When the RBI hikes the repo rate, EBLR will go up and vice versa.
• The share of EBLR loans in total advances was 39.2% in December 2021, according to RBI.

Interest rates will rise too

• According to bankers, gradual tightening of money supply in the financial system is expected to push up interest rates.
• The “extraordinary” liquidity measures undertaken in the wake of the pandemic, combined with the liquidity injected through various other operations of the RBI have left a liquidity overhang of the order of Rs 8.5 lakh crore in the system.
• With retail inflation hitting 6.95% in March and wholesale inflation at 14.55%, the central bank is expected to take measures to bring down prices.
• The tightening of the accommodative policy is normally accompanied by a rise in interest rates in the system.
• The US Federal Reserve recently announced a tightening of the policy and raised interest rates.
• The next round of rate hikes is expected around end-May-June. However, the rise in rates is likely to be gradual.
• According to the SBI research report, deposit rates are likely to increase over the next one-two month.

Banks expect a repo rate hike

• Banks expect the repo rate to go up from June onwards as the RBI seeks to suck out liquidity from the system to rein in inflation.
• Indicating upward pressure on interest rates, the yield on 10-year benchmark government bonds has reached 7.15 per cent, rising 24 bps in less than two weeks. On the other hand, the cost of funds is set to increase, prompting banks to hike lending rates.

Exam track

Prelims Take Away

• Marginal cost of funds-based lending rates (MCLR)
• Repo rate