Of Benchmarks & Benefits

Banks use various benchmark rates to determine loan pricing. Initially, they had complete discretion over interest rates, leading to the adoption of the Prime Lending Rate (PLR). This internally determined rate was applied to the bank’s most creditworthy customers, with additional risk premiums charged for borrowers deemed riskier. However, this system resulted in a wide disparity in interest rates among borrowers.

- Saptarshi Roy Bardhan

To enhance transparency, the Reserve Bank of India (RBI) introduced the Base Rate, a standardized benchmark computed using four components: the cost of funds (interest payable on various sources of funds), operational expenses, the cost of maintaining the Cash Reserve Ratio (CRR), and the bank’s profit margin. The intent behind this reform was to ensure that changes in RBI’s policy rates were transmitted to borrowers in the form of corresponding adjustments in lending rates. This process, known as Monetary Policy Transmission (MPT), was not functioning effectively under the Base Rate system due to banks’ reluctance to adjust rates.

To address this, RBI introduced the Marginal Cost of Funds-Based Lending Rate (MCLR) in 2016, linking lending rates more directly to the RBI’s policy rate—the Repo Rate, which is the rate at which RBI lends to banks. Three key changes were implemented in the MCLR formula: (1) replacing the cost of funds with the marginal cost of funds, (2) including the bank’s return on net worth as part of the marginal cost, and (3) allowing for tenor-based adjustments based on loan duration.