MCLR can soon start to pinch borrowers

The new marginal cost of funds-based lending rate (MCLR), that the central bank introduced in April last year, has brought much respite to borrowers.

The issue of transmission of policy rate action that was stark under the erstwhile base rate system, has to a lot extent been addressed under MCLR.

Over the past year, banks have reduced their benchmark lending rate — MCLR — by nearly one percentage point. This has benefitted new borrowers.

But the new MCLR structure that has forced banks to lower rates at a faster pace during the rate cut cycle, can prove to be a double-edged sword in a rising rate cycle. This is because lending rates may move up at a steeper pace under MCLR, than under the earlier base rate system.

With the RBI indicating near-zero possibility of rate cuts and inflation raising its ugly head again, a rate hike cycle may not be far away. MCLR could start to pinch borrowers sooner than later.

The math

All loans sanctioned after April 1, 2016, are now priced with reference to MCLR. MCLR differs from the existing base rate in that when calculating the cost of funds, the latest (at the time of review) rates offered on deposits or borrowings are taken into account.

Banks have to review and publish every month their MCLR of different maturities — overnight, one-month, three-month, six-month and one-year. Loans are benchmarked against a particular MCLR. For instance, home loans are mostly benchmarked against one-year MCLR.

Hence, purely on math, banks have been forced to reduce their benchmark MCLR substantially over the past one year. The Centre’s demonetisation move, accelerated the fall in MCLR.

The sharp rise in deposits, that triggered cuts in deposit rates, led banks to pass on the benefit to borrowers, at a quicker pace. Hence, MCLR across most banks has fallen by a steep 70-100 basis points since April 2016.

The weighted average lending rate data put out by the RBI for fresh loans, until September 2016, shows a 100 basis points fall since January 2015, when the rate easing cycle began. All in all, over the entire rate cut cycle, lending rates for new loans appear to have fallen by over 130-150 basis points, against the RBI’s 175 basis point reduction in policy repo rate during this period.

Considering transmission of rate cuts in the past, the introduction of MCLR has indeed brought good tidings to borrowers.

Double-edged sword

But the good times may be short-lived, if risks to inflation heighten in the coming months.

The RBI holding rates did rattle markets. But what really jolted the industry and India Inc. was the shift in the RBI’s stance from accommodative to neutral — a subtle indication of the end of the rate easing cycle. While a rate hike in the near term is unlikely, it cannot be completely ruled out.

With risks to the RBI’ inflation target — hardening crude prices, 7th pay commission dole outs and exchange rate volatility —having a high probability of playing out, rates hikes could be in the offing over the next 18-24 months.

This, under the MCLR framework, could bring more pain to borrowers, than under the erstwhile base rate system. This is because changes in deposit rates will immediately reflect on banks’ cost of funds under MCLR, leading to much sharper and quicker rise in lending rates.

As such, banks have been more nimble in passing on rate hikes to borrowers in the past. For instance, between March 2012 and June 2013, when repo rate fell by 125 basis points, only a fifth of this rate cut was passed on to borrowers.

But in the period between March 2010 and October 2011, when RBI raised repo rates by 375 basis points, banks increased their base rates by about 275 basis points.

Borrowers, however, may find some solace in the reset clauses under the MCLR structure. Unlike under the base rate system, where a revision in base rate was immediately reflected in the lending rates of all loans benchmarked against it, under the MCLR-based pricing, lending rates are reset only at intervals corresponding to the tenure of the MCLR.

In case home loans, for instance, since the loans are benchmarked against the one-year MCLR, lending rates will only be reset every year.

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