By Vivek Iyer
To understand the future of the Marginal Cost of Funding Linked Rates (MCLR) in India, it is imperative to understand the objectives of the Monetary Policy of the Reserve Bank of India (RBI). The RBI Monetary policy has three objectives (1) price stability (2) economic growth and (3) exchange rate stability. The repo rate is the key monetary policy tool for the purpose of achieving all these three objectives. A lower interest rate would increase demand for credit, increasing economic activity on account of investments fuelled by credit and helping move the economy towards full employment. As the economy would move beyond full employment, inflation starts kicking in and the RBI increases the interest rates, creating a reverse impact of decreased credit and reduced economic activity.
The effectiveness of the monetary policy thus depends on the effectiveness with which these interest rates are transmitted at an operational level. If the interest rates are not transmitted, the effectiveness of the RBI monetary policy, ability to control inflation, economic growth and consequently, currency exchange rates are impacted. Therefore, an interest rate regime geared towards an effective transmission of RBI monetary policy repo rates is critical. This is what has resulted in the RBI transitioning from a Benchmark Prime Lending Rate (“BPLR”) regime in 2010 to an MCLR regime in 2016 to an External Benchmark Lending Rate (“EBLR”) in 2019.
At the risk of over-simplification
- BPLR is an interest rate based on the average cost of funds
- MCLR is an interest rate based on the marginal cost of funds for the bank, which effectively means the latest rate and has an annual reset frequency
- EBLR is an interest rate linked to an external benchmark like a repo rate with a quarterly reset frequency
The above explanations of each rate would give us a sense of how the monetary policy transmission is lowest to highest from BPLR to MCLR to EBLR. Almost all the loans in the industry are either MCLR or EBLR today.
What does EBLR mean for borrowers and lenders
While the above explanations are more from a macroeconomic perspective, let us shift gears and look at this from a borrower perspective. Today, borrowers exist under both the MCLR and the EBLR today. Under a reduced interest rate scenario, the speed of transmission will be higher, and the borrower will be able to experience reduced EMIs on a far higher frequency compared to the borrower being under an MCLR regime. From a lender’s perspective, the bank would be able to ensure that the interest rates are communicated in an orderly manner, which will ensure reduced friction with customers and build trust. Higher levels of trust will ensure a greater level of financial inclusion.
What is the future – Will MCLR be replaced by EBLR
We expect the MCLR to be replaced by EBLR in the next 5 years. India is going to be on a growth trajectory, resulting in interest rates being low in the long term and an EBLR regime being far more beneficial to borrowers. While we will not experience low-interest rates as we experienced in the decade of 2010-2020, we will be experiencing interest rates far lower than what we are seeing today. An EBLR will enable borrowers to share the benefits of a growing economy, which the MCLR probably won’t and there will be a lot of switches that borrowers will drive from MCLR to EBLR.
Financial Literacy Initiatives
Every bank should take it upon itself to educate the customers through various financial literacy initiatives on the interest rate regime and how they have evolved over the years, with a detailed explanation being offered to them on the advantages of being under an MCLR or an EBLR model, also indicating the right time to shift. The key foundation of the financial services ecosystem is trust, and thus, it is crucial that the system is resilient. I expect the financial services ecosystem to take this path, the ultimate outcome of which I believe will be EBLR being the only interest rate in town.
(Vivek Iyer is Partner at Grant Thornton Bharat. Views expressed are the author’s own.)
