Transmission of Eventual Lending Rates: MCLRs. Note Quote.

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Given that capital market instruments are not subject to MCLR/base rate regulations, the issuances of Commercial Paper/bonds reflect the current interest rates as banks are able to buy/subscribe new deposits reflecting extant interest rates, making transmission instantaneous. 

The fundamental challenge we have here is that there is no true floating rate liability structure for banks. One can argue that banks themselves will have to develop the floating rate deposit product, but customer response, given the complexity and uncertainty for the depositor, has been at best lukewarm. In an environment where the banking system is fighting multiple battles – asset quality, weak growth, challenges on transition to Ind AS accounting practice, rapid digitization leading to new competition from non-bank players, vulnerability in the legacy IT systems –  creating a mindset for floating rate deposits hardly appears to be a priority. 

In this context, it is clear that Marginal Costs of Funds Based Lending Rates (MCLRs) have largely come down in line with policy rates. MCLR is built on four components – marginal cost of funds, negative carry on account of cash reserve ratio (CRR), operating costs and tenor premium. Marginal cost of funds is the marginal cost of borrowing and return on net worth for banks. The operating cost includes cost of providing the loan product including cost of raising funds. Tenor premium arises from loan commitments with longer tenors. Some data indicate that while MCLR has indeed tracked policy rates (especially post-demonetization), as liquidity has been abundant, average leading rates have not yet reflected the fall in MCLR rates. This is simply because MCLR reset happens over a period of time depending on the benchmark MCLR used for sanctioning the loans. 

Before jumping the gun that this is a flaw in the structure as the benefit of lower interest rates is significantly lagging, the benefit will be to the borrower when the interest cycle turns. In fact, given that MCLR benchmarks vary from one month to one year, unlike base rate, banks are in a better situation to cut MCLRs, as not the entire book resets immediately. The stakeholders must therefore want for a few more months before concluding on the effectiveness of transmission on eventual lending rates. 

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