Marginal Cost of Funds based Lending Rate

Indian Economy glossary

Also called: MCLR · Topic: Banking Regulation, NPAs and Financial Stability · NCERT: Beyond NCERT

Meaning

Marginal Cost of Funds based Lending Rate (MCLR) is the lowest loan rate a bank sets for itself. It has been used in India since April 2016. Each bank works it out from its marginal cost of funds, which means what it costs the bank to raise new money today, not the average cost of all the money it already holds.

  • Loan rate (MCLR-linked loan) = MCLR of the chosen tenor + spread
  • MCLR replaced the base rate (from July 2010), which was built on the average cost of funds.
  • It was meant to pass on the RBI's repo rate changes to borrowers faster. The repo rate is the interest rate at which the RBI lends money to banks for a short time.
  • It is still an internal benchmark, meaning each bank calculates its own. So it moved slowly, and in 1 Oct 2019 it was replaced by the External Benchmark Lending Rate (EBLR) for new floating-rate retail and MSME loans.

Explanation

How MCLR works

  • Marginal cost = cost of the next rupee. Suppose the RBI cuts the repo rate and deposit rates fall. The new deposits a bank raises now cost less, so MCLR can fall straight away.
  • Components (textbook level):
  • Marginal cost of funds: the rates the bank pays today on new deposits and borrowings. This is the main part.
  • Negative carry on CRR: CRR (Cash Reserve Ratio) is money a bank must park with the RBI, and it earns no interest on it. This is a cost the bank has to recover.
  • Operating costs: the cost of running branches, staff and so on.

  • Tenor premium: longer loans carry more risk, so they get a higher rate.

  • A separate MCLR for each tenor. A tenor is the length of time the loan rate is fixed for. So a bank has, for example, a 1-year MCLR and other tenors next to it.

  • Reset periods:
  • A borrower's rate does not change every day.
  • It is reset only on fixed reset dates.

  • So a repo cut reaches an existing borrower only at the next reset.

  • Spread: the bank adds a spread (an extra margin for the borrower's credit risk and the bank's profit) on top of the MCLR.

Worked example: average cost vs marginal cost (illustrative numbers)

  • A bank has Rs 1,000 crore of old deposits taken at 7%.
  • The RBI cuts the repo rate, and the bank can now raise new deposits at 6%. It raises Rs 100 crore.
  • Base rate (average cost): (1,000 × 7% + 100 × 6%) ÷ 1,100 = 76 ÷ 1,100 ≈ 6.9%. The cost has barely moved.
  • MCLR (marginal cost): it uses the cost of the new money, which is 6%. The cost falls at once.
  • Lesson: the average carries old, costly deposits for years. The marginal cost looks only at today's price of money. This is why MCLR was expected to respond faster.

What makes MCLR rise or fall

  • Repo rate changes → deposit rates change → marginal cost of funds changes → MCLR changes.
  • CASA ratio: the share of current and savings deposits in total deposits. This is the bank's cheapest money.
  • Current accounts pay no interest, and savings accounts pay little.
  • When savers move money into mutual funds and term deposits, CASA falls.

  • The cost of funds then rises, and so does MCLR.

  • Credit-deposit (CD) ratio: loans ÷ deposits. It was about 80% in 2024-25 (verify current).

  • A high CD ratio means the bank has little spare money to lend.
  • It then competes harder for deposits, so deposit rates rise.
  • As a result, MCLR and loan rates rise. A high CD ratio also strengthens the pass-through of repo-rate hikes [1].

Why MCLR still fell short

  • Internal benchmark: each bank calculates its own MCLR, so its timing and method are in the bank's hands.
  • Deposit rates are sticky. Banks have already promised fixed rates on term deposits, so their cost of funds moves slowly.
  • Reset periods add a further delay before a change reaches old borrowers.
  • Result: transmission stayed weak. This is how fully and how fast the RBI's rate changes reach borrowers.

In India

  • Lending-rate history: PLR (1994) → BPLR (2003) → Base rate (July 2010) → MCLR (April 2016) → EBLR (1 Oct 2019).
  • Who manages it: the RBI sets the rules for how MCLR is calculated. Each bank calculates and publishes its own MCLR.
  • Review:
  • In August 2017 the RBI set up an Internal Study Group to review MCLR.

  • The group found transmission was weak and recommended an external benchmark-based lending rate (report, October 2017) [2].

  • Replacement: EBLR is compulsory for new floating-rate retail and MSME loans from 1 October 2019.

  • It is linked to the repo rate, the 3- or 6-month T-bill yield, or another FBIL benchmark, plus a spread.

  • Old MCLR loans still continue.

  • Evidence from the tightening cycle, May 2022 to September 2023:

  • The repo rate rose 250 basis points (1 basis point = 0.01%) [1].
  • 1-year median MCLR rose only 152 bps [1].
  • WALR (weighted average lending rate) on fresh loans rose 187 bps, about 75% transmission [1].

  • WALR on outstanding loans rose only 111 bps, about 44%, because many old loans were still on MCLR [1].

  • Who still depends on MCLR (June 2023): the share of floating-rate loans linked to an external benchmark was foreign banks 87.6%, private banks 73.2% and public sector banks only 36.1% [1]. PSB loan books still lean on MCLR, so transmission is slower there.

Don't confuse with

  • Base rate (July 2010): this was built on the average cost of funds, including old deposits. MCLR uses the marginal cost, the cost of new money. This is a classic swap trap.
  • EBLR (1 Oct 2019): this is an external benchmark such as the repo rate, and the bank cannot change it; the bank sets only the spread. MCLR is internal, meaning the bank calculates it itself.
  • BPLR (2003): this was opaque, and most loans were given below it, so it meant little. MCLR is a proper rate for each tenor, with fixed reset dates.
  • Repo rate: this is the RBI's policy rate for lending to banks. MCLR is a bank's own lending benchmark for its customers, and the repo rate reaches it only indirectly, through the cost of funds.

Prelims Hooks

  • MCLR was introduced in April 2016 and replaced the base rate (July 2010).
  • Base rate = average cost of funds; MCLR = marginal cost of funds.
  • MCLR is an internal benchmark with a separate rate for each tenor and reset periods.
  • The RBI's Internal Study Group (August 2017) on MCLR recommended an external benchmark (report, October 2017) [2].
  • EBLR (1 Oct 2019) is mandatory for new floating-rate retail and MSME loans. MCLR is not mandatory for them.
  • Trap: in the May 2022–Sept 2023 hiking cycle, outstanding-loan pass-through (~44%) was lower than fresh-loan pass-through (~75%), because old loans were still on MCLR [1].

Mains Points

  • Benchmark design and monetary transmission:
  • Moving from the average cost (base rate) to the marginal cost (MCLR) improved transmission, but the internal benchmark and the reset periods kept it slow.
  • The 1-year median MCLR rose 152 bps against a 250 bps repo hike (May 2022–Sept 2023) [1].

  • Moving old MCLR loans to EBLR would make monetary policy work faster. The trade-off is that bank NIMs (net interest margins, a measure of how profitable lending is) would swing more.

  • The public sector bank gap:

  • Only 36.1% of PSB floating-rate loans were linked to an external benchmark, against 73.2% for private banks (June 2023) [1].
  • So PSB borrowers, who include many MSMEs and small borrowers, feel RBI rate cuts late.

  • This is a case for faster migration and clearer disclosure to borrowers.

  • Funding costs set the floor:

  • MCLR is only as low as the bank's cost of new money.
  • Falling CASA, as savings move to mutual funds, and a CD ratio near 80% raise banks' cost of funds and push loan rates up [1].
  • This links loan pricing to how households save and to the growth of capital markets.

Related concepts

Read more

Sources

  1. 1RBI Bulletin article on monetary policy transmission (EBLR/MCLR shares, WALR pass-through, CD ratio)rbi.org.in · tier 1
  2. 2RBI: Report of the Internal Study Group to Review the Working of the MCLR Systemrbi.org.in · tier 1