CHAPTER IX

INTEREST RATE ON ADVANCES

Introduction
Banks should charge interest on loans / advances / cash credits / overdrafts or any other
financial accommodation granted / provided / renewed by them or discount usance bills in
accordance with the directives on interest rates on advances issued by Reserve Bank of India
from time to time.
Reserve Bank of India began prescribing the rate of interest on advances granted by
Scheduled Commercial Banks .The structure of lending rates of Scheduled Commercial
Banks, as it had evolved over time, was characterised by an excessive proliferation of rates.
An objective of financial sector reform has been to ensure that the financial repression
inherent in administered interest rates is removed. Accordingly, in the context of granting
greater functional autonomy to banks, effective October 18, 1994, RBI decided to free the
lending rates of scheduled commercial banks for credit limits of over Rupees two lakh; for
loans up to Rupees two lakh, it was decided that it was necessary to continue to protect these
borrowers by prescribing the lending rates .
It was prescribed by RBI that for loans up to and inclusive of Rupees two lakh, the lending
rates of banks should not exceed the Benchmark Prime Lending Rate (BPLR) of the
respective banks. For credit limits of over Rupees two lakh, the prescription of minimum
lending rate was abolished and banks were given the freedom to fix the lending rates for such
credit limits subject to BPLR and spread guidelines. The BPLR system, introduced in 2003,
fell short of its original objective of bringing transparency to lending rates. This was mainly
because under the BPLR system, banks could lend below BPLR.
Base Rate
Accordingly, based on the recommendations of the Working Group on Benchmark Prime
Lending Rate, banks were advised to switch over to the system of Base Rate with effect from
July 1, 2010. Banks may determine their actual lending rates on loans and advances with
reference to the Base Rate and by including such other customer specific charges as
considered appropriate.
As per the calculations, Base rate = a+b+c+d where
a= cost of deposit/funds
b= Negative carry on CRR and SLR. (That is negative return to the bank due to maintaining CRR
and SLR as CRR will not fetch any interest and the return on SLR is minimum.)
c= Unallocatable overhead cost
d= Average return on net worth.

In effect banks will have to compute Base Rate by choosing a benchmark rate (for example,
banks cost of deposits/ funds) and arrive at the Base Rate taking into account all such
elements/ costs which are common to different types of lending. Banks will have to take into
account their negative carry on CRR and SLR, average return on net worth as also the
overhead costs/ establishment expenses, etc which cannot be specifically allocated to any
particular type of lending, while arriving at the Base Rate.

However, under Base Rate regime, though Banks could not lend below their internal
benchmark i.e. their respective Base Rate, policy transmission could not become very
effective as Banks adopted various methods in calculating their cost of funds. Banks were
found to be slow to change their interest rate in accordance with Repo Rate change by RBI.

Thus w.e.f April 1 2016, MCLR - Marginal Cost based Lending Rate (MCLR) has been
introduced aiming at enhancing transparency in lending rates of banks and enabling better
assessment of transmission of monetary policy.
Marginal Cost based Lending Rate (MCLR)
RBI vide its notification dated 17.12.2015 announced the introduction of Marginal Cost
based Lending Rate (MCLR) as the new internal benchmark for pricing loans sanctioned/
renewed from 01st April 2016.
As against cost of funds in Base Rate, MCLR is calculated based on marginal cost of funds.
his essentially means that changes in deposit rates and borrowing rates (increase or decrease)
may change the marginal cost of funds and hence the MCLR will also change. The change in
deposit rates will affect MCLR significantly.
Tenor premium was not a component of Base Rate. It formed part of spread over Base Rate.
Return on net worth forms part of marginal cost of funds for pricing loans under the MCLR
framework.
The key difference between Base Rate and MCLR are summarised below

Components of Base Rate

Cost of Deposits

Components of MCLR

Negative Carry on SLR/CRR

Marginal cost of funds (including minimum

desired return on equity)

Un-allocable overhead cost

Negative Carry on CRR

Average Return on Net worth

Operating costs associated with lending

Tenor premium

Base Rate

Marginal Cost based Lending Rate (MCLR)

Cost of Deposits Weighted average cost Marginal cost of funds

of deposits
Marginal cost of funds = 92% x Marginal cost of
deposits/borrowings + 8% x Minimum Return on
net worth.
Negative Carry on CRR/SLR

Negative Carry on CRR

Required CRR x (marginal cost) / (1- CRR)

Un-allocable overhead costs

Operating costs All operating costs associated

with providing the loan product including cost of
raising funds will be included under this head.

Tenor premium

Tenor premium - These costs arise from loan

commitments with longer tenure. The change in
tenure premium should not be borrower specific
or loan class specific.

Average Return on Net worth

Minimum return on net worth forms part of

marginal cost of funds. the weightage given for
this component in the marginal cost of funds is
8%. The cost of equity will be the minimum
desired rate of return on equity computed as a
mark-up over the risk free rate. This rate can be
reviewed annually.

The salient features of the guidelines are given below:

All rupee loans sanctioned/ renewed with effect from 01st April 2016 shall be priced
with reference to MCLR, which replaces Base Rate as internal benchmark for the
purpose.
Existing loans under Base Rate can continue till repayment or renewal, as the case
may be. Bank will continue to review and publish Base Rate on a quarterly basis.
Banks shall give existing borrowers an option to switch over to MCLR linked pricing at
mutually acceptable terms.
MCLR is a tenor linked benchmark. As mandated by RBI guidelines, Bank shall
publish MCLR for 5 different maturities
a. Overnight MCLR
b. One-month MCLR
c. Three-month MCLR
d. Six-month MCLR
e. One-year MCLR
In addition to the above, RBI has given banks the option to publish MCLR of any other
longer maturity.
MCLR of a particular maturity will be arrived at by adding the corresponding tenor
premium to the sum of Marginal cost of funds, Negative carry on CRR and Operating
costs.
MCLR of corresponding maturity will be the minimum lending rate for all floating
rate rupee loans linked to it. Lending below the same will not be permitted, other than
for specifically exempted categories given below
Advances to Banks depositors against their own deposits.

Advances to Banks own employees, retired employees, CEO and Whole

Time Directors.
Loans covered by schemes formulated by Govt of India and refinance
schemes of Govt of India/ Govt Undertakings (to the extent refinance is
available) where interest rates are prescribed under such schemes. In case
of refinance schemes that partly cover the loans, the part not covered by
refinance shall not be exempted from MCLR guidelines.
Working Capital Term Loan (WCTL), Funded Interest Term Loan (FITL)
etc., granted as part of rectification/ restructuring package.
Loans linked to market determined external benchmarks and fixed rate
loans. Fixed rate loan means loans with interest rates fixed throughout the
tenor (RBI has clarified that all other loans, including loans with periodic
reset of interest rates would be termed as floating rate loans). However, if
interest rates are partly fixed and partly floating, the floating portion shall
not be exempted from MCLR guidelines.
Banks shall determine actual lending rates for loans and advances by adding the
components of spread to the applicable MCLR.
RBI has also prescribed broad components of Spread chargeable over MCLR as
follows:
o Business strategy: arrived at considering factors like business strategy, market
competition, embedded options in the loan product, market liquidity of loan
etc.
o Credit risk premium: representing default risk, arrived at based on credit
rating, collaterals, expected credit losses, customer relationship etc.
Spread charged to an existing borrower shall not be increased except on account of
deterioration in credit risk profile of the borrower, ascertained based on full-fledged
risk profile review of the borrower. However, this stipulation is not applicable for
loans under consortium/ multiple banking arrangements.
Banks are required to review and publish MCLR of different maturities every month
on a pre-announced date with approval of the Board/ ALCO. However, banks are
given freedom to review MCLR on a quarterly basis on a pre-announced date, till 31st
March 2017.
Banks shall at their option specify interest reset dates on their floating rate loans.
MCLR prevailing on the day loan is sanctioned shall be applicable till the next reset
date, irrespective of the changes in the benchmark during the interim. Accordingly,
rate of interest contracted for a loan with periodic interest reset shall not change till
next interest reset date, irrespective of the changes in MCLR in the interim.
Banks are given the option to link reset dates either to the date of sanction of
individual loans or to the date of review of MCLR (Bank has decided to link reset
date to the date of review of MCLR). For e.g. Suppose Bank decides to review MCLR
on 05th of every month and a loan is disbursed on 20.05.2016 linking to one-year
MCLR with reset periodicity of 6 months. The loan will be initially priced based on
latest one-year MCLR (which is effective from 05.05.2016) and the first interest reset

date would be 05.11.2016. Thereafter, the interest rate of that loan would be reset on
every 05th of May and November, till its repayment.
Banks Interest rate structure now consists of
(a) Floating interest rates linked to MCLR
(b) Fixed rates of interest under MCLR framework, for select types of loans.
It may be noted that interest rates for foreign currency denominated loans are not linked to
MCLR.
Different interest rate tables are prescribed generally in line with the different credit rating
models for rating borrowers (in case of models in Risk Assessment Model) or types of loan
(in case of models in CRESS), with a few exceptions that are specifically stated. Details of
MCLR will be published in Banks website for the information of all concerned. Branches
shall also display the information on MCLR as given in Annexure I, on the Notice Board.
The periodicity of reset of interest rates shall be one year, for all floating loans of one
year and above, and linked to MCLR. Those floating rate loans having an original
tenor of less than one year shall be linked to the applicable MCLR
Other general guidelines
Levying of Penal Rates of Interest
Banks are permitted to formulate a transparent policy for charging penal interest with the
approval of their Board of Directors. However, in the case of loans to borrowers under
priority sector, no penal interest should be charged for loans up to Rs 25,000. Penal interest is
levied for reasons such as default in repayment, non-submission of financial statements, etc.
However, the policy on penal interest should be governed by well-accepted principles of
transparency, fairness, incentive to service the debt and due regard to genuine difficulties of
customers.
Periodicity of Interest application
Banks were advised by RBI to charge interest on loans/advances at monthly rests with effect
from April 1st, 2002. The interest at the specified rates should be charged at monthly rests and
rounded off to the nearest rupee.

Instructions on charging interest at monthly rests shall not be applicable to agricultural

advances and banks shall continue to follow the existing practice of charging / compounding
of interest on agricultural advances linked to crop seasons. Banks should charge interest on
agricultural advances for long duration crops at annual rests. As regards other agricultural
advances in respect of short duration crop and allied agricultural activities such as dairy,
fishery, piggery, poultry, bee-keeping, etc., banks should take into consideration due dates
fixed on the basis of harvesting / marketing season while charging interest and compounding
the same if the loan / installment becomes overdue. Further, banks should ensure that the total
interest debited to an account should not exceed the principal amount in respect of short term
advances granted to small and marginal farmers.