Effectiveness of monetary policy transmission: Base rate versus marginal cost based lending rate (MCLR)

Abstract

The RBI announced a transition from the base rate system to MCLR system in April 2016 to facilitate effective transmission of monetary policy decisions. The drawback of the base rate methodology was that banks did not transmit the cut in repo rates by RBI to the customers as cheaper loans. Hence, in the MCR system, the banks have been mandated to revise their MCLR rates every month. The new system is fairer to the banks, RBI and the end customers. The MCLR is determined based on 4 parameters namely Marginal Cost of funds, Negative carry because of CRR, Operating Costs and Tenor Premium. The results of MCLR thus far have been mixed- The rate cuts of RBI are being passed to the end customer with a significant lag. This has been disappointing at a time when the government has been trying hard to incentivize private investment and consumption by cutting interest rates. The key recommendations to overcome the drawbacks of MCR would be through completely eliminating the arbitrary components in determining MCLR rate by banks, enable free transfer for borrowers to shift to MCLR based interest rates and reducing the periodicity of adjusting floating rate loans by banks. The effect of MCLR on monetary transmission has been distorted due to demonetization and NPA issue and this has also been addressed in this study. Proposals have emerged advocating the migration to external benchmark s like T-Bill rate, Certificates of Deposit Rate or repo rate.