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Thursday, 12 May 2016

MCLR - Marginal Cost of Funds Lending Rate by RBI - An Ethmos perspective



RBI [ Bhartiya Reserve Bank]  has implemented MCLR based rate since April 2016, Mr. Superman was bit confused whether this new rate will help him in having reduced EMI [ Equated monthly installments ] towards his existing liabilities. So he met his mentor Mr. Nobody to unravel some mysteries related to MCLR so that it will help a sada bhartiya [ pun intended as it will be really difficult to use the phrase “ AAM  ADAMI” as it might hurt His Highness Shri. Khujliwal ]. Mr . Nobody pushed him to his limits to find about MCLR.


Research : Marginal cost of Funds based lending rate [MCLR]

Marginal Cost of Funds [ Nidhi Ki Simant Lagat ] as per the terminology the rate of interest should be based on the actual cost funds borne by the financial institutions [ SCBs Scheduled commercial banks ]

As per RBI

MCLR comprises of
1. Marginal Cost of funds
2. Negative carry on account of CRR
3. Operating costs
4. Tenor Premium

1. Marginal cost of funds

The basic banking is to accept the deposits from the customer and lend it to customer. FIs make use of this spread to make profit. Marginal cost comprises of Marginal cost of borrowings and Return on net worth.

1.a Whats is the marginal cost ?

The marginal cost is the cost of funds available to the institutions from the customer/ Public. Customers invest in banks in the form of Fixed deposits, Savings and Current accounts[ CASA] etc. For these funds banks provide the interest to the customer in lieu of the money deposited by them. FIs also arrange the funds by way of borrowing to meet their commitments.[ Long term borrowing and Short term borrowing]

Lets take an example ABC bank has total liability of Rs 100 cr , the average rate of interest offered by the bank against these deposits is say 7.5%.
So the cost of funds is 100 Cr X 7.5%=7.5 Cr



1.b The  Return on net worth
Component of Tier 1 capital is 8% of RWA [ Risk Weighted Asset ] as per the RBI guidelines this should be included for the Marginal cost of funds. Probably in future when capital conservation buffer will be implemented as part of Basel III, then this will be increased to 10.5%. As per the Basel guidelines banks have to make provision as per their risk appetite.

Marginal cost of funds = 92% x Marginal cost of borrowings + 8% x Return on net worth 

Negative Carry on CRR [ Eureka moment ]

Why this component has been included for the MCLR ? Earlier the rate cuts offered by the central bank have not been transferred by the FIs smoothly. With CRR in picture whenever there will be an increase or decrease in repo rate it will be passed to the consumer directly.

CRR : cash reserve ratio it is the amount of money need to be deposited by the FIs with RBI, it fetches them a woofing amount of return and the return amount is a big Zero “0 “.

For the calculation of Negative carry RBI has prescribed below formula

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

So negative factor : CRR/(1-CRR) - simple mathematics tells that this will always be greater than CRR

CRR    : 4% :  [0.04/(1-0.04)] = 0.0416  
SLR     : 21.25% : [0.2125/(1-.2425)] = 0.2698  [ Maximum CRR ]
So negative factor will always multiply the marginal cost by multiplier which is greater than CRR.

Operating cost

The cost associated with providing the loan product including cost of raising the funds.
This cost includes all the expenses incurred while delivering the loan product.

Training of Staff
Research
Modeling [ Different scoring models]
Appraisal cost [ this may include salary expenses towards staff ]
Promotions and advertisements
Pre paid expense : Tie up arrangement expense

Tenor Premium

Based on different tenor of loans , different premium will be applied to the loans  irrespective of the type of loan.

Mr. Superman was still doubtful regarding the success of MCLR so again asked his guruji Mr. Nobody how this will help the banks to make profit?


Mr Nobody

Lets take an example Mr RBI has very successful brand 27 players [ PSU] approached him for franchise. Then Mr RBI being a boss came up with long list of terms conditions to which these 27 gentlemen merely agreed. However they dint know that they are in the risk business.

Mr RBI came up with an innovative idea of based rate way back in July 2010, which he has gain modified to MCLR in order to serve his customer in a better way at his franchise.

Every year RBI collects a franchise fee from 27 players it has been fixed at Rs 100/year. Now yearly profit of the 27 players stands at Rs 500/year each. Now in order to serve his customers better Mr. RBI came up with an idea of X factor that franchise's should only charge [10-X]% instead of 10%  to the customer.

Lets take a break even analysis of one of the franchises’s   X= 0.50
Description
Cost [ Rs]
Rent
20/month = 240/year
Staff expenses
30/month = 360/year
Advertisement
10/month = 120/year
Maintenance
5/month =  60/year
Franchise fee
          100/year
Total
880/year       


In order to make a profit of Rs 500 , the franchise has to do a business of Rs 1380/year. Profit is directly proportional to the interest that stands at 10%.
.
Illustration :
Business                                              : 1380
ROI                                        : 10%
Capital employed                    : 1380/.10= 13800


This ROI has been reduced by 0.50%
Business                                              : 1380
ROI                                        : 9.5%
Capital employed                    : 1380/.095= 14527


So in order to maintain the same profit level the franchise has to employ more funds and the cost these funds will again reduce the profitability.

Suppose the excess fund of Rs 727 has been borrowed by franchise from Mr RBI at 6.50% [ repo rate ] , the cost of funds will 47.25/year . Again this reduce the profitability by Rs 47.25.


Description
Cost [ Rs]
Profit
500
Funds required
727
Rate of interest
6.5%
Time period
1 year
Interest to be paid
47.25
Net profit
452.75


Here after doing all this mumbo jumbo the franchise is unable to reach the profit made last year. The same thing is about to happen with this MCLR  to our banking industry.The new base rate is a actually a burden on the Indian banking industry . The banks/FIs should be independent from RBI as far as the policy related to interest is concerned. Customer centric policies are good but if bank will not be there then how will we be bale to cater the customer.

What is the gist of this all? 
In simple layman terms, it means that the MCLR system of charging rate of interest will be a doom for our banking industry since the banks should be only lucky enough to generate operating profit using such a thin profit margin running into 0.XXX percentage points.  Which again means that the dividend being paid to shareholders as well as the retained earnings and surplus funds generated by the banks during its erstwhile days are going to be under heavy stress.  The bottom line advise by Ethmos - Don't go for banking sector stocks in the share market until some clarity emerges on the situation.



Happy Ethmos to All

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