Base Rate vs MCLR vs External Benchmark Rate – Complete RBI Lending Rate Evolution

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Base Rate vs MCLR vs External Benchmark Rate – Complete RBI Lending Rate Evolution

Base Rate vs MCLR vs External Benchmark Rate

The lending rate system in India has undergone significant evolution under the guidance of the Reserve Bank of India (RBI). From highly regulated interest rates to market-linked benchmarks, the objective has been to improve transparency, efficiency, and monetary policy transmission. The transition from BPLR → Base Rate → MCLR → External Benchmark reflects India’s shift towards a more responsive and borrower-friendly banking system.

Evolution of Lending Rate System in India (RBI)

1. Early Regulation of Interest Rates (1960–1990)

The Reserve Bank of India began regulating lending rates by prescribing a minimum lending rate from October 1960.
In 1968, this was replaced by a maximum lending rate, but the system reverted to a minimum lending rate in 1970.
The ceiling rate on advances to be charged by banks was again introduced in 1976, and banks were also advised, for the first time, to charge interest on advances at periodic intervals, that is, at quarterly rests. In the following period, various sector-specific, programme-specific and purpose-specific interest rates were introduced.

2. Rationalisation of Lending Rates (1990)

Given the prevailing structure of lending rates of Scheduled Commercial Banks, as it had evolved over time, characterised by an excessive proliferation of rates, in 1990, a new structure of lending rates linking interest rates to the size of loan was prescribed which significantly reduced the multiplicity and complexity of interest rates.
However, schemes like the Differential Rate of Interest (DRI) and Export Credit continued under separate regimes.

3. Financial Sector Reforms (1994)

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, it was decided to free the lending rates of scheduled commercial banks for credit limits of over Rs. 2 lakh; for loans up to Rs. 2 lakh, it was decided that it was necessary to continue to protect these borrowers by prescribing the lending rates and accordingly it was prescribed that for loans up to and inclusive of Rs.2 lakh, the lending rates of banks should not exceed the BPLR of the respective banks.
For credit limits of over Rs.2 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.
Banks were required to obtain the approval of their respective Boards for the Benchmark Prime Lending Rate (BPLR), which would be the reference rate for credit limits of over Rs.2 lakh. Each bank’s BPLR has to be declared and be made uniformly applicable at all branches.

4. Benchmark Prime Lending Rate (BPLR) System and Its Limitations

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.
For the same reason, it was also difficult to assess the transmission of policy rates of the Reserve Bank to lending rates of banks.
Accordingly, based on the recommendations of the Working Group on Benchmark Prime Lending Rate which submitted its report in October 2009, and banks were advised to switch over to the system of Base Rate with effect from July 1, 2010.

5.Introduction of Base Rate (2010)

The Benchmark Prime Lending Rate (BPLR) was replaced in 2010 with Base Rate.
The Base Rate is the minimum interest rate at which Indian banks could lend. They were not permitted to resort to any lending below this rate. The base rate was determined significantly by the average cost of funds. As per RBI policies, lenders were required to review their base rate at least once every quarter.
The Base Rate system was aimed at enhancing transparency in lending rates of banks and enabling better assessment of transmission of monetary policy.

6. Introduction of MCLR (2016)

Why did the central bank move banks to the MCLR system when the base rate and BPLR worked fine?
- The RBI was not satisfied with the effectiveness of the base rate system. That’s why it decided to move banks to the new system to benefit borrowers and the country’s economy.The RBI figured out that the base rate system was not sensitive to changes in the policy rates, which is vital for the proper implementation of monetary policies in the country. Before the central bank made it mandatory for banks to follow the MCLR system, there was no uniform system in place. Banks were calculating the base rate based on various methodologies as per their discretion. While some were using the average cost of funds, others used the blended cost of funds and the marginal cost of funds.
- Most importantly, the RBI moved banks to the MCLR system to ensure the swifter transmission of its policy rates into banks’ lending rates. Therefore, the MCLR came into effect to fulfill the following objectives:
  - Enhance transmission of RBI policy rates into the country’s banking system.
  - Improve transparency in the system utilized by banks to fix interest rates on loans.
  - Ensure fairness in credit interest rates for both banks and borrowers.
  - It provides a competitive advantage to banks and boosts their long-term value while contributing to the country’s economic growth.
From 1 April 2016, RBI introduced the Marginal Cost of Funds based Lending Rate (MCLR).
Each bank calculates its own MCLR based on:
- Marginal cost of deposits
- Cost of maintaining CRR and SLR
- Operational costs of banks
- Tenor premium
Difference between Base Rate and MCLR:
- Lending rates shifted from average cost → marginal cost of funds.
Thus, MCLR acts as an internal benchmark, and lending rates are linked to it.

7. Introduction of External Benchmark Lending Rate (2019) for Certain Categories of Loans

Due to various reasons, the transmission of policy rate changes to the lending rate of banks under the marginal cost of funds based lending rate (MCLR) framework was not satisfactory.
Therefore, RBI decided to make “it mandatory for banks to link all new floating rate personal or retail loans and floating rate loans to MSMEs (micro, small and medium enterprises) to an external benchmark effective October 1, 2019.
The external benchmarks, to which the banks will be required to link their lending rates, could be repo, 3-month or 6-month treasury bill yield, or any other benchmark published by the Financial Benchmarks India Private Ltd (FBIL).
This system ensures faster and more transparent transmission of monetary policy.

Example – External Benchmark (Home Loan)

Ravi takes a home loan of ₹30 lakh from a bank
The loan is linked to the RBI Repo Rate
At the time of taking loan
- Repo rate = 6%
- Bank adds 2.5% spread
- Hence, Loan interest rate = 8.5%

After RBI reduces repo rate
- Repo rate falls to 5.5%
- New loan rate becomes: 5.5% + 2.5% = 8%

Impact on Ravi
- His EMI decreases automatically
- He does not need to request the bank
- This system ensures faster and more transparent transmission of monetary policy.

The banks were also asked to reset the interest rate under external benchmark at least once in three months.

Example – Reset of Interest Rate (Every 3 Months)

Riya takes a home loan linked to Repo Rate
Bank rule: Interest rate will be reset every 3 months

Initial Situation (January)

Repo rate = 6%
Spread = 2%
Loan rate = 8%

After 1 Month (February)

Repo rate falls to 5.5%
But Riya’s loan rate does not change immediately because reset is allowed only after 3 months

After 3 Months (April – Reset Date)

- Repo rate = 5.5%
New loan rate becomes:5.5% + 2% = 7.5%

To promote transparency, standardisation, and simplicity in loan products, the RBI has mandated that banks must use a single external benchmark within a particular loan category.This means that a bank cannot use different benchmarks for the same type of loans.
Spread:
- Banks have the flexibility to decide both the components and the size of the spread added over the external benchmark.
- Typically, the spread includes factors such as:
  - Credit risk premium (based on borrower’s risk profile)
  - Operational costs of the bank
  - Business strategy
- Although banks can determine the spread, there are certain restrictions:
  - The credit risk premium can be revised only when there is a substantial change in the borrower’s creditworthiness.
  - Further, other components of spread including operating cost could be altered once in three years.
- These rules ensure that banks do not arbitrarily change lending rates, thereby protecting borrowers and maintaining transparency.

The evolution from BPLR to External Benchmark reflects RBI’s continuous effort to improve transparency, fairness, and efficiency in the lending system. The current framework ensures quick transmission of policy rates, benefiting borrowers while maintaining stability in the banking system.

FAQs

1. What is the Base Rate?

It is the minimum lending rate below which banks were not allowed to lend (introduced in 2010).

2. What is MCLR?

MCLR is the internal benchmark rate based on marginal cost of funds (introduced in 2016).

3. What is an External Benchmark Rate?

It is a lending rate linked to external indicators like repo rate or treasury bill yields (introduced in 2019).

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