Unit 3

Evaluating Consumer loans

By
Dr Virupaksha Goud

Evaluating consumer loans – Types- Credit analysis of consumer loans- Risk–return analysis of
consumer loans- Customer profitability analysis and loan pricing- Fixed Vs floating rates

ADVANCES

Fund Based Non-Fund Limit

For funding Fixed For Working Bank Guarantees Letter of Credits

Assets and Long Capital
Term Loan Over Draft

Cash Credit

Export Credit

Demand Loan Bill Finance

Consumer Loans

Consumer loans in the aggregate currently produce greater percentage profits for banks than
commercial loans. This is true despite the higher default rates on consumer loans. Not
surprisingly, consumer loan rates typically exceed commercial loan rates.

Evaluating Consumer Loans

An analyst should addresses the same issues discussed with commercial loans:

 The use of loan proceeds

 The amount needed
 The primary and secondary source of repayment

However, consumer loans differ so much in design that no comprehensive analytical format
applies to all loans

Types of Consumer Loans:

1. Installment Loans

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  Require the periodic payment of principal and interest
 Can be extremely profitable
 Direct: Negotiated between the bank and the ultimate user of the funds
 Indirect: Funded by a bank through a separate retailer that sells merchandise to a
customer

2. Credit Cards and Other Revolving Credit

Credit cards and overlies tied to checking accounts are the two most popular forms of revolving
credit agreements. Most banks operate as franchises of Master Card and /or Visa. Bank pays a
one-time membership fee plus an annual charge determined by the number of its customers
actively using the cards. Credit cards are attractive because they provide higher risk-adjusted
returns than do other types of loans. Card issuers earn income from three sources:

 Cardholders’ annual fees

 Interest on outstanding loan balances
 Discounting the charges that merchants accept on purchases.

Credit Card Systems and Profitability: Returns depend on the specific role the bank plays. A
bank is called a card bank if it administers its own credit card plan or serves as the primary
regional agent of a major credit card operation. A non-card bank does not issue its own card

3. Overdraft Loans

A type of revolving credit open Credit Lines: A recent trend is to offer open credit lines to
affluent individuals whether or not they have an existing account relationship. Typically, the
bank provides customers with special checks that activate a loan when presented for payment

4. Personal Loans

Personal loans can be used for any personal expenses and don’t have a designated purpose. This
makes them an attractive option for people with outstanding debts, such as credit card debt, who
want to reduce their interest rates by transferring balances. Like other loans, personal loan terms
depend on customer credit history.

6. Auto Loans

Like mortgages, auto loans are tied to your property. They can help customer afford a vehicle,
but customer risk losing the vehicle if customer miss payments. This type of loan may be
distributed by a bank or by the car dealership directly but customer should understand that while
loans from the dealership may be more convenient, they often carry higher interest rates and
ultimately cost more overall.

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7 Student Loans

Student loans are offered to college students and their families to help cover the cost of higher
education. There are two main types: government student loans and private student loans.
Government funded loans are better, as they typically come with lower interest rates and more
borrower-friendly repayment terms.

8. Home Equity Loans

Home equity loans and home equity lines of credit (HELOCs) use the borrower’s home as a
source of collateral so interest rates are considerably lower than other loans. The major
difference between the two is that a home equity loan has a less interest rate and regular monthly
payments are expected,

9. Non-Installment Loans

Often require a single principal and interest payment. Bridge loans are representative of single
payment consumer loans. Bridge loans often arise when an individual borrows funds for the
down payment on a new house. The loan is repaid when the borrower sells the previous home

10. Subprime Loans

One of the hottest growth areas during the 2000s is Subprime loans. Subprime loans are higher-
risk loans labeled “B,” “C,” and “D” credits. They have been especially popular in auto, home
equity, and mortgage lending. Typically have the same risk as loans originated through consumer
finance companies. Subprime loans have greater risk and must be priced consistently higher than
prime-grade loans.

11. High LTV Loans

High Loan-To-Value. Many lenders upped the stakes by making “high LTV” loans based on the
equity in a borrower’s home. Where traditional home equity loans are capped at 75 percent of
appraised value minus the outstanding principal balance, high LTV loans equal as much as 125%
of the value of a home.

Consumer Credit Regulations: - Equal Credit Opportunity

Credit Scoring Systems:

Credit scoring systems are acceptable if they statistically justified. Credit scoring systems can
use information about age, sex, and marital status as long as these factors contribute positively to
the applicant's creditworthiness. Credit scoring models are based on historical data obtained from
applicants who actually received loans. Statistical techniques assign weights to various borrower
characteristics that represent each factor's contribution toward distinguishing between good loans
that were repaid on time and problem loans that produced losses.

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CREDIT ANALYSIS

Credit analysis is the method by which one calculates the creditworthiness of a business or
organization. In other words, it is the evaluation of the ability of a individual to honor its
financial obligations. Or, a bank may analyze the financial statements of a small business before
making or renewing a commercial loan. The objective of credit analysis is to look at both the
borrower and the lending facility being proposed and to assign a risk rating. The risk rating is
derived by estimating the probability of default by the borrower at a given confidence level over
the life of the facility, and by estimating the amount of loss that the lender would suffer in the
event of default.

Credit analysis involves a wide variety of financial analysis techniques, including ratio and trend
analysis as well as the creation of projections and a detailed analysis of cash flows. Credit
analysis also includes an examination of collateral and other sources of repayment as well as
credit history and management ability. Analysts attempt to predict the probability that a borrower
will default on its debts, and also the severity of losses in the event of default.

Before approving a commercial loan, a bank will look at all of these factors with the primary
emphasis being the cash flow of the borrower. A typical measurement of repayment ability is the
debt service coverage ratio. A credit analyst at a bank will measure the cash generated by a
borrower. In case of commercial Loan, the debt service coverage ratio divides this cash flow
amount by the debt service (both principal and interest payments on all loans) that will be
required to be met. Commercial bankers like to see debt service coverage of at least 120 percent.
In other words, the debt service coverage ratio should be 1.2 or higher to show that an extra
cushion exists and that the business can afford its debt requirements.

CLASSIC CREDIT ANALYSIS

To make prudent credit decision, bank essentially should know the borrower well. Without these
information bank cannot judge the loan application. Credit worthiness of the applicants is
evaluated to ensure that the borrower conform to the standards prescribed by the bank. It can be
said that a loan properly made is half-collected. So, a bank should make proper analysis before
making any credit decision. With increasing credit risks, banks have to ensure that loans are
sanctioned to „safe‟ and „profitable‟ projects. For this they need to fine tune their appraisal
criteria. A mix of both formal and non-formal credit appraisal techniques will go a long way to
ensure perfection in credit appraisal.

The credit evaluation process involves three steps:

1. Gathering Credit information

2. Credit Analysis (credit worthiness of applicants)
3. Credit Decision

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1. Gathering credit information:

The credit department of a bank collects various important information regarding borrower from
different sources to evaluate the customer. A number of sources would available for gathering
information which depends upon the nature of the business, form of loan, amount of loan etc.
these sources are,

 Interview:

Interview with the borrower enables the banks to secure the detail information about the
borrower‟s business which can help in credit decision process. If the applicant does not satisfy
the credit norms, the lending officer may stop further procedure. In case of the success of
preliminary investigation, as up to the standards, borrower may be asked to submit various
financial reports.

 Financial statements:

Financial statements include the balance sheet and the profit and loss account. The financial
statements of the last few years should be obtained. This analysis would provide an insight into
the borrower‟s financial position, funds management capacity, liquidity, profitability and
repaying capacity of the borrower.

 Report of credit rating agencies:

Credit Information Companies (Regulation) Act 2005, (CICRA) provided for the creation of
credit information agencies or companies, which enable the banks to readily access the full credit
history of the borrower. This is an institution that is set up by the lenders like bankers, credit card
companies etc. Banks can gather information on the creditworthiness of the applicant. These
companies maintain the credit histories on individuals and business entities. The CICRA became
a piece of legislation with effect from June 23, 2005. Credit information in this context only
includes past track record in loans availed and future repayment ability.

 Bank‟s own records:

If the applicant is the existing customer of the bank, the banker can study the previous records,
which provides an insight into the past dealings with the bank. Every bank maintains a record of
all depositors and borrowers. The transactions of borrower can give depth idea to banker.

 Bazaar report:

Report regarding applicant can also be obtained from various markets. The strengths and
weaknesses of the borrowers are monitored by the markets continuously. Market opinion can
also predict the future of the business. Market intelligence can also be gathered through

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borrower‟s competitors. It should be a continuous process on existing current account holders
and other prominent businessmen.

 Report from other banks:

Bank credit department may ask to other banks in which the applicant has dealings.

 Other non-formal methods:

There are other ways also which can give many clues and make the judgment more accurate. The
most popular non-traditional method is to understand the personality, motive and the capabilities
of the borrowers, based on non-verbal clues as trying to predict the results of a human mind.19

2. Credit analysis (credit worthiness of applicants):

After gathering the credit information, banker analyses it to evaluate the creditworthiness of the
borrower. This is known as Credit Analysis. It involves the credit investigation of a potential
customer to determine the degree of risk in the loan. The creditworthiness of the applicant calls
for a detailed investigation of the 5 „C‟ of credit – Character, Capacity, Capital, Collateral and
Conditions. In deciding whether or not to make a given loan above 5 C’s are widely
used. Developing this type of expert system is time-consuming and expensive. That is why, from
time to time, banks have tried to clone their decision-making process. Even so, in the granting of
credit to corporate customers, many banks continue to rely primarily on their traditional expert
system for evaluating potential borrowers.

Objective of consumer credit analysis is to assess the risks associated with lending to individuals.
When evaluating loans, bankers cite the 5 Cs of credit:

 Character: The most important element, but difficult to assess

 Capital: Refers to the individual's wealth position
 Capacity: The lender often imposes maximum allowable debt-service to income ratios
 Conditions: The impact of economic events on the borrower's capacity to pay
 Collateral: The importance of collateral is in providing a secondary source of repayment

Two additional Cs are along with above are

 Customer Relationship: A bank’s prior relationship with a customer reveals information

about past credit and deposit experience that is useful in assessing willingness and ability
to repay.
 Competition: Has an impact by affecting the pricing of a loan. All loans should generate
positive risk-adjusted returns. Lenders periodically react to competitive pressures by
undercutting competitors’ rates in order to attract new business. Competition should not
affect the accept/reject decision

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While each of the C’s is evaluated, none of them on their own will prevent or ensure access to
financing. There is no automatic formula or guaranteed percentages that are used with the Five
C’s. They are only a variety of factors that lenders evaluate to determine how much of a risk the
potential borrower is for the financial institution.

1. Character – This is a highly subjective evaluation of the business owner’s personal history.
Lenders have to believe that a business owner is a reliable individual who can be depended on to
repay the loan. Background characteristics such as personal credit history, education, and work
experience are all factors inn this business credit analysis. Character is the single most important
factor considered by a reputable bank. Banks want to do business with people who are honest,
ethical and fair. (The difference between the ability to repay a loan and the willingness to repay a
loan is an example of a person’s character.) The knowledge, skills, and abilities of the owner and
management team are vital components of this credit factor.

2. Capacity – This is an evaluation of the company’s ability to repay the loan. The bank needs to
know how you will repay the funds before it will approve your loan. Capacity is evaluated by
several components, including the following:

 Cash Flow refers to the income a business generates versus the expenses it takes to run
the business analyzed over a specific time period-usually two or three years. If the
business is a start up, prepare a monthly cash flow statement for Year 1.

 Payment history refers to the timeliness of the payments that have been made on previous
loans. Today there are companies that evaluate commercial credit ratings (such as Dun &
Bradstreet) that are able to provide this kind of history to lenders.

 Contingent sources for repayment are additional sources of income that can be used to
repay a loan. These could include personal assets, savings or checking accounts, and
other resources that might be used. For small businesses, the income of a spouse
employed outside the business is commonly considered.

3. Capital – A company’s owner must have his own funds invested in the company before a
financial institution will be willing to risk their investment. Capital is the owner’s personal
investment in his/her business which could be lost if the business fails. The single most common
reason that new businesses fail is undercapitalization. There is no fixed amount or percentage
that the owner must be vested in his/her own company before he is eligible for a business
loan. However, most lenders want to see at least 25% of a company’s funding coming from
the owner. Contrary to what is advertised in the media, a bank will not fund 100% of the
business venture. In almost every case, any principal that will own more than 10% of the
company is required to sign a personal guarantee for the business debt.

4. Collateral – Machinery, accounts receivable, inventory, and other business assets that can be
sold if a borrower fails to repay the loan are considered collateral. Since small items such as

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computers and office equipment are not typically considered collateral, in the case of most small
business loans, the owner’s personal assets (such as his/her home or automobile) are required in
order for the loan to be approved. When an owner of a small business uses his/her personal assets
as a guarantee on a business loan, that means the lender can sell those personal items to satisfy
any outstanding amount that is not repaid. Collateral is considered a “secondary” source of
repayments-banks want cash to repay the loan, not sale of business assets.

5. Conditions – This is an overall evaluation of the general economic climate and the purpose of
the loan. Economic conditions specific to the industry of the business applying for the loan as
well as the overall state of the country’s economy factor heavily into a decision to approve a
loan. Clearly, if a company is a thriving industry during a time of economic growth, there is
more of a chance that the loan will be granted than if the industry is declining and the economy
is uncertain. The purpose of the loan is an important factor. If a company plans to invest the loan
into business by acquiring assets or expanding its market, there is more of a chance of approval
than if it plans to use the fund for more expenses. Typical factors included in this evaluation step
include: the strength and number of competitors, size and attractiveness of the market,
dependence on changes in consumer tastes and preferences, customer or supplier concentration,
length of time in business, and any relevant social, economic, or political forces that could
impact the business.

6. Confidence – A successful borrower instills confidence in the lender by addressing all of the
lender’s concerns on the other Five C’s. Their loan application sends the message that the
company is professional, with an honest reputation, a good credit history, reasonable financial
statements, good capitalization and adequate collateral.

 When applying for a small business loan, don’t forget the importance of personal
relationships. Apply for a loan at a bank where you already have a positive business
relationship. Also, make an attempt to meet with the person who will be evaluating your
application, such as the bank’s lending officer, rather than the teller who handles your
day-to-day banking transactions.

 When lending small amounts of money, typically under Rs 5,00,000, eligibility depends
largely on personal and business credit scores. A credit analysis is not usually performed
and the results of the personal and business credit scores will determine whether or not
the loan is approved. If the loan request is declined, a credit analysis may be completed or
the borrower may be asked to have another person or entity act as co-signer or guarantor.

 Some businesses don’t need to have a business plan to obtain a loan (where previous
personal relationship has already been established) although business plans can be
beneficial for reasons other than obtaining financing.

3.Credit decision:

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After passing through whole this process, the banker has to take decision about sanctioning of
credit facility. The creditworthiness should be matched against the credit standards of loan
policy. The banker should be very conscious about this, for taking right decision to avoid the
possible credit risks to arise in future.

Evaluation Procedures:

 Judgmental
 Quantitative, Credit Scoring

Judgmental: The loan officer subjectively interprets the information in light of the bank’s lending
guidelines and accepts or rejects the loan

Quantitative credit scoring / Credit scoring model: The loan officer grades the loan request
according to a statistically sound model that assigns points to selected characteristics of the
prospective borrower. In both cases, judgmental and quantitative, a lending officer collects
information regarding the borrower’s character, capacity, and collateral.

Loan Processing:

Prospecting: Prospecting is identifying the right customer/borrower who is in need of a loan is

the first phase of the loan process.

Pre-approval and documentation: Sales team will be assessing the applicant details, to check
whether it is meeting the basic requirements and he/she is eligible for a loan. Documentation
includes loan applications, KYC documents, income documents, employment documents,
residential details and other supporting documents as per the lender’s requirements.

Loan processing: In processing stage, the applicant details will be confirmed, the risk team will
be checking the authenticity of documents submitted, residential, employment and reference
verification will be completed. Credit report CIBIL request to check credit history, internal and
external verification will be completed before sending the file for credit appraisal.

Credit appraisal: Loan officer/credit officer will evaluate the applicant documents based on
5C’s on credit and decides approval or rejection with valid reason.

Disbursal: Once the loan is approved by credit officer, the operations team prepares the final
documents and this document goes through the verification process. Then the loan amount on
agreed basis is disbursed to the customer.

Post disbursal evaluation: Auditing and post disbursal evaluation will be conducted through the
centralized system to verify all the systems, process, documentation and other policy related
aspects are covered under each stage of loan processing.

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The root cause of non-performing asset in India is non-adherence to credit system, especially
unsecured personal loan. It is extremely important to follow stringent credit processing and credit
appraisal system which assist in risk mitigation and reduction in non-performing assets. 5 C’s –
capacity, capital, character, collateral and common sense will assist in determining the credit
worthiness of a prospective borrower. 6 major loan processing methods are critical to the success
of banks/financial institutions in maximizing their return on investment.

RISKS AND RETURN CHARACTERISTICS OF CONSUMER LOANS

 Revenues from Consumer Loans

The attraction is two-fold:
Competition for commercial customers narrowed commercial loan yields so that returns fell
relative to potential risks. Developing loan and deposit relationships with individuals presumably
represents a strategic response to deregulation. Consumer loan rates have been among the highest
rates quoted at banks in recent years. In addition to interest income, banks generate substantial
non-interest revenues from consumer loans. With traditional installment credit, banks often
encourage borrowers to purchase credit life insurance on which the bank may earn a premium
 Consumer Loan Losses
Losses on consumer loans are normally the highest among all categories of bank credit. Losses
are anticipated because of mass marketing efforts pursued by many lenders, particularly with
credit cards. Credit card fraud losses amounted to more than $2.4 billion in mid-2004.
 Interest Rate and Liquidity Risk with Consumer Credit

The majority of consumer loans are priced at fixed rates. New auto loans typically carry 4-year
maturities, and credit card loans exhibit an average 15- to 18-month maturity.
Bankers have responded in two ways:
 Price more consumer loans on a floating-rate basis
 Commercial and investment banks have created a secondary market in consumer loans,
allowing loan originators to sell a package of loans

CUSTOMER PROFITABILITY ANALYSIS

The bank‟s profitability depends on the loan price. Price of loans is based on the credit risk
rating of the borrower. The loan pricing should be enough to recover cost of funds, credit risk
premium, capital adequacy cost and overhead. However, the bank is operating in the market, in
highly competitive environment. Hence, its price should be comparable to the market price. In
this global and competitive market, bank has to attract the customer with such an attractive prices
and returns. Growth of bank depends upon the stability of bank in this competition.

Two different costs associated with the loan are: fees and interest.
Fees

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A fee is an amount charged by a financial institution for the services it provides.
Examples of fees include:

 Maintenance fees
 Service charges
 Late fees
 Application Fees or processing fees.
Interest
Interest is the amount of money the bank charges you for letting you use its money. Interest is
only part of the total cost of credit. Interest rates can be either variable or fixed. Variable rate
means the interest rate may change during any period of the loan term, as written in the contract.
Fixed rate means the interest rate stays the same throughout the term of the loan.

Customer profitability (CP) is the profit the firm makes from serving a customer or customer
group over a specified period of time, specifically the difference between the revenues earned
from and the costs associated with the customer relationship in a specified period. Calculating
customer profit is an important step in understanding which customer relationships are better
than others.

Two significant differences alter the analysis when evaluating the profitability of individual
accounts:
1. Consumer loans are much smaller than commercial loans, on average
2. Processing costs per rupee of loan are much higher than for commercial loans

Loans will not generate enough interest to cover costs if they are too small or the maturity is too
short, even with high interest rates. Thus, banks set minimum targets for loan size, maturity, and
interest rates.
Break-even analysis of consumer loans
The break-even relationship is based on the objective that loan interest revenues net of funding
costs and losses equal loan costs:

Net Interest income = Interest expense + Loan losses + Acquisition costs + Collection costs
Break-even analysis of consumer loans general analysis: If:
R = annual percentage loan rate (%)
D = interest cost of debt (%)
L = average loan loss rate (%)
S = initial loan size
B=avg. loan balance outstanding (% of initial loan)
M = number of monthly payments
Ca = loan acquisition cost, and

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Cc = collection cost per payment
 Then:
(r - d - l) SB (M/12) = Ca + (Cc)(M)

PRICING NEW COMMERCIAL LOANS:

The interest rate structure in the banking sector in India was largely administered in nature and
was characterized by numerous rate prescriptions for various segments till 1980s. After the
financial sector reforms launched by the Narasimha Rao government in the early 1990s, interest
rates were progressively deregulated. A system of prime lending rate (PLR), the rate charged
from the prime borrowers of the bank, was introduced in October 1994. “Since then, for almost a
decade till March 2003, the PLR system went through several modifications from a single PLR
to multiple PLRs and tenor-linked PLRs and banks were given increasingly greater freedom in
setting lending rates,”.

The system of the BPLR was introduced in 2003, which was expected to serve as a benchmark
rate for banks’ pricing of their loan products so as to ensure that it truly reflected the actual cost;
however, the BPLR system fell short of its original objective of bringing transparency to lending
rates. Competition forced the pricing of a significant proportion of loans far out of alignment
with BPLRs and in a non-transparent manner.

On the basis of the recommendations of a working group, the RBI — when D Subbarao was the
Governor — introduced the base rate system in July 2010, under which all categories of loans
were to be priced only with reference to the base rate with a few exceptions. The base rate” is
computed on the basis of the cost of funds to the bank. However the method of computing base

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rate was followed by different banks in different methods like average cost funds, marginal cost
funds, blended cost funds. The base rate included all those elements of the lending rate that are
common across all categories of borrowers. Banks are allowed to determine their actual lending
rates on loans and advances with reference to the base rate.

MCLR was the next experiment which was kicked off when Raghuram Rajan was the RBI
Governor. The RBI directed that all rupee loans approved and credit limits renewed with effect
from April 1, 2016, should be priced with reference to the MCLR which will be the internal
benchmark for such purposes. The MCLR comprises marginal cost of funds, negative carry on
account of cash reserve ratio (CRR), operating costs and tenor premium. Banks reduced their
MCLR by nearly one percentage point, benefiting new borrowers.

“For different banks, the cost of funds is different. The asset-liability situation of banks is also
different. The pricing can vary from bank to bank. There can’t a uniform rate”. The base rate of
some banks after the introduction of MCLR has moved significantly less than MCLR.

Method of determining ” which was constant for all loans, “MCLR is different for loans with
different tenors, The banks would finalize actual lending rates for different maturities by adding
the components of spread to the MCLR. Every commercial bank defines the components of
spread finalized by it with the approval of its board. However, to introduce uniformity in
deciding the components of spread, RBI has directed the banks to adopt the broad components of
spread finalized by IBA.

Existing loans and credit limits linked to the Base Rate (internal benchmark rate used to
determine interest rates uptill 31 March 2016) or Benchmark Prime Lending Rate (BPLR or the
internal benchmark rate used to determine the interest rates on advances/loans sanctioned upto
June 30, 2010.) would continue till repayment or renewal, as the case may be. However, existing
borrowers will have the option to move to the Marginal Cost of Funds based Lending Rate
(MCLR) linked loan at mutually acceptable terms.

Reasons for introducing MCLR

RBI decided to shift from base rate to MCLR because the rates based on marginal cost of funds
are more sensitive to changes in the policy rates. This is very essential for the effective
implementation of monetary policy. Prior to MCLR system, different banks were following
different methodology for calculation of base rate /minimum rate – that is either on the basis of
average cost of funds or marginal cost of funds or blended cost of funds. Thus, MCLR aims

 To improve the transmission of policy rates into the lending rates of banks.
 To bring transparency in the methodology followed by banks for determining interest
rates on advances.
 To ensure availability of bank credit at interest rates which are fair to borrowers as well
as banks.

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  To enable banks to become more competitive and enhance their long run value and
contribution to economic growth.

Calculation of MCLR

The MCLR is a tenor linked internal benchmark (tenor means the amount of time left for the
repayment of a loan). The actual lending rates are determined by adding the components of
spread to the MCLR. Banks will review and publish their MCLR of different maturities, every
month, on a pre-announced date.

The MCLR comprises of the following:

a) Marginal cost of funds which is a novel concept under the MCLR methodology comprises of
Marginal cost of borrowings and return on net worth, appropriately weighed.

i.e., Marginal cost of funds = (92% x Marginal cost of borrowings) + (8% x Return on net worth)

Thus, marginal cost of borrowings has a weightage of 92% while return on net worth has 8%
weightage in the marginal cost of funds. Here, the weight given to return on net worth is set
equivalent to the 8% of risk weighted assets prescribed as Tier I capital for the bank. The
marginal cost of borrowing refers to the average rates at which deposits of a similar maturity
were raised in the specified period preceding the date of review, weighed by their outstanding
balance in the bank’s books.

i.e, Rates offered on deposits of a similar maturity on the date of review/ rates at which funds
raised x Balance outstanding as a percentage of total funds (other than equity) as on any day, but
not more than seven calendar days prior to the date from which the MCLR becomes effective.

b) Negative carry on account of' Cash reserve ratio (CRR)- Negative carry on the mandatory
CRR arises because the return on CRR balances is nil. Negative carry on mandatory Statutory
Liquidity Ratio (SLR) balances may arise if the actual return thereon is less than the cost of
funds.

c) Operating Cost associated with providing the loan product, including cost of raising funds, but
excluding those costs which are separately recovered by way of service charges.

d) Tenor Premium- The change in tenor premium cannot be borrower specific or loan class
specific. In other words, the tenor premium will be uniform for all types of loans for a given
residual tenor.

Banks may publish every month the internal benchmark/ MCLR for the following maturities:
 Overnight MCLR,
 One-month MCLR,
 Three-month MCLR,

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  Six month MCLR,
 One year MCLR.
 MCLR for any other maturity which the bank considers fit

Banks have the freedom to offer all categories of advances on fixed or floating interest rates.
Banks have to determine their actual lending rates on floating rate advances in all cases by
adding the components of spread to the MCLR. Accordingly, there cannot be lending below the
MCLR of a particular maturity, for all loans linked to that benchmark. Fixed rate loans upto three
years are also priced with reference to MCLR.

However, certain loans like Fixed rate loans of tenor above three years, special loan schemes
formulated by Government of India, Advances to banks’ depositors against their own deposits,
Advances to banks’ own employees etc. are not linked to MCLR.

Base Rate vs MCLR

Base rate calculation is based on cost of funds, minimum rate of return, i.e margin or profit,
operating expenses and cost of maintaining cash reserve ratio while the MCLR is based
on marginal cost of funds, tenor premium, operating expenses and cost of maintaining cash
reserve ratio. The main factor of difference is the calculation of marginal cost under MCLR.
Marginal cost is charged on the basis of following factors- interest rate for various types of
deposits, borrowings and return on net worth. Therefore MCLR is largely determined by
marginal cost of funds and especially by deposit rates and repo rates.

Risk-adjusted returns on loans

When deciding what rate to charge, loan officers attempt to forecast default losses over the life
of the loan. Credit risk, in turn, can be divided into expected losses and unexpected losses.

 Expected losses might be reasonably based on mean historical loss rates.

 In contrast, unexpected losses should be measured by computing the deviation of realized
losses from the historical mean.

Commercial loans are frequently underpriced at banks today. Strong competition for loans tends
to increase the banks underpricing of loans. Lenders appear to have systematically understated
risk. The appropriate procedure is to identify expected and unexpected losses and incorporate
both in determining the appropriate risk charge.

Mumbai Inter-Bank Offer Rate (MIBOR) and Mumbai Inter-Bank Bid Rate (MIBID) are the
benchmark rates at which Indian banks lend and borrow money to each other. The bid is the
price at which the market would buy and the offer (or ask) is the price at which the market would
sell. These rates reflect the short term funding costs of major banks. In other words, MIBOR
reflects the price at which short term funds are made available to participating banks.

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MIBID is the rate at which banks would like to borrow from other banks and MIBOR is the rate
at which banks are willing to lend to other banks. Contrary to general perception, MIBID is not
the rate at which banks attract deposits from other banks.

MIBOR is the Indian version of London Interbank Offer Rate (LIBOR). MIBOR is fixed for
overnight to 3 month long funds and these rates are published every day at a designated time. Of
the above tenors, the overnight MIBOR is the most widely used one which is used for pricing
and settlement of Overnight Index Swaps (OIS). Corporates use the OIS for hedging their
interest rate risks. The MIBID/MIBOR rate is also used as a bench mark rate for majority of
deals struck for Interest Rate Swaps (IRS), Forward Rate Agreements (FRA), Floating Rate
Debentures and Term Deposits. The aggregate amount of outstanding interbank/Primary Dealers
(PD) notional principal referenced to MIBOR remained at INR 16,847.6 billion as on October
31, 2013.

FIXED RATES VERSUS FLOATING RATES

How Variable Interest Rates Work

Variable Interest Rate: An interest rate that moves up and down based on the changes of an
underlying interest rate index. Floating-rate loans: increase the rate sensitivity of bank assets,
increase the GAP & reduce potential net interest losses from rising interest rates Because most
banks operate with negative funding GAPs through one-year maturities, floating-rate loans
normally reduce a bank’s interest rate risk.

Floating-rate loans transfer interest rate risk from the bank to the borrower. Given equivalent
rates, most borrowers prefer fixed-rate loans in which the bank assumes all interest rate risk.
Banks frequently offer two types of inducements to encourage floating-rate pricing:

1. Floating rates are initially set below fixed rates for borrowers with a choice

2. A bank may establish an interest rate cap on floating-rate loans to limit the possible increase in
periodic payments

Floating interest rates typically change based on a reference rate usually MCLR in India(a
benchmark of any financial factor, such as the Consumer Price Index).

The rate for such debt will usually be referred to as a spread or margin over the base rate: for
example, a five-year loan may be priced at the six-month MCLR + 2.50%. At the end of each
six-month period, the rate for the following period will be based on the MCLR at that point (the
reset date), plus the spread. The basis will be agreed between the borrower and lender, but 1, 3, 6
or 12 month money market rates are commonly used for commercial loans.

Typically, floating rate loans will cost less than fixed rate loans, depending in part on the yield
curve. In return for paying a lower loan rate, the borrower takes the interest rate risk: the risk that

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rates will go up in future. In cases where the yield curve is inverted, the cost of borrowing at
floating rates may actually be higher; in most cases, however, lenders require higher rates for
longer-term fixed-rate loans, because they are bearing the interest rate risk (risking that the rate
will go up, and they will get lower interest income than they would otherwise have had).

Certain types of floating rate loans, particularly mortgages, may have other special features such
as interest rate caps, or limits on the maximum interest rate or maximum change in the interest
rate that is allowable.

Eg:- A customer borrows Rs 25,00,000 from a bank; the terms of the loan are (3 years) MCLR +
3.5%. At the time of issuing the loan, the MCLR rate is 8.5%. For the first six months, the
borrower pays the bank 12% annual interest: in this simplified case Rs 1,50,000 for six months.
At the end of the first six months, the MCLR rate has risen to 4%; the client will pay 12.5% (or
Rs 1,56,250) for the second half of the year. At the beginning of the second year, the MCLR rate
has now fallen to 0.5%, and the borrowing costs are Rs 1,12,500 for the following six months.

Interest rates options can hedge the floating rate loan - for example, an interest rate cap ensures a
borrower's future interest cash flows will not exceed a certain predefined level.

FIXED INTERST RATE

A fixed interest rate loan is a loan where the interest rate doesn't fluctuate during the fixed rate
period of the loan. This allows the borrower to accurately predict their future payments. A fixed
interest rate is based on the lender's assumptions about the average discount rate over the fixed
rate period. For example, when the discount rate is historically low, fixed rates are normally
higher than variable rates because interest rates are more likely to rise during the fixed rate
period. Conversely, when interest rates are historically high, lenders normally offer a discount to
borrowers to fix their interest rate over time, as rates are more likely to fall during the fixed rate
period.

The capital value of a fixed rate loan is generally determined as a function of future interest rates
at the time of calculation. This means that they contain a capital risk, in that if interest rates fall,
the capital value of the loan rises, and vice versa. This differs from a variable rate loan, where
the capital value is always the original loan less any capital repayments.

This can lead to counter-intuitive results. For example, a 15-year fixed rate loan of Rs 10,00,000
taken out at the middle of 2011 would have had a capital value of around Rs 11,50,000 at the
middle of 2013. Base Rate remained level at 0.5%, the forward curve, used to price such
instruments, fell (i.e., became less convex upwards).

For domestic mortgages, the lender often provides guarantees such that the break cost of a loan
(in excess of the reported capital outstanding) is limited, often to a number of month’s

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repayments. These guarantees, usually only applicable where the fixed term is relatively short,
are effectively a derivative instrument whose one-way benefit is granted to the borrower.

Some fixed interest loans - particularly mortgages intended for the use of people with previous
adverse credit - have an 'extended overhang', that is to say that once the initial fixed rate period is
over, the person taking out the loan is tied into it for a further extended period at a higher interest
rate before they are able to redeem it.

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