Loans, Advances and Interest Rates: MCLR to NPA

Lending is how a bank earns. It takes deposits at one rate and lends at a higher one, and the gap between the two is its interest margin. The banking awareness section tests this business in three ways: the names of the different credit facilities, the way a loan is secured, and the rate at which it is priced. This note takes the three in that order and keeps to the rules, not to the numbers of the day, because a policy rate changes several times in a decade while the rule behind it does not.

Loans and advances are not the same thing

A loan is a fixed sum given for a stated purpose and a stated term, drawn once and repaid in instalments, so a home loan or a vehicle loan is a loan. An advance is short-term credit given to meet working capital needs, usually for a year or less, and the borrower draws and repays within a limit. The common advances are:

• Cash credit, a running limit against stock and receivables, on which interest is charged only on the amount used.
• Overdraft, permission to draw beyond the balance in a current account, secured or clean.
• Bill discounting, where the bank pays the seller the value of a trade bill less its charge and collects from the buyer on the due date.
• Term loan for a fixed asset, and demand loan, which is repayable whenever the bank calls for it.

A facility in which the bank actually parts with money is fund based. A letter of credit and a bank guarantee are non-fund based, because the bank only promises to pay if the customer fails, and it charges a commission for the promise.

How an advance is secured

Gold kept in the bank's strong room is a pledge; a car or the stock in a shop financed by the bank is hypothecated, which is why a defaulting borrower's vehicle has to be seized before it can be sold. The Transfer of Property Act names six kinds of mortgage, of which the simple mortgage and the mortgage by deposit of title deeds are the ones banks use most. Primary security is the asset created by the loan itself, while collateral security is anything additional the borrower offers.

The three lending rate regimes

Before 2010 banks lent off the Benchmark Prime Lending Rate. The base rate replaced it on 1 July 2010 as the floor below which a bank could not lend. From 1 April 2016 new floating rate loans were priced on the marginal cost of funds based lending rate, the MCLR, which is built from the marginal cost of deposits, the negative carry on the cash reserve ratio, operating cost and a tenor premium, and is published for tenors from overnight to one year. Because even the MCLR moved slowly when the policy rate fell, the Reserve Bank required from 1 October 2019 that new floating rate retail and small business loans be tied to an external benchmark, usually the repo rate, giving the EBLR. A bank adds a spread to the benchmark, and the rate resets at least once a quarter, so a repo cut reaches the borrower quickly.

Policy rates and what they do

• Repo rate: the rate at which the Reserve Bank lends to banks for the short term against government securities. It is the policy rate the Monetary Policy Committee decides.
• Reverse repo and the standing deposit facility: the rates at which the Reserve Bank absorbs money from banks, the second without giving securities in exchange.
• Marginal standing facility: emergency overnight borrowing by banks against their statutory liquidity ratio holdings, priced above the repo rate. The bank rate is aligned with it and is used for penal purposes.
• Cash reserve ratio and statutory liquidity ratio are not rates but the proportions of net demand and time liabilities a bank must keep as cash with the Reserve Bank and in approved securities.

The nominal rate is the rate written in the agreement; the real rate is the nominal rate less inflation, and that is what decides whether a saver gains. A fixed rate does not move for the term, while a floating rate follows its benchmark.

When a loan goes bad, and where credit must go

An account becomes a non-performing asset when interest or principal stays overdue for more than 90 days. Before that it is flagged as a special mention account, SMA-0 up to thirty days, SMA-1 up to sixty and SMA-2 up to ninety. An NPA is then classified as sub-standard for the first twelve months, doubtful after that and a loss asset when it is not recoverable at all. Banks recover through Lok Adalats, the debt recovery tribunals set up under the 1993 Act, the SARFAESI Act of 2002, which lets a secured creditor seize the security without going to court, and the Insolvency and Bankruptcy Code of 2016. On the other side, priority sector lending directs credit to agriculture, micro and small enterprises, education, housing, renewable energy and weaker sections; the overall target has long stood at 40 per cent of adjusted net bank credit for domestic scheduled commercial banks, with 18 per cent for agriculture, and 75 per cent for regional rural banks and small finance banks. The Kisan Credit Card, introduced in 1998 on the recommendation of the R V Gupta Committee, is the standard short-term crop loan, and the Pradhan Mantri MUDRA Yojana of 2015 refinances small business loans in the Shishu, Kishore and Tarun categories.