What if Statutory Liquidity Ratio is abolished?

What is SLR?

Apart from keeping a portion of deposits with the RBI as cash (CRR), banks are also required to maintain a minimum percentage of their net demand and time liabilities with them at the end of every business day, in the form of gold, cash, government bonds or other approved securities. This minimum percentage is called Statutory Liquidity Ratio.

Example: If you deposit Rs. 100/- in bank, CRR being 9% and SLR being 11%, then bank can use 100-9-11= Rs. 80/- for giving loan or for investment purpose.

SLR is the requirement imposed by the regulator on commercial banks that compels them to invest a percentage (currently 23%) of their Net Time and Demand Liabilities (NDTL) in approved government securities. Through this, today, 23% all the resources – deposits and borrowings – mobilised by commercial banks are invested in government securities.

The Narasimham Committee – I (1991) had recommended scaling down SLR from a high of 38.5 per cent to 25 per cent and the RBI moved in a calibrated fashion in that direction. SLR is at 23 per cent with effect from August 11, 2012. A reference book, popularly known in the teaching-academic circle as Datt & Sundharam Indian Economy by Gaurav Datt and Ashwani Mahajan mentions as follows: “There is now a demand to abolish SLR altogether”.

Purposes of SLR

SLR is aimed at serving three purposes: (i) it is an instrument of credit control; (ii) it works as a cushion against the possibility of bank failures; and (iii) it is a conduit for financing government deficits. Out of these, SLR has been serving overwhelmingly the third purpose.

As a credit control instrument, it is relatively blunt and being used rather infrequently. Between October 25, 1997 and August 11, 2012 SLR has been changed only five times from 25 per cent to 23 per cent.

As far as its function as a cushion against bank failures is concerned, it is practically meaningless because weak commercial banks are not allowed to fail by the Government/RBI which is guided by the too-big-to-fail doctrine while resolving bank failures.

Therefore, one may conclude that the biggest casualty of abolition of SLR would be government borrowing programmes which are of gigantic size every year. So the basic question is who will subscribe to such borrowings? The answer will determine the fate of the banking structure, post-SLR abolition.

Alco Philosophy

Ones contention is that whether a bank subscribes to government securities or not is intertwined with the philosophy its ALCO (Asset-Liability Committee) follows from time to time. If a bank’s ALCO is a risk-lover it may try to minimise the bank’s holdings of government securities and increase exposure to commercial lending and corporate bonds, the market for which would eventually receive a fillip. However, in an environment of subdued investor confidence and low credit absorption capacity like the present one, even the daring ALCOs would proceed cautiously.

With commercial lending occupying the centre-stage, such banks may be required to tone up their credit administration and risk management processes, practices and procedures lest large-scale incidence of NPAs become imminent, with its attendant problematic impact on safety and soundness parameters of these banks.

An ALCO which is risk-averse may try to hold as much as possible in government securities and move rather slowly on the commercial lending front. Thus, these banks may start practising what is known as “narrow banking”, the cons of which outweigh the pros.

Thus, the banking sector may get divided into two classes — “narrow” banks and “broad” banks. However, this division would be highly volatile as the philosophies of bank ALCOs do not remain static over time. They change as and when a bank’s board and management changes, besides the operating environment.

Therefore, at some point of time the emergence of a third category of banks which would try to strike a balance with a prudent combination of government securities and commercial lending cannot be ruled out.

When SLR is abolished

With massive rupee resources getting unlocked from SLR abolition, banks may rely less on deposits. This may come as a blow to depositors as banks may reduce their deposit rates. With savings in financial assets currently being range-bound, this would not augur well for the economy.

On the whole, one may conclude that the abolition of SLR would be quite unsettling, disruptive and adverse for the entire banking system. Any attempt to reduce SLR, in a great way, should be done with a lot of brainstorming, forethought and diligence at the policy-making level.