Remove the Statutory Liquidity Ratio (SLR) requirement for commercial banks.
What is the SLR?
Briefly, here’s how banking works. Banks accept deposits with a promise to redeem them at par with an interest rate. They use the deposits to lend to customers who are in need. Banks work on the premise that not all of the depositers would want their money back at the same time. However, they keep a certain amount of their deposits as a safety net against the contingency that a large number of depositers might withdraw their money. This is done through the Cash Reserve Ratio (CRR) and the SLR.
The CRR is held in cash, the most liquid asset possible. SLR requires banks to hold government-approved securities, which are deemed to be liquid enough for banks to convert them to currency that the public would want. The current SLR requirement, as set by the RBI, is 20.5%, which means that all commercial banks have to hold 20.5% of deposits as government-approved securities.
What is the stated intent of the SLR?
The stated rationale behind mandating the SLR for commercial banks is prudence. The banks should not run out of funds if a large chunk of depositors suddenly want their money back.
What’s the hidden story?
The SLR requirement in India is one of the highest in the world. Similar ‘risk capital’ held by foreign commercial banks amounts to around 6.5% of the deposits. The remaining 14% is a means of the government strong-arming banks to lend to it.
While maintaining prudence is extremely important for a commercial bank’s risk management and the general health of a country’s financial sector, an SLR as high as 20.5% goes beyond prudence and into the territory of government preempting savings.
What are the unintended consequences?
There are three important implications of such a high SLR.
One: It reduces the resources available for lending to the private sector. Every rupee lent to the government is a rupee less for private borrowings.
Two: By creating an easy source of financing for the government, it subsidises government borrowings. In the absence of SLR, the government would be forced to borrow from the market, which would enforce the true price for capital, and, hence, the required fiscal discipline.
Three: When the government preempts savings, it fundamentally distorts the interest-rate structure in the economy.
What about prudence?
Prudence is still required to avoid financial crises. All Indian commercial banks are due to accept and comply with the Basel III norms by 2018, which mandates a concept similar to the SLR called Liquidity Coverage Ratio (LCR), where banks would invest a part of their deposits in ultra-safe assets. The RBI presently is pushing for banks to maintain both SLR and LCR, which would remove banks’ room for lending.
What will removing SLR achieve?
There are definite advantages of removing SLR and sticking to LCR. The LCR is much lower than the SLR. It takes care of the prudence problem, without giving scope for government preemption of savings. It also allows banks to self-regulate, in terms of choosing the securities that they want to invest in. If the rationale is for banks to hold ultra-safe securities, then under the LCR, they can buy the New Zealand government’s treasury bills, which are rated AAA as against India’s BBB.
Overall, there would be more money available for banks to lend to needy people, which would result in increased financial inclusion. Banks can also choose to invest in securities that give a higher return.
What is needed to carry it out?
The RBI has the authority to reduce the SLR to zero in any of its quarterly monetary policy review meetings.
What are the obstacles to this reform?
The main obstacle would be the RBI itself. However, given the mediocre effectiveness of monetary policy in India and the genuine lack of borrowing space for private entitities, this move would go a long way in correcting both. It would also instill much needed fiscal discipline in the Union Government, something which the RBI has been vocal about in the past.
Report by the Committee on Comprehensive Financial Services for Small Businesses and Low Income Households, chaired by Nachiket Mor, RBI, 2013.