What if Statutory Liquidity Ratio is abolished?

A few months ago there was a debate in the banking circle as to whether CRR (Cash Reserve Ratio) should be done away with or not. Several short articles, opinions and comments were published. However, the debate died down without any outcome. Subsequently, the Reserve Bank of India announced on September 17 a 25-basis point reduction in CRR to 4.50 per cent in its Mid-Quarter Review, which, however, need not necessarily be attributed to the debate.

While following the debate on CRR abolition, an idea came to ones mind as to what would be the medium- to long-term impact on the banking structure if SLR (Statutory Liquidity Ratio) is abolished. What follows in the subsequent paragraphs is purely hypothetical. It does not necessarily suggest in any way that such a move is currently being contemplated at any level. Even if it is, one is unaware of it.

Nevertheless, it may be worthwhile to mention here that 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. Additionally, 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”, pp.932 (66th Revised Edition, 2012).

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 (Source: Handbook of Statistics on Indian Economy, RBI, 2012 , Table 46). 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.

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.

(The author is a former commercial bank economist)

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