The pre-emption of bank funds in India have historically been exercised through three channels — the cash reserve ratio (CRR), statutory liquidity ratio (SLR) and directing credit to preferred sectors based on so-called priority sector norms.

The above pre-emptions have different implications for banking operations. This article deals with the first two channels.

Changing role of CRR

The CRR is partly a prudential requirement for banks to maintain a minimum amount of cash reserves to meet their payments obligations in a fractional reserve system.

The Reserve Bank of India (RBI) Act implicitly prescribed the CRR originally at a minimum of 3 per cent of any bank’s net demand and time liabilities. That restriction was removed by an amendment in 2006. While the RBI is now free to prescribe this rate, any CRR above 3 per cent can still be viewed as a monetary tool to contain expansion of money supply by influencing the money multiplier. But the way in which the CRR was operated historically made it serve a much wider role. During the 1990s, when there was influx of foreign funds through non-resident Indian (NRI) deposits, a differential CRR was prescribed on such deposits to restrict their inflows.

This role — CRR being used as an instrument of regulating NRI deposit flows — got relegated to the background once the relative attraction of such deposits vis-a-vis rupee deposits was removed. Now that the interest rates on NRI deposits have been freed, the above role of CRR could well be revived again.

In the more recent period after 2004, when there was a huge influx of foreign capital through varied forms of debt and non-debt flows, and the RBI ended up accumulating large forex reserves, the CRR became an optional instrument to sterilise the rupee resources released from such dollar purchases. This was particularly enabled by not paying any interest on CRR balances maintained by banks with the RBI. The other options of sterilisation through open market operations and the repo operations through the liquidity adjustment window (LAF) cost the central bank, just as the market stabilisation scheme cost the Government fiscally in terms of interest payments.

The official view on CRR has been changing. During the period of financial repression before 1990s, CRR was the most preferred monetary policy tool. But the Narasimham Committee of 1991 recommended gradual reduction in CRR and increased use of indirect market-based instruments. This was broadly accepted and the CRR reduced from more than 15 per cent to 4.5 per cent by 2003.

But since 2004, the use of CRR as an instrument of sterilisation and also a monetary tool has gained ground again. At the same time, the ratio stands now at 4.5 per cent, the previous historic low. Under these circumstances, the official philosophy on CRR in the current juncture is not known.

Since CRR acts as a tax that increases their transaction costs, banks in general would want its role to be restored to being a prudential minimum requirement of not more than 3 per cent. And since quantitative easing has become a fashion of central banking across the world, the RBI may well choose to bring the CRR further down gradually to about 3 per cent during the current easing phase, without losing sight of monetary control in the face of inflation remaining stubbornly high at around 8 per cent.

Like CRR, SLR can also be viewed as a hybrid instrument of a different variety. The SLR, according to some, is not a monetary tool and is only a prudential requirement to serve as a cushion for safety of bank deposits.

The minimum prescription in this manner was 25 per cent of bank’s demand and time liabilities. But it was also more a way of finding a captive market for government securities, particularly when they were bearing below market interest rates. Not surprisingly, this ratio touched about 38 per cent around 1991.

SLR, a cushion for safety

For the SLR too, the Narasimham Committee’s view was to bring it down to 25 per cent and resort to auctioning government securities at market related rates. Accordingly, the SLR was reduced to 25 per cent by 1997. Just as for CRR, RBI now has the freedom to also fix the level of SLR.

The effective SLR, ironically though, never fell to 25 per cent at least for public sector banks. These banks found investments in SLR securities as a safe haven to optimise their risk-weighted capital adequacy requirements during late 1990s and the early 2000s, when Basel II norms became applicable. The Government’s ever-increasing borrowings appetite also served this purpose well. It was only between 2004 and 2008, as non-performing asset (NPA) levels fell and fiscal consolidation was also in place, that banks shifted their portfolio more in favour of credit rather than SLR investments.

During the current post-global financial crisis period — when fiscal consolidation has been given a permanent holiday, the noose of Basel III is on the neck of the banking system, and NPAs have remerged as a potential threat — public sector banks seem to be reverting to their safe-haven approach to SLR investments.

The SLR now has, thus, regained its earlier status of being a tool for providing a captive market for government securities. With the Government taking over the function of issuing regulatory guidelines to public sector banks, in parallel with or even over-riding that of the central bank, this role is bound to further strengthen.

That, of course, is not a desirable trend at all. It would be worth recalling the Narasimham Committee’s view that the ownership of banks by the Government should not interfere with the conduct of banking regulation. The other dimension of SLR prescription, from the point of view of new Basel III liquidity norms, is whether the latter would be over and above, or within, the SLR prescriptions.

It must be a matter of great relief to the banking system that the RBI Deputy Governor, Anand Sinha, has recently hinted that the SLR will be tweaked to accommodate the new Basel norms on liquidity.

This notably keeps the spirit behind SLR — that though it is statutorily prescribed, it is mainly for the purpose of serving as a cushion to meet contingencies against potential liquidity threats to banking operations.

(The author is Director, EPW Research Foundation. The views are personal.)