Description
The report that discusses the pros and cons of abolishing SLR(statutory liquidity ratio) in banks.
Banking
Abolishment of SLR – pros and cons
Money Banking and Financial Markets
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ABSTRACT
The statutory liquidity ratio (SLR) as a monetary policy instrument has experienced multiple changes (many of them being infrequent) in India. Past data showed that reduction in SLR produced positive impact on bank credit and investment especially in the earlier years. In recent times, changes in SLR and cash reserve ratio (CRR) helped to reduce inflation to some extent in some years. Also in recent times, the Reserve Bank of India (RBI) has used Open Market Operations (OMOs) more frequently than changing the various rates like Repo Rate, SLR etc as instruments of monetary policy in line with its market oriented approach. In this context, it should be noted that India depends equally on both the money market and changes in reserves requirements as channels for monetary transmission. The CRR and SLR for scheduled banks are used mainly in situations of drastic imbalance resulting from major shocks (as seen currently in 2008). The effectiveness of SLR in bringing about desired outcomes however depends on adjustments of other indirect monetary policy instruments like the Repo and Reverse Repo rates. In this research, we try to highlight the effects on the various financial entities in the economy (like the banks, RBI, government etc) if SLR is completely done away with. The report discusses the advantages and disadvantages of taking this step from the different stakeholders’ perspective. It also highlights how excessive reduction in SLR can cause situations like the subprime crisis. The report also looks at how the same reserve requirements are handled in different countries other than India thereby making an attempt to draw a parallel between India and these countries. The report broadly covers the below topics: • • • • • • • • • • • SLR and its history Effects on the overall economy Effects on the banking sector Effect on the Reserve Bank of India Effect on the Indian Government Effect on the Money Market Effect on other markets (like equity and bond market) Effect on Interest and Deposit Rates Impact of other reserve ratios like the Cash Reserve Ratio (CRR) and Capital Adequacy Ratio (CAR) as per BASEL II norms Parallels from other countries Possible practical drawbacks like the subprime crisis
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INTRODUCTION
The Statutory Liquidity Ratio (SLR) is one of the quantitative and powerful tools of monetary control of the central banks. Changes in SLR can have marked effects on the money and credit situation of a country. If the central bank raises average reserve requirement of the commercial banks, this would create a reserve deficiency or decrease in available reserve of depository institutions. If the banks are unable to secure new reserves, they would be forced to contract both earnings and deposits which would result in a decline in the availability of credit and increase the market interest rates. The reverse would happen if the central bank lowers its reserve requirements.
The Reserve Bank of India (RBI) is responsible for formulating and implementing the monetary policy in the country. It provides both the RBI with the responsibility of achieving both monetary stability and economic growth. The instruments that are used to control money supply and credit can be broadly classified into direct and indirect ones. Instruments like the Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR) etc are direct instruments. Indirect instruments typically operate through the Repo and Reverse Repo rates.
A recent survey on monetary policy instruments in 48 developing, emerging and developed countries showed that majority of the countries relied on money market operations for monetary policy implementation and direct instruments of monetary policy were rarely used (Buzeneca and Maino 2007). It was argued that poor performance in terms of monetary control was a contributing factor in the removal of direct instruments in many of these countries. Alexander et al. (1995) depict many problems that have often been identified when direct instruments are used, including decreasing effectiveness of the instruments arising from evasion as the financial market develops and economic agents learn how to circumvent them, increasing inefficiency in resource allocation, potential inequity during implementation, and lack of credible enforcement.
It was also observed that such reserve requirements can also lead to disintermediation and the spread between lending and deposit rates widens as a result of its heavy use and may hamper the banks’ asset liability management. Furthermore, the imposition of statutory liquidity requirements, which obliges financial institutions to hold a certain percentage of their liabilities in the form of government securities,
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may also create market distortions, such as constraining commercial banks’ asset management, distorting the pricing of government securities in the financial markets, causing disintermediation and generating a loss of effectiveness to control monetary aggregates, and suppressing secondary markets. Thereby, the use of the rule based instruments (e.g. SLR) in some developing countries could slow down market development considerably, which is a key institutional constraint for market-based monetary policy operations. In addition, the heavy use of the rules-based instruments may have also affected the design of the lending facility in the developing countries, causing these countries to differ from the best practices in the more advanced economies.
SLR AND ITS HISTORY
Statutory Liquidity Ratio (SLR) refers to an amount which all banks need to keep cash or other liquid assets. This SLR is determined as some fixed percentage of total demand and time liabilities. These liabilities are the ones which require banks to pay anytime to their customers on demand and also the liabilities which are accruing in one months’ time due to maturity. The banks can keep this amount in any of the following form or some combination of these forms:
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Cash Gold, valued at a price not more the current market price Government Approved Securities valued at a price as specified by RBI from time to time
The Statutory Liquidity Ratio (SLR) was first introduced in USA in 1933 empowering the Board of Governors of the Federal Reserve System to change the member banks’ reserve requirements in order to control the money supply and to ensure soundness of the depository instruments. The central banks of many countries are empowered now to use SLR to control money and credit of the banking system. However, SLR is not free from limitations since the ratio can be altered only by law so that it cannot be used to make small adjustments in credit supply through frequent use.
In India, SLR was introduced through the Banking Regulation Act in 1949 with the following main objectives: • • To control the expansion of the Bank Credit To ensure the solvency of the commercial banks 5
When SLR was initially introduced, it was 20% and was defined to include the total reserves of the banks and not just the excess reserves. This was changed to include only the excess reserves in September 1962 and took effect from 16 September 1964. The changes were introduced to prevent banks from offsetting the impact of variable reserve requirements by liquidating their government security holdings.
By the means of SLR RBI also compels the banks to invest in Government securities. In case any bank defaults in keeping the SLR below the required level fixed by RBI then it is subjected to penalty as specified in the Banking Regulations Act (1949). The fixed percentage of Net Demand and Time Liabilities (NDTL) for SLR was initially decided to be kept between 25% and 40%. The SLR was in the same range until 2008 when an amendment to Banking Regulation Act was passed and it was reduced to 24%.
The Indian banks have to maintain this SLR in addition to reserve ratio requirements (CRR) which all the central banks across the world ask their commercial banks to keep as a safety measure. This additional requirement has been imposed by RBI on the banks in order to make the system more secure from the volatilities in the market. This SLR requirement is different from CRR as banks can earn on investments made for SLR requirements whereas CRR has to be kept in cash form only and no interest is earned by banks on this part.
There are mainly 2 ways in which SLR operates as an instrument of monetary control. One is by affecting the borrowings of the government by the RBI and the other is by affecting the freedom of the banks to sell government securities or borrow against them from the RBI. In both the ways, the creation of High Powered money, and thereby, variations in the supply of money is affected. Though SLR was introduced with the above specified purposes at 20% of total reserves in 1949 but it has been changed from time to time as a means for fulfilling different purposes like financing of government deficit. After 1964 its maximum and minimum limit was set to 40% and 25% of NDTL respectively. The maximum level it has touched is 38.5% between 1990 and 1992. The graph in Figure 1 highlights the changes in SLR since the time it was introduced through the Banking Regulation Act in 1949. Figure 2 highlights the changes that were brought about to SLR with the liberalization and also based on the recommendations of the Narsimham committee.
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SLR from 1949
45 40 35 30 25 20 15 10 5 0 SLR Rates in %
FIGURE 1 – SLR Rates from 1949 to 2009
Initially during the period before liberalization, i.e. till 1991-1992, SLR was also being used as a means to finance the government deficit. When the fiscal deficit increased by a significant percentage, SLR was also increased forcing the banks to buy more government securities so that the government’s deficit can be financed. This affected the profitability of the banks as their deposits on which they were supposed to earn were being channeled to finance government deficit at a much lower rate.
But in 1991, the Narsimham Committee submitted its report on Banking Sector Reforms in India and it suggested that SLR as an instrument should be used only for things it was initially introduced and not for financing the government deficit. It was of the view that it makes the government complacent as they always think that they have an instrument to finance their deficits and do not put in efforts to reduce it. So it proposed to bring down the SLR in a phased manner to a level of 25% till 1997.
After 1997, only after 11 years, SLR was again changed and brought down to 24% in 2008. This was done because of the liquidity crunch that the country was facing due to global meltdown. So in order to make credit available for the businesses RBI decided to lower SLR’s limit to 24% and along with it also reduced other monetary policy instruments like CRR, Repo and Reverse Repo rates.
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FIGURE 2 – SLR since 1990 (% of NDTL)
EFFECTS ON THE OVERALL ECONOMY DUE TO SLR ABOLISHMENT
Inflationary Pressures due to excess liquidity: - The current decrease of SLR by 1% freed up Rs 40,000 crores. Year-on-year the broad money growth is 20% and likely to grow further as a consequence of the RBI’s open market operations. In a scenario where GDP is expected to grow at 6%, even assuming an upward bias, the kind of growth in money supply should be more than adequate to oil the wheels of the economy. Indeed, it could well prove in excess of the economy’s needs. In which case, we could see a return of inflationary pressures of the kind that we witnessed not so long ago. This is also seen in the way food prices are increasing.
Easier credit availability for priority sector: - The increased liquidity would allow the priority sector to avail loans much more easily from banks than in the current scenario. This would help to fuel the growth of the Indian economy.
Pressure on exchange rate and home currency valuation: - Increased liquidity of Indian rupees will tend to depreciate the home currency thereby affecting the export-import ratio.
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EFFECTS ON THE BANKING SECTOR DUE TO SLR ABOLISHMENT
SLR is commonly used to contain inflation and fuel growth, by increasing or decreasing it respectively. This counter acts by decreasing or increasing the money supply in the system respectively. Indian banks’ holdings of government securities (Government securities) are now close to the statutory minimum that banks are required to hold to comply with existing regulation. When measured in rupees, such holdings decreased for the first time in a little less than 40 years (since the nationalization of banks in 1969) in 2005-06. While the recent credit boom is a key driver of the decline in banks’ portfolios of G-Sec, other factors have played an important role recently. These include: • • Interest rate increases. Changes in the prudential regulation of banks’ investments in G-Sec.
Most G-Sec held by banks are long-term fixed-rate bonds, which are sensitive to changes in interest rates. Increasing interest rates have eroded banks’ income from trading in G-Sec. Changes after 1992: After liberalization some important changes took place relating to the cash reserve requirement (CRR) and the separate requirement for mandatory investment in government securities through the statutory-liquidity ratio (SLR). At one stage, the CRR applicable to incremental deposits was as high as 25% and the SLR was 40%, thus pre-empting 65% of incremental deposits. These ratios were reduced in a series of steps after 1992. The statutory liquidity ratio is 25%, but its distortionary effect has been greatly reduced by the fact that the interest rate on government securities is increasingly market determined. In fact, most banks currently hold a higher volume of government securities than required under the SLR reflecting the fact that the attractive interest rate on these securities combined with the zero risk-weight, makes it commercially attractive for banks to lend to the government.
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The major effects on the banks due to SLR abolishment can be seen as below: Reduction in interest rates: - Increased liquidity in the market would drive down the lending rates which would further help to sustain corporate earnings growth and hence the country’s overall economic growth. Even with the removal of SLR, banks would still continue to invest in government securities but to a lesser extent than the current mandatory level. This SLR removal would lead to an increase in the advances exposure of the bank while the investments would decline keeping the total funds available constant. But the banks would start earning a bit higher due to the difference in the yields on the advances and investments. This in turn increases the earnings and hence the return on assets. Assuming equity (Tier I) remains the same, the ROE would improve helping in improving the implied price to book value, which is one of the major determining factor in the valuation of the banks.
Impact on total advances of the banks: - With the removal of SLR, banks would be able to make more advances to the commercial and private sector. This will increase the overall profitability of the banks as the yield differences between the advances and investments would increase the earnings.
Increase in riskier lending: - With the increased liquidity available to the banks, the banks can lend more freely without having a regulation reserve to worry about (other than CRR and CAR). This can lead the banks to lend at times without the right precautions. This would then lead to issues like the subprime crisis.
Increased competitiveness of the Indian banks: - Banks on their own cannot always ensure ‘good’ outcomes. There is a need for regulation. This, however, does not imply that each and every part of the banking system needs to be regulated. While there are parts of the financial system in India that are in need of more regulation (the non-bank financial intermediaries), India is still more a case of overregulation. The high reserve requirements in the form of SLR makes the Indian banks less competitive as compared to foreign banks. By abolishing these requirements, it would allow the Indian banks to improve their balance sheet and hence become more competitive at the international level.
Reduced profitability of banks: - Banks having a large percentage in SLR investments tend to have higher profits than the other banks. Naturally, banks were happy to see their profits bloat without much effort. But with the abolishment of SLR, banks would invest in lesser percentages into government 10
securities thereby reducing the profits they get from these investments (which they were able to earn with minimum risk).
EFFECT ON THE RBI DUE TO SLR ABOLISHMENT
SLR rate is determined and maintained by the RBI (Reserve Bank of India) in order to control the expansion of bank credit. RBI also uses SLR as a primary source for funding fiscal deficit of the government.
Profitability of RBI: - The SLR investments made by the banks form a part of the income that is earned by RBI. With the abolishment of SLR, this income would reduce or become very minimal with the reduction of investments made by the banks into government securities. This in turn affects the profitability of RBI.
Fiscal Deficit Funding: - With reduction/abolishment in SLR the RBI would no longer be able to rely on banks for funds to finance the government’s fiscal deficit. Hence RBI would need to look for other avenues to fund the fiscal deficit. The other options to fund the deficit are either raising money from the market (through OMOs) or printing more money. This hence would more pressure on RBI as it would need to increase its control over these avenues to ensure their smooth functioning. Of these printing more money is not an advisable option as it has an adverse effect on the exchange rates and the value of the currency in the international markets. In this situation the only other option left with the RBI is to fund the deficit by raising money from the market. For this RBI has to increase the volume of OMO in the market. There is a distinct cost associated with OMO operations. This has to be incurred by RBI.
Increased lending risks of banks: - With the increase in available liquidity with the banks, the advances made by banks would increase at a much faster pace and would be more diversified. Also the amount of indiscriminant lending (for example, amount of loans provided at rates below the prime lending rate) would tend to increase due to the increased competition among banks and presence of excess liquidity. This would hence increase the risks faced by the banks and hence the dangers of their insolvency. To 11
avoid these scenarios, RBI would need to tighten the provisioning norms to ensure the credit risk of banks stays within acceptable limits. (There is no significant reduction or deterioration in lending standards though credit has been growing at over 30% over the past few years). This would put more pressure on regulations and monitoring done by the RBI.
EFFECTS ON THE INDIAN GOVERNMENT DUE TO SLR ABOLISHMENT
As mentioned earlier, funds from SLR investments made by the banks is one of the main ways of financing of the fiscal deficit used by the government. The other avenues which it can use include raising funds from the market through OMOs (conducted by the RBI), printing money (done by the RBI), by making external commercial borrowings or by disinvestment of PSUs. The option of printing money carried with the danger of depreciating of the home currency whereas the option of external commercial borrowings would continue to add the overall deficit of the government. Hence using funds from SLR investments is one of the major approaches used by the government. This is also evident from the graph in Figure 3 where it can be seen that whenever there was a substantial increase in the fiscal deficit, SLR was also increased to increase the funds inflow to finance this growing fiscal deficit. This was prior to the liberalization after which SLR was reduced as per the recommendations of the Narsimham committee. For example, in 1978-79, the fiscal deficit increased by approximately 55% and hence to fund this high deficit, the SLR rate was increased from 30 to 32 which corresponded to an increase of approximately of 3% which is quite high for an SLR change.
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60.00% 55.00% 50.00% 45.00% 40.00% 35.00% 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% -5.00% -10.00% -15.00% -20.00% -25.00%
Fiscal Deficit vs SLR from 1971 to 1993
% change
1971-72
1972-73
1973-74
1974-75
1975-76
1976-77
1977-78
1978-79
1979-80
1980-81
1981-82
1982-83
1983-84
1984-85
1985-86
1986-87
1987-88
1988-89
1989-90
1990-91
1991-92
YEAR
% change in Fiscal Deficit
Figure 3 – Fiscal Deficit vs SLR
If we look at the graphs of SLR across the years and percentage change in Government’s gross fiscal deficit across the years we will see that in the years between 1970 and 1992, an increase in SLR is mostly accompanied by an increase in percentage change of fiscal deficit. This we can see in the years like 1972, 1974, 1978, 1985 etc. where SLR is increased and also the fiscal deficit has increased by a considerably great margin. This gives us an indication that during these years SLR as an instrument along with its normal purposes was also being used as a source of financing government deficit. Government borrowing at concessional rates of interest has become possible only due to the compulsion imposed on the financial institutions. This also results in the monetization of the public debt if the RBI is unable to pick up what cannot be absorbed by banks and other institutions. Such restrictions limit the ability of these institutions to raise resources at market rates. Narsimham Committee hence suggested in their report on Banking Sector Reforms in 1991 that SLR should only be used for the purposes it was initially introduced. This was because if an instrument like SLR is always present to finance government deficit it tends to make government complacent and they do not put required efforts in controlling and bringing down the deficit. So the committee proposed to bring down the SLR in a phased manner to its minimum value of 25%. So the SLR was reduced in phases from 38.5% in 1992 to 25% in 1997. This was done to ensure that SLR remains in the system for 13
1992-93
controlling the banks credit expansion and also to keep them solvent, the two basic things for which it was originally adopted. If SLR is abolished, the government would be affected in the following ways: Difficulty in financing of fiscal deficit: - With SLR being of one of the major sources of finance, the abolishment would lead to problems for the government as they would need to develop an alternative source which would allow raising of funds in a quick and yet easy manner (as in the case of SLR). This alternative approach would also need to be as reliable as SLR is currently as the government is always guaranteed to get the current funds fixed due to the mandatory SLR requirement set by the RBI. The consolidated fiscal deficit of the Centre and States will continue to be close to 6 per cent of GDP, even after attainment of the current FRBM (Fiscal Responsibility and Budget Management) targets, which would be among the highest level of fiscal deficit in the major economies in the world, coupled with an extremely high level of overall Government debt to GDP ratio, which is in excess of 80 per cent of the GDP. Until the consolidated fiscal deficit of the Government comes down even further, enabling a reduction or abolishment in the SLR, SLR will continue to be an important parameter in the banks’ functioning for quite some time to come. Hence, management of government debt, regulation of the banks and monetary policy will continue to be intertwined. Development of a better fiscal deficit monitoring system: - Currently as the government is assured of funds through the SLR mechanism, it is not concerned about how it is going to finance the growing fiscal deficit. Due to this, there is lack of planning from the government’s side. This has lead to the main area of concern i.e. management of government debt. Hence by abolishing SLR, it would make the government improve their planning process of expenditure while at the same time ensure that the government monitors the deficit with proper care.
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EFFECTS ON THE MONEY MARKET DUE TO SLR ABOLISHMENT
SLR is used by RBI to control the expansion of bank credit. These reserve requirements limit the ability of banks to lend into the market but at the same time it also makes banks safe by ensuring that certain liquidity is always available at their disposal. This additional requirement imposed on banks in addition to Cash Reserve Ratio (CRR) requirements gives RBI an additional means to control liquidity in the money market.
Advantages of SLR reduction/abolishment for money markets: • • • Reduction in SLR increases the banks’ ability to lend to corporate, individuals and in the market. It reduces the rate at which loans are available. With the money available at cheap rate it gives rise to various other types of investments in bond and securities market and the easy availability of funds increases competition and thus helps in development of these markets where interest rates are governed by market parameters of demand and supply.
Disadvantages of reduction in SLR for money markets: • • • It makes funds easily available and thus reduces the interest in the market. The increase in liquidity increases the inflation which further reduces the real value of interest that people get on their investments. The reduction in SLR increases the exposure of banks to different types of risks as it reduces the safety margin that banks keep with RBI. As all the banks are mostly interrelated with each other this increases the systemic risk and thereby affecting the market as a whole.
Overall the existence of this SLR is one of the ways to ensure that appropriate amount liquidity into the system and along with it also helps in financing the government deficit, though it is not its primary function. It compels banks to invest in government securities which in turn help in development of bond market in India. The presence of this extra additional reserve requirement was one of the factors that insulated India from the global crisis. Due to the presence of this additional requirement the Indian banks were prevented from lending excessively as they had to use a significant portion of NDTL in meeting the SLR requirements.
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In contrast to this the US banks where there is only one reserve ratio requirement which is around 10% of NDTL in addition to the negligent lending behavior of their banking system could not handle the sudden liquidity crunch when the housing boom busted. They could not completely use their reserve requirements with a longer term perspective and the amount they had was not enough to support the falling level of liquidity due to falling land prices. Thus with this additional measure though the credit expansion of bank is put under a limit but it helps in providing additional safety to the market and the system as a whole from such external and also from internal shocks.
EFFECTS ON THE OTHER MARKETS (EQUITY/BOND) DUE TO SLR ABOLISHMENT
As credit is available cheap, people will tend to borrow cheap and invest in either bond or equity markets. This can have the possible effects as mentioned below: Crowding out of corporate bonds: - The corporate bond market may get crowded out as a result of reduction or removal in SLR. As a consequence of reduction in SLR, RBI will resort to funding the fiscal deficit through market borrowing. As a result the volume of government bonds in the bond market will increase. To ensure the sale of bonds, RBI will have to increase the yields on government bonds. These high yield government bonds will compete with corporate bonds. Now from the corporate borrower’s point of view, they have two avenues for raising debts: either through borrowing from banks or by issuing bonds and raising money from the market. Bank credit is now cheaper and bonds are costlier, so the obvious choice will be bank credit. In this condition the growth and sustainability of the just emerging bond market in India will be jeopardized.
SLR cut would help to reflect true 10 year yields: - We believe that the current 10 year yields do not reflect the true yields as the huge demand for government securities from the various banks have brought down the yields. In the absence of large supply of new government paper in the market, the demand-supply mismatch would become more pronounced. The government’s borrowing programme can be restricted from the banks by using other means to raise funds like higher tax collections. With this restriction and in the absence of large fresh supplies, it allows banks to bring down their SLR holdings since the government does not require as much support as before. This would help to reflect
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the true yields of the government’s 10 year securities as now the banks would invest in these more from a trading perspective rather than due to the mandatory requirement.
Allow development of Government Securities market: - The Reserve Bank of India said that the stipulated Statutory Liquidity Ratio prescription of 24 - 25 per cent of net domestic demand and time liabilities of banks hampers the genuine development government securities market. The RBI’s dilemma is that a lower SLR will mean that banks need to keep lesser government papers in their Held-ToMaturity portfolio. Therefore, more papers will be available for trading and volumes in the G-Sec market. But if banks’ requirement of G-Secs comes down, it could lead to a reduction in demand for government papers, affecting thereby the government’s borrowing programme.
EFFECTS ON THE LENDING INTEREST RATES AND DEPOSIT RATES DUE TO SLR ABOLISHMENT
Reduction of SLR or its abolishment mainly releases a large amount of liquidity for the banks to lend to the private or public sector. For example, a 1% reduction in SLR in 2008 freed up Rs 40,000 crores for the banks. This amount would be magnified when we consider abolishment of SLR i.e. from 24% to 0%. This excess liquidity is bound to affect both the lending interest rates and deposit rates.
Lending interest Rate Fluctuations: - When SLR is reduced, more money is available with the banks to lend, and hence there should be supply side pressures and hence the interest rates should logically fall. However apart from SLR there is one more factor which needs to be considered when discussing the price discovery process of interest rates. This factor is size of government borrowings. If the government borrowings are high, the yields on government bonds will be high owing to supply side pressures. As a result banks will continue to invest in government securities. Hence there will be no actual increase in the credit available in the market; hence interest rates will continue to be high. As part of the reforms
process, the government has begun borrowing at market-related rates. Therefore, banks get better interest rates compared to earlier for their statutory investments in government securities. This means that despite a lower SLR requirement, banks’ investment in government securities will go up as government borrowing rises. As a result, bank investment in gilts continues to be high despite the RBI
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bringing down the minimum SLR to 24 per cent. Therefore, for the purpose of determining the interest rates, it is not the SLR requirement that is important but the size of the government’s borrowing programme. As government borrowing increases, interest rates, too, rise. We can conclude that, the
effect of SLR reduction on interest rates cannot be studied in isolation as there are other factors that manipulate the impact.
Reduction in deposit rates: - The deposit rates are a function of the demand supply situation of the credit demanded from banks. When SLR is reduced, the money available with banks will increase, as a result banks will face less need to attract deposits to be able to lend. In such a situation the demand for deposits from the banks side is reduced and hence the deposit rates will fall. If government borrowing program goes in sync with the SLR reduction, more and more money will be transacted in the market, as keeping deposits is less lucrative and credit is cheaper. The overall volume of operations in the market will increase.
IMPACT OF OTHER RESERVE RATIOS LIKE CASH RESERVE RATIO (CRR) AND CAPITAL ADEQUACY RATIO (CAR) AS PER BASEL II NORMS
Impact of CRR: - In general, if rapid credit growth is a concern, CRR hikes are very likely as they affect the quantity of funds available for lending purposes and hence have a more direct impact on credit growth than the repo or reverse repo rates. However given the huge increase in commercial banks’ holdings in government securities, CRR changes may not be made without changes in SLR as well. This is because if only CRR is changed, banks can simply unwind their investments in government bonds to meet higher cash reserve requirements and demand for funds from the commercial sector. This way CRR is intertwined with SLR. Abolishment of SLR would put pressure on the CRR rates as central banks would need to ensure that the banks and hence the financial system remains solvent and stable. The graph in Figure 4 shows the trend of CRR and SLR In India (in addition, it also provides the trend in the bank rate. It can be seen that in most cases, there were tandem increases in both the rates to ensure that banks do not take advantage of their excess investments to cover for the CRR hikes. The period after liberalization saw a decrease in these rates to ensure that liquidity in the market.
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45 40 35 30 25 20 15 10 5 0
SLR
CRR
SLR Bank Rate
CRR
Figure 4 – Trends in CRR and SLR Impact of CAR: - The BASEL II norms have lead to stricter norms for maintaining a minimum amount of capital for the risks faced by the banks to prevent their insolvency. On a world wide scale, this ratio is 8% whereas in India, as per the RBI, the banks need to maintain a CAR of 9%. This 9% of the equity which needs to be maintained by the banks is in addition to the existing reserves of 5% in the form of CRR and 24% in the form of SLR. These norms hence provide additional protection to depositors of the banks by ensuring that banks do not become illiquid due to the risks that they face i.e. credit, market and operational risks. So overall, the banks currently have to maintain a minimum of 38% (5% CRR + 24% SLR + 9% CAR) of reserves either with themselves or with RBI. In addition to this, they have to maintain a target of 40% lending to the priority sector. Due to this, effectively the banks have only a maximum of 22% of their deposits with which they can actually earn substantial profits by lending to the private sector. By reducing or removing SLR, banks will not have more funds available for providing loans to other sectors other than the priority sector like the private sector. This will help to improve the profitability of the commercial banks in India. Also by freeing up the funds, the interest rates for lending and deposits would also see a downward slope due to the demand-supply criteria. Also currently in India, the banks are well above the minimum CAR specified by RBI. The banks have on an average of 11-12% of their equity kept as reserves to avoid insolvency. On the whole, reserve ratios like the CRR and CAR will tend to reduce the need for maintaining a separate ratio like the SLR (especially such a high percentage). These international reserve ratios would 19
help the Indian banks align to the international standards while at the same time allowing the banks to have a slightly wider scope in conducting their business.
PARALLELS FROM OTHER COUNTRIES
A minimum level of reserves was once regarded as necessary to ensure that a bank could meet the withdrawal of deposits. However experience has shown that a monetary system can operate successfully with no minimum reserve requirements. Examples include the UK, Canada, Australia, and Sweden. Unremunerated reserves are an implicit tax on banks, but it is their customers who ultimately pay. The interest rate a bank charges on loans must reflect its operating costs. Most of the countries worldwide have removed the explicit requirements set forward by SLR. Instead these countries maintain only a single reserve ratio which includes the functions of both the CRR and SLR that prevail in India. One country which also maintains an SLR is Bangladesh. Bangladesh and SLR: A persistent feature of the financial sector in Bangladesh is that the commercial banks suffer substantially from default loans. This is partly due to information problems in the form of moral hazard, adverse selection, or monitoring cost of commercial banks in selecting borrowers. Other factors include lack of legal action against defaulters due to various reasons and the government's policy of granting loan forgiveness discouraging the borrowers not to repay loans on time. Therefore, there is a possibility that default culture of the borrowers may force commercial banks in Bangladesh toward credit rationing and thus prevent the interest rate from falling following an expansionary monetary policy. As a result, bank credit, deposits and economic activity may remain unchanged or even may fall leading to insensitivity of policy through credit channel as well.
In Bangladesh, the direct credit control policy was abandoned in the early 1990s and Bangladesh Bank (BB) has been using open market operation (OMO), repo and reverse repo as indirect monetary policy instruments to control money supply and credit. Since then, SLR has infrequently been adjusted to increase supply of fund to reduce interest rate differential and increase investment and economic activity in Bangladesh.
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Evidence shows that the immediate effect of downward adjustment of SLR was to enhance the cash flow of the money market in general and increase the output through both lending and cash flow channel. This is as indicated in Table 1. The table shows that the growth of credit and investment was highest during the periods prior to 1987 whereas reduction in SLR was seen to be associated with higher investment growth since 1991 which in turn lead to a higher GDP growth. From this, it can be seen that Bangladesh has already seen growth in its economy by reducing the SLR as it gives the banks more leeway to carry out its operations thereby more loans to be given to the private sector which is one of the major drivers of economy growth. Also with the central bank moving to market based operations to raise funds for the government, there is lesser requirement for the SLR funds and hence it can be done away with or atleast can be reduced.
Table 1 – Impact of SLR on the Lending Channel 21
China and SLR: Central bank’s prescribed reserve ratio for banks is somewhere in the range of 16 per cent in China (Nov 2008), and recently the central bank of China has been changing it quite frequently to tackle issues like inflation and liquidity whereas RBI prescribed 32 per cent (25 per cent statutory liquidity ratio and 7 per cent cash reserve ratio) reserve ratio. Pakistan and SLR: Presently the Cash Reserve Requirement is 5% on weekly average basis subject to daily minimum of 4% of Time & Demand Liabilities. In addition to that banks are required to maintain Statutory Liquidity Requirement (SLR) @ 15% of their Time & Demand Liabilities. Canada and SLR In Canada there is no mandatory reserve ratio requirement but banks by themselves keep 4.5% of their deposits with central bank. Its central bank, the Bank of Canada (BOC), freely lends overnight at its socalled bank rate to ensure that payment orders between banks will clear. That sets an upper limit on overnight rates. It also pays interest on any clearing balances that banks hold at the BOC at a rate 0.5 percentage point below the bank rate. That sets a floor on overnight rates. Volatility in the money market rate is effectively limited to within this operating range. The BOC target rate is the midpoint of the range. In order to steer the overnight rate toward its target, the BOC conducts open market operations similar to those used by the Fed. To compensate for variations in clearing balances caused by federal government inflows and outflows, on a daily basis the BOC offers to buy or sell government balances at the BOC on an auction basis to a select group of securities dealers. US and SLR In the U.S., the required reserve ratio is currently set at 10%. Reservable liabilities consist of net transaction accounts, non-personal time deposits, and euro currency liabilities. The reserve ratio on net transactions accounts depends on the amount of net transactions accounts at the depository institution.
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From the above, it is clearly seen that developed countries are moving towards a zero reserve or atleast a minimal reserve ratio system. But these are the countries where the major financial shocks have happened due to the very relaxed regulations. The banks are more advanced in these countries but the level of risk associated with these banks is also sufficiently high as seen from the subprime crisis. On the other hand, developing countries like Bangladesh and Pakistan do maintain a SLR ratio so as to ensure that banking system is robust and does not encounter too many problems.
POSSIBLE PRACTICAL DRAWBACKS LIKE THE SUBPRIME CRISIS DUE TO SLR ABOLISHMENT
To understand how the abolition of SLR can lead to crisis like US Subprime mortgage crisis we will first have to see what happened exactly in the subprime crisis: • • • • With the US economy performing quite well since 2003 there was a dramatic rise in the liquidity as a result of which interest rates declined. With people having huge money at their disposal and increasing demand for property led to sudden rise in prices of houses. Banks having excess liquidity gave loans to people with low or no credit history in order to earn higher interest rates. People started by houses even at very higher rates by getting it financed from these banks.
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• • • •
This excess of liquidity and increased consumer spending levels paved the way for increasing the inflation levels. The rising level of inflation led to increase in interest rates which prevented the people from taking loans and decrease their spending levels. As a result demand for everything including the houses went down leading to crashing of their prices and many people unable to pay their loans. Since banks had given many loans like those which turned into NPA leading to fall of the banks and ultimately shaking the roots of the whole system.
The whole process started with excess liquidity and banks lending recklessly. So if SLR is suddenly abolished in an environment where people want to spend it would lead to situation like the one mentioned above. If SLR is abolished banks will have huge surplus liquidity which would bring down the interest rates. This would not only decrease the bank interest rates but would result in decrease in returns on most of the investments due to excess supply of money. So banks will try to earn on their surplus money by lending it to even those people who would not have got loan in normal circumstances. This easy availability of loans would intimidate people to spend more and also try to invest in other riskier assets by borrowing from banks at cheaper rates. This might ultimately lead to a phenomenon which is similar to subprime crisis described above. Though in a scenario which is similar to the present one where banks are cautious in lending and demand for loans is also low there might be very les effect. As we saw that there was no great effect of reducing the SLR limit to 24% because banks are not willing to lend and have kept 28-29% of their NDTL invested in SLR type assets only. The extra money that was supposedly infused in the system was invested in back liquid assets by banks because of the environment full of low credit trustworthiness. So both the conditions SLR abolition and negligent lending by banks would be required to create a situation like above.
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CONCLUSION
In the past years when interest rates were on a decline, the value of the statutory liquidity ratio (SLR) portfolio kept going up. Naturally, banks were happy to see their profits bloat without much effort. But now that the tide is turning, the rush to the rescuer, the Reserve Bank of India (RBI), has started. However, there are some defects in the current SLR mechanism followed in India. Besides mobilizing some cheap money for the government, SLRs are supposed to be defenses against a sudden run on banks by their depositors when there is a liquidity crunch. The first issue is that the RBI Act does not offer much help (other than prescribing the maximum limit), nor does the Banking Regulation Act, nor Section 58 of the Companies Act that governs non-bank finance companies (NBFCs) and companies (that have to maintain a lower percentage of SLRs on their fixed deposits and specified liabilities). When we know that these are fire-fighting tools, why does the government or RBI wait till the “fire” actually occurs to start defining what will constitute a “fire”? Second, SLRs are guardians that can be trouble makers, too. They may be good as risk management tools against liquidity risks, but the structure itself imposes other and, perhaps, more demonic risks — interest rate risks — on banks. While the existing scheme of things will work well in a stable interest rate regime, these SLRs become a source of instability for the banks’ profitability when the rates fluctuate gradually over a period of time. It is difficult to immunize the SLR portfolio from fluctuations in valuation. Based on the effects (both the advantages and disadvantages on all the entities mentioned above), abolishment of SLR would be a major step in the Indian financial system’s history. It would have been appropriate if banks and the plethora of committees that have looked at the banking systems came up with ways to clean up the mess in the SLRs rather than come up with inanities (however concrete they are) such as a mere reduction in the percentage of SLRs — from 38.5 per cent at the start of reforms to 25 per cent. The actual holding of SLR securities seem nowhere near coming down; it is just that bankers now have the satisfaction of holding them out of their free will and not because of coercive rules or statutory stipulations. What this has created now is a strong coupling between the SLR funds and the economy especially the fiscal deficit. In such a scenario, a complete abolishment of SLR would not be appropriate as it can have adverse impacts considering that the financial system in India is still developing. A complete abolishment would require more stringent regulations in other areas, better 25
management approach for government debt and more developed financial markets to allow the RBI to raise funds in a simpler and easier way which would then act as an alternative source of funding the fiscal deficit. An ideal solution to this would be to develop SLR instruments that are issued and are encashable anytime at par with the RBI. The coupon rate on these instruments would be varying and should be linked to the 360 day interest rates. In addition to this, there should be a premium payable on maturity which should depend on the actual time the securities were held by banks before being presented for redemption. The government would then be able to get market related interest rates whereas banks would not have been tempted to rush to the RBI very frequently as they would end up losing the premium if they redeem their portfolios too often. Also the banks would feel safe about the liquidity aspects. Considering that development of such a system would take time and effort from RBI, in the meantime we believe that as an adhoc solution, RBI should look to reduce the SLR further by 8 – 10 % in a phased manner (rather than complete elimination) over a period of 5-7 years. This would give time for the government to improve its planning process and debt management process in the meantime. In addition, it would allow the Indian banks to become competitive at the international level and would also allow development of the government securities market and the bond market in general thereby making the complete Indian financial market more competitive at the global level.
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REFERENCES
Websites
• • • • Wikipedia RBI site Federal Reserve India Stat www.wikipedia.org www.rbi.org.in www.federalreserve.gov www.indiastat.com
Periodicals
• • • • • • India Today Business World Business Week Business Today Outlook Live Mint www.indiatoday.com www.businessworld.in www.businessweek.com www.businesstoday.digitaltoday.in www.business.outlookindia.com www.livemint.com (Wall Street Journal)
Newspapers
• • • Business Line Indian Express Business Standard www.thehindubusinessline.com www.indianexpress.com www.business-standard.com
Articles
• Alexander, William E., Tomás J. T. Baliño, and Charles Enoch, 1995, The Adoption of Indirect Instruments of Monetary Policy, IMF Occasional Paper No.126, Washington: International Monetary Fund Buzeneca, Inese and Maino, Rodolfo 2007, "Monetary Policy Implementation: Results from a Survey", IMF Working Paper, WP/07/7WP/07/7, January, pp.1-43. RBI Regulations – Impact on Commercial Banks’ Functioning, Dr. P. Kallu Rao and Dr. Shaji Thomas Reserve Bank of India – Fifty Years (1935 – 1985) Don’t mention the reserve ratio -http://www.islamic-finance.com/item113_f.htm RBI in a dilemma over SLR – Business Line – Aug 30, 2008 Bank Reforms – flexible approach to profitability – Business Standard, Jul 03, 2009 27
• • • • • •
doc_906191977.pdf
The report that discusses the pros and cons of abolishing SLR(statutory liquidity ratio) in banks.
Banking
Abolishment of SLR – pros and cons
Money Banking and Financial Markets
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ABSTRACT
The statutory liquidity ratio (SLR) as a monetary policy instrument has experienced multiple changes (many of them being infrequent) in India. Past data showed that reduction in SLR produced positive impact on bank credit and investment especially in the earlier years. In recent times, changes in SLR and cash reserve ratio (CRR) helped to reduce inflation to some extent in some years. Also in recent times, the Reserve Bank of India (RBI) has used Open Market Operations (OMOs) more frequently than changing the various rates like Repo Rate, SLR etc as instruments of monetary policy in line with its market oriented approach. In this context, it should be noted that India depends equally on both the money market and changes in reserves requirements as channels for monetary transmission. The CRR and SLR for scheduled banks are used mainly in situations of drastic imbalance resulting from major shocks (as seen currently in 2008). The effectiveness of SLR in bringing about desired outcomes however depends on adjustments of other indirect monetary policy instruments like the Repo and Reverse Repo rates. In this research, we try to highlight the effects on the various financial entities in the economy (like the banks, RBI, government etc) if SLR is completely done away with. The report discusses the advantages and disadvantages of taking this step from the different stakeholders’ perspective. It also highlights how excessive reduction in SLR can cause situations like the subprime crisis. The report also looks at how the same reserve requirements are handled in different countries other than India thereby making an attempt to draw a parallel between India and these countries. The report broadly covers the below topics: • • • • • • • • • • • SLR and its history Effects on the overall economy Effects on the banking sector Effect on the Reserve Bank of India Effect on the Indian Government Effect on the Money Market Effect on other markets (like equity and bond market) Effect on Interest and Deposit Rates Impact of other reserve ratios like the Cash Reserve Ratio (CRR) and Capital Adequacy Ratio (CAR) as per BASEL II norms Parallels from other countries Possible practical drawbacks like the subprime crisis
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INTRODUCTION
The Statutory Liquidity Ratio (SLR) is one of the quantitative and powerful tools of monetary control of the central banks. Changes in SLR can have marked effects on the money and credit situation of a country. If the central bank raises average reserve requirement of the commercial banks, this would create a reserve deficiency or decrease in available reserve of depository institutions. If the banks are unable to secure new reserves, they would be forced to contract both earnings and deposits which would result in a decline in the availability of credit and increase the market interest rates. The reverse would happen if the central bank lowers its reserve requirements.
The Reserve Bank of India (RBI) is responsible for formulating and implementing the monetary policy in the country. It provides both the RBI with the responsibility of achieving both monetary stability and economic growth. The instruments that are used to control money supply and credit can be broadly classified into direct and indirect ones. Instruments like the Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR) etc are direct instruments. Indirect instruments typically operate through the Repo and Reverse Repo rates.
A recent survey on monetary policy instruments in 48 developing, emerging and developed countries showed that majority of the countries relied on money market operations for monetary policy implementation and direct instruments of monetary policy were rarely used (Buzeneca and Maino 2007). It was argued that poor performance in terms of monetary control was a contributing factor in the removal of direct instruments in many of these countries. Alexander et al. (1995) depict many problems that have often been identified when direct instruments are used, including decreasing effectiveness of the instruments arising from evasion as the financial market develops and economic agents learn how to circumvent them, increasing inefficiency in resource allocation, potential inequity during implementation, and lack of credible enforcement.
It was also observed that such reserve requirements can also lead to disintermediation and the spread between lending and deposit rates widens as a result of its heavy use and may hamper the banks’ asset liability management. Furthermore, the imposition of statutory liquidity requirements, which obliges financial institutions to hold a certain percentage of their liabilities in the form of government securities,
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may also create market distortions, such as constraining commercial banks’ asset management, distorting the pricing of government securities in the financial markets, causing disintermediation and generating a loss of effectiveness to control monetary aggregates, and suppressing secondary markets. Thereby, the use of the rule based instruments (e.g. SLR) in some developing countries could slow down market development considerably, which is a key institutional constraint for market-based monetary policy operations. In addition, the heavy use of the rules-based instruments may have also affected the design of the lending facility in the developing countries, causing these countries to differ from the best practices in the more advanced economies.
SLR AND ITS HISTORY
Statutory Liquidity Ratio (SLR) refers to an amount which all banks need to keep cash or other liquid assets. This SLR is determined as some fixed percentage of total demand and time liabilities. These liabilities are the ones which require banks to pay anytime to their customers on demand and also the liabilities which are accruing in one months’ time due to maturity. The banks can keep this amount in any of the following form or some combination of these forms:
• • •
Cash Gold, valued at a price not more the current market price Government Approved Securities valued at a price as specified by RBI from time to time
The Statutory Liquidity Ratio (SLR) was first introduced in USA in 1933 empowering the Board of Governors of the Federal Reserve System to change the member banks’ reserve requirements in order to control the money supply and to ensure soundness of the depository instruments. The central banks of many countries are empowered now to use SLR to control money and credit of the banking system. However, SLR is not free from limitations since the ratio can be altered only by law so that it cannot be used to make small adjustments in credit supply through frequent use.
In India, SLR was introduced through the Banking Regulation Act in 1949 with the following main objectives: • • To control the expansion of the Bank Credit To ensure the solvency of the commercial banks 5
When SLR was initially introduced, it was 20% and was defined to include the total reserves of the banks and not just the excess reserves. This was changed to include only the excess reserves in September 1962 and took effect from 16 September 1964. The changes were introduced to prevent banks from offsetting the impact of variable reserve requirements by liquidating their government security holdings.
By the means of SLR RBI also compels the banks to invest in Government securities. In case any bank defaults in keeping the SLR below the required level fixed by RBI then it is subjected to penalty as specified in the Banking Regulations Act (1949). The fixed percentage of Net Demand and Time Liabilities (NDTL) for SLR was initially decided to be kept between 25% and 40%. The SLR was in the same range until 2008 when an amendment to Banking Regulation Act was passed and it was reduced to 24%.
The Indian banks have to maintain this SLR in addition to reserve ratio requirements (CRR) which all the central banks across the world ask their commercial banks to keep as a safety measure. This additional requirement has been imposed by RBI on the banks in order to make the system more secure from the volatilities in the market. This SLR requirement is different from CRR as banks can earn on investments made for SLR requirements whereas CRR has to be kept in cash form only and no interest is earned by banks on this part.
There are mainly 2 ways in which SLR operates as an instrument of monetary control. One is by affecting the borrowings of the government by the RBI and the other is by affecting the freedom of the banks to sell government securities or borrow against them from the RBI. In both the ways, the creation of High Powered money, and thereby, variations in the supply of money is affected. Though SLR was introduced with the above specified purposes at 20% of total reserves in 1949 but it has been changed from time to time as a means for fulfilling different purposes like financing of government deficit. After 1964 its maximum and minimum limit was set to 40% and 25% of NDTL respectively. The maximum level it has touched is 38.5% between 1990 and 1992. The graph in Figure 1 highlights the changes in SLR since the time it was introduced through the Banking Regulation Act in 1949. Figure 2 highlights the changes that were brought about to SLR with the liberalization and also based on the recommendations of the Narsimham committee.
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SLR from 1949
45 40 35 30 25 20 15 10 5 0 SLR Rates in %
FIGURE 1 – SLR Rates from 1949 to 2009
Initially during the period before liberalization, i.e. till 1991-1992, SLR was also being used as a means to finance the government deficit. When the fiscal deficit increased by a significant percentage, SLR was also increased forcing the banks to buy more government securities so that the government’s deficit can be financed. This affected the profitability of the banks as their deposits on which they were supposed to earn were being channeled to finance government deficit at a much lower rate.
But in 1991, the Narsimham Committee submitted its report on Banking Sector Reforms in India and it suggested that SLR as an instrument should be used only for things it was initially introduced and not for financing the government deficit. It was of the view that it makes the government complacent as they always think that they have an instrument to finance their deficits and do not put in efforts to reduce it. So it proposed to bring down the SLR in a phased manner to a level of 25% till 1997.
After 1997, only after 11 years, SLR was again changed and brought down to 24% in 2008. This was done because of the liquidity crunch that the country was facing due to global meltdown. So in order to make credit available for the businesses RBI decided to lower SLR’s limit to 24% and along with it also reduced other monetary policy instruments like CRR, Repo and Reverse Repo rates.
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FIGURE 2 – SLR since 1990 (% of NDTL)
EFFECTS ON THE OVERALL ECONOMY DUE TO SLR ABOLISHMENT
Inflationary Pressures due to excess liquidity: - The current decrease of SLR by 1% freed up Rs 40,000 crores. Year-on-year the broad money growth is 20% and likely to grow further as a consequence of the RBI’s open market operations. In a scenario where GDP is expected to grow at 6%, even assuming an upward bias, the kind of growth in money supply should be more than adequate to oil the wheels of the economy. Indeed, it could well prove in excess of the economy’s needs. In which case, we could see a return of inflationary pressures of the kind that we witnessed not so long ago. This is also seen in the way food prices are increasing.
Easier credit availability for priority sector: - The increased liquidity would allow the priority sector to avail loans much more easily from banks than in the current scenario. This would help to fuel the growth of the Indian economy.
Pressure on exchange rate and home currency valuation: - Increased liquidity of Indian rupees will tend to depreciate the home currency thereby affecting the export-import ratio.
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EFFECTS ON THE BANKING SECTOR DUE TO SLR ABOLISHMENT
SLR is commonly used to contain inflation and fuel growth, by increasing or decreasing it respectively. This counter acts by decreasing or increasing the money supply in the system respectively. Indian banks’ holdings of government securities (Government securities) are now close to the statutory minimum that banks are required to hold to comply with existing regulation. When measured in rupees, such holdings decreased for the first time in a little less than 40 years (since the nationalization of banks in 1969) in 2005-06. While the recent credit boom is a key driver of the decline in banks’ portfolios of G-Sec, other factors have played an important role recently. These include: • • Interest rate increases. Changes in the prudential regulation of banks’ investments in G-Sec.
Most G-Sec held by banks are long-term fixed-rate bonds, which are sensitive to changes in interest rates. Increasing interest rates have eroded banks’ income from trading in G-Sec. Changes after 1992: After liberalization some important changes took place relating to the cash reserve requirement (CRR) and the separate requirement for mandatory investment in government securities through the statutory-liquidity ratio (SLR). At one stage, the CRR applicable to incremental deposits was as high as 25% and the SLR was 40%, thus pre-empting 65% of incremental deposits. These ratios were reduced in a series of steps after 1992. The statutory liquidity ratio is 25%, but its distortionary effect has been greatly reduced by the fact that the interest rate on government securities is increasingly market determined. In fact, most banks currently hold a higher volume of government securities than required under the SLR reflecting the fact that the attractive interest rate on these securities combined with the zero risk-weight, makes it commercially attractive for banks to lend to the government.
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The major effects on the banks due to SLR abolishment can be seen as below: Reduction in interest rates: - Increased liquidity in the market would drive down the lending rates which would further help to sustain corporate earnings growth and hence the country’s overall economic growth. Even with the removal of SLR, banks would still continue to invest in government securities but to a lesser extent than the current mandatory level. This SLR removal would lead to an increase in the advances exposure of the bank while the investments would decline keeping the total funds available constant. But the banks would start earning a bit higher due to the difference in the yields on the advances and investments. This in turn increases the earnings and hence the return on assets. Assuming equity (Tier I) remains the same, the ROE would improve helping in improving the implied price to book value, which is one of the major determining factor in the valuation of the banks.
Impact on total advances of the banks: - With the removal of SLR, banks would be able to make more advances to the commercial and private sector. This will increase the overall profitability of the banks as the yield differences between the advances and investments would increase the earnings.
Increase in riskier lending: - With the increased liquidity available to the banks, the banks can lend more freely without having a regulation reserve to worry about (other than CRR and CAR). This can lead the banks to lend at times without the right precautions. This would then lead to issues like the subprime crisis.
Increased competitiveness of the Indian banks: - Banks on their own cannot always ensure ‘good’ outcomes. There is a need for regulation. This, however, does not imply that each and every part of the banking system needs to be regulated. While there are parts of the financial system in India that are in need of more regulation (the non-bank financial intermediaries), India is still more a case of overregulation. The high reserve requirements in the form of SLR makes the Indian banks less competitive as compared to foreign banks. By abolishing these requirements, it would allow the Indian banks to improve their balance sheet and hence become more competitive at the international level.
Reduced profitability of banks: - Banks having a large percentage in SLR investments tend to have higher profits than the other banks. Naturally, banks were happy to see their profits bloat without much effort. But with the abolishment of SLR, banks would invest in lesser percentages into government 10
securities thereby reducing the profits they get from these investments (which they were able to earn with minimum risk).
EFFECT ON THE RBI DUE TO SLR ABOLISHMENT
SLR rate is determined and maintained by the RBI (Reserve Bank of India) in order to control the expansion of bank credit. RBI also uses SLR as a primary source for funding fiscal deficit of the government.
Profitability of RBI: - The SLR investments made by the banks form a part of the income that is earned by RBI. With the abolishment of SLR, this income would reduce or become very minimal with the reduction of investments made by the banks into government securities. This in turn affects the profitability of RBI.
Fiscal Deficit Funding: - With reduction/abolishment in SLR the RBI would no longer be able to rely on banks for funds to finance the government’s fiscal deficit. Hence RBI would need to look for other avenues to fund the fiscal deficit. The other options to fund the deficit are either raising money from the market (through OMOs) or printing more money. This hence would more pressure on RBI as it would need to increase its control over these avenues to ensure their smooth functioning. Of these printing more money is not an advisable option as it has an adverse effect on the exchange rates and the value of the currency in the international markets. In this situation the only other option left with the RBI is to fund the deficit by raising money from the market. For this RBI has to increase the volume of OMO in the market. There is a distinct cost associated with OMO operations. This has to be incurred by RBI.
Increased lending risks of banks: - With the increase in available liquidity with the banks, the advances made by banks would increase at a much faster pace and would be more diversified. Also the amount of indiscriminant lending (for example, amount of loans provided at rates below the prime lending rate) would tend to increase due to the increased competition among banks and presence of excess liquidity. This would hence increase the risks faced by the banks and hence the dangers of their insolvency. To 11
avoid these scenarios, RBI would need to tighten the provisioning norms to ensure the credit risk of banks stays within acceptable limits. (There is no significant reduction or deterioration in lending standards though credit has been growing at over 30% over the past few years). This would put more pressure on regulations and monitoring done by the RBI.
EFFECTS ON THE INDIAN GOVERNMENT DUE TO SLR ABOLISHMENT
As mentioned earlier, funds from SLR investments made by the banks is one of the main ways of financing of the fiscal deficit used by the government. The other avenues which it can use include raising funds from the market through OMOs (conducted by the RBI), printing money (done by the RBI), by making external commercial borrowings or by disinvestment of PSUs. The option of printing money carried with the danger of depreciating of the home currency whereas the option of external commercial borrowings would continue to add the overall deficit of the government. Hence using funds from SLR investments is one of the major approaches used by the government. This is also evident from the graph in Figure 3 where it can be seen that whenever there was a substantial increase in the fiscal deficit, SLR was also increased to increase the funds inflow to finance this growing fiscal deficit. This was prior to the liberalization after which SLR was reduced as per the recommendations of the Narsimham committee. For example, in 1978-79, the fiscal deficit increased by approximately 55% and hence to fund this high deficit, the SLR rate was increased from 30 to 32 which corresponded to an increase of approximately of 3% which is quite high for an SLR change.
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60.00% 55.00% 50.00% 45.00% 40.00% 35.00% 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% -5.00% -10.00% -15.00% -20.00% -25.00%
Fiscal Deficit vs SLR from 1971 to 1993
% change
1971-72
1972-73
1973-74
1974-75
1975-76
1976-77
1977-78
1978-79
1979-80
1980-81
1981-82
1982-83
1983-84
1984-85
1985-86
1986-87
1987-88
1988-89
1989-90
1990-91
1991-92
YEAR
% change in Fiscal Deficit
Figure 3 – Fiscal Deficit vs SLR
If we look at the graphs of SLR across the years and percentage change in Government’s gross fiscal deficit across the years we will see that in the years between 1970 and 1992, an increase in SLR is mostly accompanied by an increase in percentage change of fiscal deficit. This we can see in the years like 1972, 1974, 1978, 1985 etc. where SLR is increased and also the fiscal deficit has increased by a considerably great margin. This gives us an indication that during these years SLR as an instrument along with its normal purposes was also being used as a source of financing government deficit. Government borrowing at concessional rates of interest has become possible only due to the compulsion imposed on the financial institutions. This also results in the monetization of the public debt if the RBI is unable to pick up what cannot be absorbed by banks and other institutions. Such restrictions limit the ability of these institutions to raise resources at market rates. Narsimham Committee hence suggested in their report on Banking Sector Reforms in 1991 that SLR should only be used for the purposes it was initially introduced. This was because if an instrument like SLR is always present to finance government deficit it tends to make government complacent and they do not put required efforts in controlling and bringing down the deficit. So the committee proposed to bring down the SLR in a phased manner to its minimum value of 25%. So the SLR was reduced in phases from 38.5% in 1992 to 25% in 1997. This was done to ensure that SLR remains in the system for 13
1992-93
controlling the banks credit expansion and also to keep them solvent, the two basic things for which it was originally adopted. If SLR is abolished, the government would be affected in the following ways: Difficulty in financing of fiscal deficit: - With SLR being of one of the major sources of finance, the abolishment would lead to problems for the government as they would need to develop an alternative source which would allow raising of funds in a quick and yet easy manner (as in the case of SLR). This alternative approach would also need to be as reliable as SLR is currently as the government is always guaranteed to get the current funds fixed due to the mandatory SLR requirement set by the RBI. The consolidated fiscal deficit of the Centre and States will continue to be close to 6 per cent of GDP, even after attainment of the current FRBM (Fiscal Responsibility and Budget Management) targets, which would be among the highest level of fiscal deficit in the major economies in the world, coupled with an extremely high level of overall Government debt to GDP ratio, which is in excess of 80 per cent of the GDP. Until the consolidated fiscal deficit of the Government comes down even further, enabling a reduction or abolishment in the SLR, SLR will continue to be an important parameter in the banks’ functioning for quite some time to come. Hence, management of government debt, regulation of the banks and monetary policy will continue to be intertwined. Development of a better fiscal deficit monitoring system: - Currently as the government is assured of funds through the SLR mechanism, it is not concerned about how it is going to finance the growing fiscal deficit. Due to this, there is lack of planning from the government’s side. This has lead to the main area of concern i.e. management of government debt. Hence by abolishing SLR, it would make the government improve their planning process of expenditure while at the same time ensure that the government monitors the deficit with proper care.
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EFFECTS ON THE MONEY MARKET DUE TO SLR ABOLISHMENT
SLR is used by RBI to control the expansion of bank credit. These reserve requirements limit the ability of banks to lend into the market but at the same time it also makes banks safe by ensuring that certain liquidity is always available at their disposal. This additional requirement imposed on banks in addition to Cash Reserve Ratio (CRR) requirements gives RBI an additional means to control liquidity in the money market.
Advantages of SLR reduction/abolishment for money markets: • • • Reduction in SLR increases the banks’ ability to lend to corporate, individuals and in the market. It reduces the rate at which loans are available. With the money available at cheap rate it gives rise to various other types of investments in bond and securities market and the easy availability of funds increases competition and thus helps in development of these markets where interest rates are governed by market parameters of demand and supply.
Disadvantages of reduction in SLR for money markets: • • • It makes funds easily available and thus reduces the interest in the market. The increase in liquidity increases the inflation which further reduces the real value of interest that people get on their investments. The reduction in SLR increases the exposure of banks to different types of risks as it reduces the safety margin that banks keep with RBI. As all the banks are mostly interrelated with each other this increases the systemic risk and thereby affecting the market as a whole.
Overall the existence of this SLR is one of the ways to ensure that appropriate amount liquidity into the system and along with it also helps in financing the government deficit, though it is not its primary function. It compels banks to invest in government securities which in turn help in development of bond market in India. The presence of this extra additional reserve requirement was one of the factors that insulated India from the global crisis. Due to the presence of this additional requirement the Indian banks were prevented from lending excessively as they had to use a significant portion of NDTL in meeting the SLR requirements.
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In contrast to this the US banks where there is only one reserve ratio requirement which is around 10% of NDTL in addition to the negligent lending behavior of their banking system could not handle the sudden liquidity crunch when the housing boom busted. They could not completely use their reserve requirements with a longer term perspective and the amount they had was not enough to support the falling level of liquidity due to falling land prices. Thus with this additional measure though the credit expansion of bank is put under a limit but it helps in providing additional safety to the market and the system as a whole from such external and also from internal shocks.
EFFECTS ON THE OTHER MARKETS (EQUITY/BOND) DUE TO SLR ABOLISHMENT
As credit is available cheap, people will tend to borrow cheap and invest in either bond or equity markets. This can have the possible effects as mentioned below: Crowding out of corporate bonds: - The corporate bond market may get crowded out as a result of reduction or removal in SLR. As a consequence of reduction in SLR, RBI will resort to funding the fiscal deficit through market borrowing. As a result the volume of government bonds in the bond market will increase. To ensure the sale of bonds, RBI will have to increase the yields on government bonds. These high yield government bonds will compete with corporate bonds. Now from the corporate borrower’s point of view, they have two avenues for raising debts: either through borrowing from banks or by issuing bonds and raising money from the market. Bank credit is now cheaper and bonds are costlier, so the obvious choice will be bank credit. In this condition the growth and sustainability of the just emerging bond market in India will be jeopardized.
SLR cut would help to reflect true 10 year yields: - We believe that the current 10 year yields do not reflect the true yields as the huge demand for government securities from the various banks have brought down the yields. In the absence of large supply of new government paper in the market, the demand-supply mismatch would become more pronounced. The government’s borrowing programme can be restricted from the banks by using other means to raise funds like higher tax collections. With this restriction and in the absence of large fresh supplies, it allows banks to bring down their SLR holdings since the government does not require as much support as before. This would help to reflect
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the true yields of the government’s 10 year securities as now the banks would invest in these more from a trading perspective rather than due to the mandatory requirement.
Allow development of Government Securities market: - The Reserve Bank of India said that the stipulated Statutory Liquidity Ratio prescription of 24 - 25 per cent of net domestic demand and time liabilities of banks hampers the genuine development government securities market. The RBI’s dilemma is that a lower SLR will mean that banks need to keep lesser government papers in their Held-ToMaturity portfolio. Therefore, more papers will be available for trading and volumes in the G-Sec market. But if banks’ requirement of G-Secs comes down, it could lead to a reduction in demand for government papers, affecting thereby the government’s borrowing programme.
EFFECTS ON THE LENDING INTEREST RATES AND DEPOSIT RATES DUE TO SLR ABOLISHMENT
Reduction of SLR or its abolishment mainly releases a large amount of liquidity for the banks to lend to the private or public sector. For example, a 1% reduction in SLR in 2008 freed up Rs 40,000 crores for the banks. This amount would be magnified when we consider abolishment of SLR i.e. from 24% to 0%. This excess liquidity is bound to affect both the lending interest rates and deposit rates.
Lending interest Rate Fluctuations: - When SLR is reduced, more money is available with the banks to lend, and hence there should be supply side pressures and hence the interest rates should logically fall. However apart from SLR there is one more factor which needs to be considered when discussing the price discovery process of interest rates. This factor is size of government borrowings. If the government borrowings are high, the yields on government bonds will be high owing to supply side pressures. As a result banks will continue to invest in government securities. Hence there will be no actual increase in the credit available in the market; hence interest rates will continue to be high. As part of the reforms
process, the government has begun borrowing at market-related rates. Therefore, banks get better interest rates compared to earlier for their statutory investments in government securities. This means that despite a lower SLR requirement, banks’ investment in government securities will go up as government borrowing rises. As a result, bank investment in gilts continues to be high despite the RBI
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bringing down the minimum SLR to 24 per cent. Therefore, for the purpose of determining the interest rates, it is not the SLR requirement that is important but the size of the government’s borrowing programme. As government borrowing increases, interest rates, too, rise. We can conclude that, the
effect of SLR reduction on interest rates cannot be studied in isolation as there are other factors that manipulate the impact.
Reduction in deposit rates: - The deposit rates are a function of the demand supply situation of the credit demanded from banks. When SLR is reduced, the money available with banks will increase, as a result banks will face less need to attract deposits to be able to lend. In such a situation the demand for deposits from the banks side is reduced and hence the deposit rates will fall. If government borrowing program goes in sync with the SLR reduction, more and more money will be transacted in the market, as keeping deposits is less lucrative and credit is cheaper. The overall volume of operations in the market will increase.
IMPACT OF OTHER RESERVE RATIOS LIKE CASH RESERVE RATIO (CRR) AND CAPITAL ADEQUACY RATIO (CAR) AS PER BASEL II NORMS
Impact of CRR: - In general, if rapid credit growth is a concern, CRR hikes are very likely as they affect the quantity of funds available for lending purposes and hence have a more direct impact on credit growth than the repo or reverse repo rates. However given the huge increase in commercial banks’ holdings in government securities, CRR changes may not be made without changes in SLR as well. This is because if only CRR is changed, banks can simply unwind their investments in government bonds to meet higher cash reserve requirements and demand for funds from the commercial sector. This way CRR is intertwined with SLR. Abolishment of SLR would put pressure on the CRR rates as central banks would need to ensure that the banks and hence the financial system remains solvent and stable. The graph in Figure 4 shows the trend of CRR and SLR In India (in addition, it also provides the trend in the bank rate. It can be seen that in most cases, there were tandem increases in both the rates to ensure that banks do not take advantage of their excess investments to cover for the CRR hikes. The period after liberalization saw a decrease in these rates to ensure that liquidity in the market.
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45 40 35 30 25 20 15 10 5 0
SLR
CRR
SLR Bank Rate
CRR
Figure 4 – Trends in CRR and SLR Impact of CAR: - The BASEL II norms have lead to stricter norms for maintaining a minimum amount of capital for the risks faced by the banks to prevent their insolvency. On a world wide scale, this ratio is 8% whereas in India, as per the RBI, the banks need to maintain a CAR of 9%. This 9% of the equity which needs to be maintained by the banks is in addition to the existing reserves of 5% in the form of CRR and 24% in the form of SLR. These norms hence provide additional protection to depositors of the banks by ensuring that banks do not become illiquid due to the risks that they face i.e. credit, market and operational risks. So overall, the banks currently have to maintain a minimum of 38% (5% CRR + 24% SLR + 9% CAR) of reserves either with themselves or with RBI. In addition to this, they have to maintain a target of 40% lending to the priority sector. Due to this, effectively the banks have only a maximum of 22% of their deposits with which they can actually earn substantial profits by lending to the private sector. By reducing or removing SLR, banks will not have more funds available for providing loans to other sectors other than the priority sector like the private sector. This will help to improve the profitability of the commercial banks in India. Also by freeing up the funds, the interest rates for lending and deposits would also see a downward slope due to the demand-supply criteria. Also currently in India, the banks are well above the minimum CAR specified by RBI. The banks have on an average of 11-12% of their equity kept as reserves to avoid insolvency. On the whole, reserve ratios like the CRR and CAR will tend to reduce the need for maintaining a separate ratio like the SLR (especially such a high percentage). These international reserve ratios would 19
help the Indian banks align to the international standards while at the same time allowing the banks to have a slightly wider scope in conducting their business.
PARALLELS FROM OTHER COUNTRIES
A minimum level of reserves was once regarded as necessary to ensure that a bank could meet the withdrawal of deposits. However experience has shown that a monetary system can operate successfully with no minimum reserve requirements. Examples include the UK, Canada, Australia, and Sweden. Unremunerated reserves are an implicit tax on banks, but it is their customers who ultimately pay. The interest rate a bank charges on loans must reflect its operating costs. Most of the countries worldwide have removed the explicit requirements set forward by SLR. Instead these countries maintain only a single reserve ratio which includes the functions of both the CRR and SLR that prevail in India. One country which also maintains an SLR is Bangladesh. Bangladesh and SLR: A persistent feature of the financial sector in Bangladesh is that the commercial banks suffer substantially from default loans. This is partly due to information problems in the form of moral hazard, adverse selection, or monitoring cost of commercial banks in selecting borrowers. Other factors include lack of legal action against defaulters due to various reasons and the government's policy of granting loan forgiveness discouraging the borrowers not to repay loans on time. Therefore, there is a possibility that default culture of the borrowers may force commercial banks in Bangladesh toward credit rationing and thus prevent the interest rate from falling following an expansionary monetary policy. As a result, bank credit, deposits and economic activity may remain unchanged or even may fall leading to insensitivity of policy through credit channel as well.
In Bangladesh, the direct credit control policy was abandoned in the early 1990s and Bangladesh Bank (BB) has been using open market operation (OMO), repo and reverse repo as indirect monetary policy instruments to control money supply and credit. Since then, SLR has infrequently been adjusted to increase supply of fund to reduce interest rate differential and increase investment and economic activity in Bangladesh.
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Evidence shows that the immediate effect of downward adjustment of SLR was to enhance the cash flow of the money market in general and increase the output through both lending and cash flow channel. This is as indicated in Table 1. The table shows that the growth of credit and investment was highest during the periods prior to 1987 whereas reduction in SLR was seen to be associated with higher investment growth since 1991 which in turn lead to a higher GDP growth. From this, it can be seen that Bangladesh has already seen growth in its economy by reducing the SLR as it gives the banks more leeway to carry out its operations thereby more loans to be given to the private sector which is one of the major drivers of economy growth. Also with the central bank moving to market based operations to raise funds for the government, there is lesser requirement for the SLR funds and hence it can be done away with or atleast can be reduced.
Table 1 – Impact of SLR on the Lending Channel 21
China and SLR: Central bank’s prescribed reserve ratio for banks is somewhere in the range of 16 per cent in China (Nov 2008), and recently the central bank of China has been changing it quite frequently to tackle issues like inflation and liquidity whereas RBI prescribed 32 per cent (25 per cent statutory liquidity ratio and 7 per cent cash reserve ratio) reserve ratio. Pakistan and SLR: Presently the Cash Reserve Requirement is 5% on weekly average basis subject to daily minimum of 4% of Time & Demand Liabilities. In addition to that banks are required to maintain Statutory Liquidity Requirement (SLR) @ 15% of their Time & Demand Liabilities. Canada and SLR In Canada there is no mandatory reserve ratio requirement but banks by themselves keep 4.5% of their deposits with central bank. Its central bank, the Bank of Canada (BOC), freely lends overnight at its socalled bank rate to ensure that payment orders between banks will clear. That sets an upper limit on overnight rates. It also pays interest on any clearing balances that banks hold at the BOC at a rate 0.5 percentage point below the bank rate. That sets a floor on overnight rates. Volatility in the money market rate is effectively limited to within this operating range. The BOC target rate is the midpoint of the range. In order to steer the overnight rate toward its target, the BOC conducts open market operations similar to those used by the Fed. To compensate for variations in clearing balances caused by federal government inflows and outflows, on a daily basis the BOC offers to buy or sell government balances at the BOC on an auction basis to a select group of securities dealers. US and SLR In the U.S., the required reserve ratio is currently set at 10%. Reservable liabilities consist of net transaction accounts, non-personal time deposits, and euro currency liabilities. The reserve ratio on net transactions accounts depends on the amount of net transactions accounts at the depository institution.
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From the above, it is clearly seen that developed countries are moving towards a zero reserve or atleast a minimal reserve ratio system. But these are the countries where the major financial shocks have happened due to the very relaxed regulations. The banks are more advanced in these countries but the level of risk associated with these banks is also sufficiently high as seen from the subprime crisis. On the other hand, developing countries like Bangladesh and Pakistan do maintain a SLR ratio so as to ensure that banking system is robust and does not encounter too many problems.
POSSIBLE PRACTICAL DRAWBACKS LIKE THE SUBPRIME CRISIS DUE TO SLR ABOLISHMENT
To understand how the abolition of SLR can lead to crisis like US Subprime mortgage crisis we will first have to see what happened exactly in the subprime crisis: • • • • With the US economy performing quite well since 2003 there was a dramatic rise in the liquidity as a result of which interest rates declined. With people having huge money at their disposal and increasing demand for property led to sudden rise in prices of houses. Banks having excess liquidity gave loans to people with low or no credit history in order to earn higher interest rates. People started by houses even at very higher rates by getting it financed from these banks.
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• • • •
This excess of liquidity and increased consumer spending levels paved the way for increasing the inflation levels. The rising level of inflation led to increase in interest rates which prevented the people from taking loans and decrease their spending levels. As a result demand for everything including the houses went down leading to crashing of their prices and many people unable to pay their loans. Since banks had given many loans like those which turned into NPA leading to fall of the banks and ultimately shaking the roots of the whole system.
The whole process started with excess liquidity and banks lending recklessly. So if SLR is suddenly abolished in an environment where people want to spend it would lead to situation like the one mentioned above. If SLR is abolished banks will have huge surplus liquidity which would bring down the interest rates. This would not only decrease the bank interest rates but would result in decrease in returns on most of the investments due to excess supply of money. So banks will try to earn on their surplus money by lending it to even those people who would not have got loan in normal circumstances. This easy availability of loans would intimidate people to spend more and also try to invest in other riskier assets by borrowing from banks at cheaper rates. This might ultimately lead to a phenomenon which is similar to subprime crisis described above. Though in a scenario which is similar to the present one where banks are cautious in lending and demand for loans is also low there might be very les effect. As we saw that there was no great effect of reducing the SLR limit to 24% because banks are not willing to lend and have kept 28-29% of their NDTL invested in SLR type assets only. The extra money that was supposedly infused in the system was invested in back liquid assets by banks because of the environment full of low credit trustworthiness. So both the conditions SLR abolition and negligent lending by banks would be required to create a situation like above.
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CONCLUSION
In the past years when interest rates were on a decline, the value of the statutory liquidity ratio (SLR) portfolio kept going up. Naturally, banks were happy to see their profits bloat without much effort. But now that the tide is turning, the rush to the rescuer, the Reserve Bank of India (RBI), has started. However, there are some defects in the current SLR mechanism followed in India. Besides mobilizing some cheap money for the government, SLRs are supposed to be defenses against a sudden run on banks by their depositors when there is a liquidity crunch. The first issue is that the RBI Act does not offer much help (other than prescribing the maximum limit), nor does the Banking Regulation Act, nor Section 58 of the Companies Act that governs non-bank finance companies (NBFCs) and companies (that have to maintain a lower percentage of SLRs on their fixed deposits and specified liabilities). When we know that these are fire-fighting tools, why does the government or RBI wait till the “fire” actually occurs to start defining what will constitute a “fire”? Second, SLRs are guardians that can be trouble makers, too. They may be good as risk management tools against liquidity risks, but the structure itself imposes other and, perhaps, more demonic risks — interest rate risks — on banks. While the existing scheme of things will work well in a stable interest rate regime, these SLRs become a source of instability for the banks’ profitability when the rates fluctuate gradually over a period of time. It is difficult to immunize the SLR portfolio from fluctuations in valuation. Based on the effects (both the advantages and disadvantages on all the entities mentioned above), abolishment of SLR would be a major step in the Indian financial system’s history. It would have been appropriate if banks and the plethora of committees that have looked at the banking systems came up with ways to clean up the mess in the SLRs rather than come up with inanities (however concrete they are) such as a mere reduction in the percentage of SLRs — from 38.5 per cent at the start of reforms to 25 per cent. The actual holding of SLR securities seem nowhere near coming down; it is just that bankers now have the satisfaction of holding them out of their free will and not because of coercive rules or statutory stipulations. What this has created now is a strong coupling between the SLR funds and the economy especially the fiscal deficit. In such a scenario, a complete abolishment of SLR would not be appropriate as it can have adverse impacts considering that the financial system in India is still developing. A complete abolishment would require more stringent regulations in other areas, better 25
management approach for government debt and more developed financial markets to allow the RBI to raise funds in a simpler and easier way which would then act as an alternative source of funding the fiscal deficit. An ideal solution to this would be to develop SLR instruments that are issued and are encashable anytime at par with the RBI. The coupon rate on these instruments would be varying and should be linked to the 360 day interest rates. In addition to this, there should be a premium payable on maturity which should depend on the actual time the securities were held by banks before being presented for redemption. The government would then be able to get market related interest rates whereas banks would not have been tempted to rush to the RBI very frequently as they would end up losing the premium if they redeem their portfolios too often. Also the banks would feel safe about the liquidity aspects. Considering that development of such a system would take time and effort from RBI, in the meantime we believe that as an adhoc solution, RBI should look to reduce the SLR further by 8 – 10 % in a phased manner (rather than complete elimination) over a period of 5-7 years. This would give time for the government to improve its planning process and debt management process in the meantime. In addition, it would allow the Indian banks to become competitive at the international level and would also allow development of the government securities market and the bond market in general thereby making the complete Indian financial market more competitive at the global level.
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REFERENCES
Websites
• • • • Wikipedia RBI site Federal Reserve India Stat www.wikipedia.org www.rbi.org.in www.federalreserve.gov www.indiastat.com
Periodicals
• • • • • • India Today Business World Business Week Business Today Outlook Live Mint www.indiatoday.com www.businessworld.in www.businessweek.com www.businesstoday.digitaltoday.in www.business.outlookindia.com www.livemint.com (Wall Street Journal)
Newspapers
• • • Business Line Indian Express Business Standard www.thehindubusinessline.com www.indianexpress.com www.business-standard.com
Articles
• Alexander, William E., Tomás J. T. Baliño, and Charles Enoch, 1995, The Adoption of Indirect Instruments of Monetary Policy, IMF Occasional Paper No.126, Washington: International Monetary Fund Buzeneca, Inese and Maino, Rodolfo 2007, "Monetary Policy Implementation: Results from a Survey", IMF Working Paper, WP/07/7WP/07/7, January, pp.1-43. RBI Regulations – Impact on Commercial Banks’ Functioning, Dr. P. Kallu Rao and Dr. Shaji Thomas Reserve Bank of India – Fifty Years (1935 – 1985) Don’t mention the reserve ratio -http://www.islamic-finance.com/item113_f.htm RBI in a dilemma over SLR – Business Line – Aug 30, 2008 Bank Reforms – flexible approach to profitability – Business Standard, Jul 03, 2009 27
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