07 October 2015 11:43:20 IST

RBI’s pre-emptive measures can impact interest rates too

A look at what the central bank’s tweaking of the statutory liquidity ratio means

While the RBI’s sharp cut in its key policy repo rate hogged the limelight in its latest monetary policy review, there was yet another unassuming tweak in one of its pre-emptive measures that can also have a far-reaching impact on the way interest rate move in the economy. The RBI has decided to bring down the total SLR (statutory liquidity ratio) requirement for banks in a phased manner from next year. This change is in line with the recommendations of the Urjit Patel Committee, to facilitate a quicker transmission of policy rates to borrowers.

Before we understand the impact of an SLR reduction, let us first look at what it means, in the broader context of the RBI’s arsenal of pre-emptive measures.

Back to basics

As we all know, the monetary policy is essentially the management of money supply, interest rates and availability of credit in the economy. The central bank in any country manages money supply and interest rates through various monetary policy tools. Aside from the repo rate — the rate at which banks borrow short-term money from the RBI —there are other tools, such as the Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR), that the central bank uses to achieve its objectives.

The CRR is a certain percentage of deposits that banks hold as reserves with the central bank. Say, for instance, a bank has ₹1 lakh of deposits and the RBI prescribes 4 per cent as the CRR, then the bank will have to park ₹4,000 as reserves with the RBI. The amount specified as the CRR is held in cash and cash equivalents. The CRR serves two purposes — one, to ensure that banks don’t run out of cash to meet the payment demands of their depositors. Two, CRR is also a crucial monetary policy tool and is used for controlling money supply in an economy.

The RBI uses CRR either to drain excess liquidity or to release funds needed for economic growth from time to time. An increase in CRR means that banks have less funds available and money is sucked out of circulation. A tight liquidity situation, in turn, leads to higher interest rates.

While over the years, CRR has been substantially reduced from 15 per cent in the 1990s to 4 per cent now, banks have been demanding a reduction in the CRR and also its complete elimination over a period of time. This is because the amount banks set aside with the RBI does not fetch them any interest. This means that 4 per cent of the deposits, for which banks pay interest to depositors, cannot be put to lending use and neither does it earn interest.

Safe investments

Aside from setting aside a portion of deposits as CRR with the RBI, banks also need to hold a portion of their deposits in the form of government securities that are highly liquid and can be easily sold to raise money. This portion is termed SLR (statutory liquidity ratio). From levels of 37-38 per cent in the early 1990s, the RBI has substantially reduced the prescribed amount to be invested in G-secs to 21.5 per cent now.

It is this requirement that the RBI has decided to lower in a phased manner. The RBI has decided to lower the current 21.5 per cent SLR limit by 0.25 per cent every quarter, starting next year till March 2017. The one obvious result of this is that it will free up close to about ₹20,000 crore of bank funds at every stage. Loosening up banks’ kitty, will facilitate a pick-up in the investment cycle, as banks will have more funds to lend.

But there is a more long-term impact of reducing SLR too. In the past, there has been a ready market for bond buybacks by the RBI through open-market operations as well as through the SLR mandate. This has kept rates on government borrowing suppressed. According to the Urjit Patel Committee recommendation, to facilitate quicker transmission of policy rates to borrowers, it is essential to align interest rates across different segments to market-determined rates. By reducing SLR, the RBI wants to ensure better transmission by doing away with a captive market for government securities.

Why banks hold excess

But reducing the total SLR requirement for banks alone, as in the past, cannot free up funds. This is because banks, on an average, invest 3-5 per cent more than the mandated requirement. Banks carry excess investments due to lack of viable lending opportunities and the comfort of parking funds in highly safe assets, which can be used as collateral to borrow from the RBI.

What could force banks’ hands to some extent, is the reduction in the ceiling for bonds held under HTM (Held To Maturity) category. Banks are allowed to keep a portion of their SLR securities under HTM. These bond values do not have to be reset at the end of every quarter to reflect their market value; thus helping reduce the loss that could occur if they were marked to market. A higher percentage of SLR holdings in HTM is, therefore, favourable as it lowers the volatility in treasury income.

Currently, banks are allowed to hold more securities in the HTM category (22 per cent), than the level mandated for SLR. The RBI will reduce the HTM ceiling by 0.5 per cent in January 2016, to align it with the total SLR requirement. Changes in market value for a higher proportion of SLR securities will now have to be accounted for in banks’ income statements.

Tuning in with global practices

From January 2015, banks are required to meet the guidelines on the minimum liquidity coverage ratio (LCR) set out by the Basel III norms — a comprehensive set of global reform measures, developed by the Basel Committee on Banking Supervision, to strengthen the regulation, supervision and risk management of the banking sector. The main objective of LCR is to ensure that banks maintain sufficient liquid assets to meet obligations in a 30-day stress scenario.

The LCR requires that the stock of liquid assets should at least equal 60 per cent of total net cash outflows over 30 days. This will gradually be increased to 100 per cent by January 2019. As banks have to maintain such liquid assets over and above the mandated SLR requirement, the RBI will continue to reduce the SLR requirement in a phased manner.

On an average, the reserve requirement globally is in the 10-15 per cent range. India’s higher reserve requirement is mainly due to SLR, a close substitute for LCR. As per a recent Basel report, liquidity requirements for Indian banks are more conservative than the Basel standards.