V Kumaraswamy: Need for a new SLR mechanism

The existing scheme of things works well only in a stable interest rate regime

In the past four years when interest rates were on a secular 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 our current SLR mechanism. Besides mobilising some cheap money for the government, SLRs are supposed to be defences against a sudden run on banks by their depositors when there is a liquidity crunch.

It is surprising, however, to note that nowhere in the laws and rules governing banks or the RBI does one find either a definition of what will be deemed a crunch situation, how these assets are supposed to be used to douse the situation, or how long a beleaguered bank will be allowed to stay below the prescribed minimum limit.

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, our 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 immunise the SLR portfolio from fluctuations in valuation.

If the deposits (that are on the opposite side of the balance sheet) also gyrate in tandem, they may counter-balance the valuation fluctuations.

But by and large, deposits are subject to valuation gains or losses. Banks, at best, renew or accept newer deposits at the new rates but cannot do much on the existing portfolio.

This wrong design has been the source of many embarrassing somersaults on the part of the RBI in fixing classification norms. Witness the recent permission to banks to re-classify SLR between "held to maturity" or "for sale" category to escape valuation losses and fixing absurd interest rates for valuing the securities.

In a scientific system, these should automatically be the last accounting days' market interest rates. Why should the RBI fix it?

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 is perhaps needed is an SLR instrument that is issued and is encashable anytime at par with the RBI. The coupon should be varying and it should be the 180-days or 360-days interest rates, or very closely linked to it.

Apart from all this, there must be a premium payable on maturity, which should depend on the actual time the securities were held by banks before being presented for redemption.

Together with this should be a set of guidelines on what constitutes a crunch, how much will be allowed to be encashed, for how long can a bank stay below the prescribed limits and with what penalties.

All this would have saved the RBI the embarrassment of various rules regarding valuation since there would be no risk of capital erosion.

The government would have got market-related interest rates; banks would not have been tempted to rush to the RBI too frequently because if they churn their portfolio, they are bound to lose out on the additional redemption premium.

Banks and the NBFCs can also feel safe about the liquidity aspects without having to worry about runs and having to take care of them separately, even as they have a SLR guardian at the gate.

Alternatively, as a minimum measure, a portion equal to the prescribed SLR limit should be mandated to be carried without re-valuation, thus not accounting for either profits or losses.

Whatever is more than this limit, even if they are eligible securities, should be mandated to be revalued at closing market interest rates and profits or losses should be shown in their current year's profits.

(The writer works for Atul Limited. The views expressed are personal)