Bank reforms - flexible approach to profitability

The unshackling of SLR and CRR will improve liquidity in the banking system and lead to better profit.

A week after announcing the managerial autonomy package for the public sector banks, finance minister P Chidambaram today unveiled a slew of measures to encourage competition and greater operational freedom to all commercial banks.

The Budget has proposed to amend the Banking Regulation Act to impart flexibility in banks' statutory liquidity ratio (SLR). The limits on the cash reserve ratio (CRR) is also being removed through amendment of the RBI Act.

Besides, banks are being allowed to issue preference shares which was hitherto not permitted. Preference share capital can be treated as regulatory capital under specified circumstances as per the Basel II norms.

Once the floors for SLR and CRR are removed, banks will be able to build more corporate/ retail assets earning a higher yield. This will push their net interest margin (NIM) up and add to the profitability.

For instance, if a bank earns 5-5.50 per cent on a government bond, it can unlock the investment and give out a retail loan at 8-8.5 per cent making a clear spread of 3 per cent. At present, banks earn as little as 3 per cent on their CRR balance with the RBI.

"Freeing CRR would improve liquidity and interest earnings while freeing SLR would help banks to lend in more profitable avenues such as retail for instance," said O N Singh, CMD, Allahabad Bank.

"We can maximise our net interest margins since the yield on assets is much higher than the yield on government securities," he added.

Section 42(1) of the RBI Act, 1934, states that scheduled commercial banks have to maintain with RBI an average cash balance or cash reserve ratio (CRR) which shall not be less than 3 per cent of the total of the net demand and time liabilities (NDTL) in India, on a fortnightly basis. The CRR limit is now pegged at 5 per cent. It was as high as 15 per cent in 1981.

Under section 24 of the Banking Regulation Act, 1949, all scheduled commercial banks are required to maintain a uniform SLR of 25 per cent of the total of their demand and time liabilities in India as on the last Friday of the second preceding fortnight. The SLR limit is now 25 per cent. It was as high as 38 per cent in 1990s.

Removal of these limits will allow banks to unlock investments and earn more on corporate assets. Even today banks invest more than the mandated level in government securities at about 30 per cent of deposits, down from the highs of 40 per cent about a year back. Bankers feel the shift from bonds to be gradual since lending means higher credit risks and provisions.

In many western countries, the concept of SLR does not exist while the CRR requirement is minimal at below 1 per cent.

Banks are being given freedom in resource raising which is most pertinent since banks are expected to have 2-3 per cent of their capital adequacy ratios shaved off with the implementation of the stringent Basel II norms in 2006.

"Allowing the issue of preference shares is a most welcome measure which will help us meet our capital requirements. If it is not done, banks will find it difficult to raise capital given that the government's stake in PSU banks must not slip below 51 per cent," said V P Shetty, CMD, Canara Bank.