The Statutory Liquidity Ratio (SLR) mandates that commercial banks maintain a minimum percentage of their deposits—currently set at 18%—in highly liquid assets such as cash, gold, or government securities. This requirement serves as a protective measure for customer deposits, ensuring that banks have sufficient liquid resources to meet withdrawal demands. Additionally, the SLR plays a role in regulating credit flow within the economy by influencing the availability of funds for lending. By requiring banks to set aside a portion of their deposits, the SLR helps to maintain financial stability and reduce the risk of liquidity shortages. Let’s delve deeper into the concept of SLR, its applications, and its significance.
What is the Statutory Liquidity Ratio (SLR)
The statutory liquidity ratio is the minimum percentage of deposits that commercial banks must maintain before they extend credit facilities to their customers. These deposits can be held in different ways — in the form of liquid cash, gold, government and other approved securities, or other instruments.
The SLR is calculated as the ratio of a bank’s liquid assets to its Net Demand and Time Liabilities (NDTL). In our country, the responsibility of deciding the statutory liquidity ratio lies with the Reserve Bank of India (RBI). While the current SLR is 18%, the RBI is authorised to increase or decrease the ratio as it deems fit. The SLR can be increased up to a maximum limit of 40% but has no minimum limit.
Objectives of the SLR
Based on the meaning of the statutory liquidity ratio, it becomes evident that the SLR fulfils various purposes. Its key objectives include the following:
- To prevent over-liquidation
The Cash Reserve Ratio (CRR) is the minimum amount of cash deposits banks must have with the RBI. When the RBI raises the CRR, banks may attempt to sell some of their liquid assets to generate the cash needed for such deposits. To prevent this kind of over-liquidation and ensure that banks remain solvent, the RBI has also established a statutory liquidity ratio. - To regulate the flow of bank credit
By increasing or decreasing the statutory liquidity ratio, the central bank can regulate the flow of credit from commercial banks to their customers. An increase in the SLR limits the flow of credit during periods of inflation. Conversely, a decrease in the SLR accelerates the flow of credit when the economy shows signs of recession. This helps curb both inflationary and recessionary pressures as required.
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Importance of SLR
The Statutory Liquidity Ratio (SLR) is crucial for maintaining financial stability and ensuring the safety of customer deposits. By mandating banks to hold a portion of their deposits in liquid assets like cash, gold, or government securities, it ensures banks have sufficient resources for withdrawals, reducing liquidity risks. The SLR also helps regulate credit flow, as higher reserve requirements limit the funds available for lending, thus controlling inflation and economic growth. Additionally, it supports monetary policy objectives, allowing the central bank to influence interest rates and credit availability by adjusting the SLR percentage.
How does statutory liquidity ratio work?
The Statutory Liquidity Ratio (SLR) requires banks to hold a specified percentage of their deposits in liquid assets, such as cash, gold, or government securities. This reserve is calculated based on a bank's net demand and time liabilities. By setting aside these assets, banks limit the funds available for lending, which helps control liquidity in the financial system. The central bank adjusts the SLR to regulate credit flow; increasing the SLR restricts lending to curb inflation, while lowering it encourages lending to stimulate economic growth. This mechanism ensures banks maintain sufficient liquidity to meet customer withdrawal demands.
Impact of statutory liquidity ratio on the base rate
The Statutory Liquidity Ratio (SLR) plays a crucial role in determining the base rate, the minimum interest rate that banks in India can offer loans. Here's how:
- SLR & base rate: A higher SLR (currently 18%) requires banks to hold a larger portion of deposits as liquid assets. This can limit the funds available for lending, potentially pushing up base rates.
- Transparency & affordability: The base rate promotes transparency in lending practices and aims to ensure banks offer loans at competitive rates. Ideally, a lower base rate translates to lower borrowing costs for individuals and businesses.
- Factors affecting base rate: Several factors influence the base rate, including SLR, Cash Reserve Ratio (CRR), cost of funds for banks, and operating expenses. The Reserve Bank of India (RBI) considers these factors when setting the base rate.
Reasons for reduction in statutory liquidity ratio by RBI
The Reserve Bank of India (RBI) may reduce the SLR to influence various aspects of the economy. Here's a breakdown of the key reasons:
- Boost credit availability: A lower SLR frees up more funds for banks to lend. This can increase loan availability for businesses and individuals, potentially stimulating economic growth.
- Manage base rate: SLR impacts the base rate, the minimum lending rate for banks. By reducing SLR, the RBI can indirectly influence the base rate, potentially bringing it down and making loans more affordable.
- Encourage active lending practices: Some banks might adopt a passive lending approach. A lower SLR can incentivise banks to lend more actively by making additional funds available.
- Promote financial stability: The RBI strategically adjusts SLR to maintain financial stability. A balanced approach ensures sufficient liquidity for banks while also encouraging credit flow in the economy.
Understanding these reasons behind SLR reduction can help us analyse its potential impact on loan interest rates, credit availability, and overall economic activity.
Different uses and benefits of the statutory liquidity ratio (SLR)
As a monetary policy tool, the statutory liquidity ratio has several uses. The Reserve Bank of India may increase or decrease the SLR depending on the economic phase or cycle. Here is how this benefits the banks, their customers, and the economy at large.
- It ensures the solvency of commercial banks in the country.
- It promotes investments in government securities, gold, and other approved instruments.
- When increased, it curbs inflation by limiting the amount of credit available to users and the cash flow in the economy.
- When reduced, it increases the cash flow in the economy and promotes growth.
The two key components of the statutory liquidity ratio
As is evident from the meaning of the statutory liquidity ratio, it is calculated using two metrics: liquid assets and the Net Demand and Time Liabilities (NDTL). Here’s what they each entail.
- Liquid assets
These are the assets that can easily be converted into cash. Some common examples of such assets include treasury bills, government bonds, other government securities, gold, and money market instruments. - Net Demand and Time Liabilities (NDTL)
This is the net amount that a commercial bank owes its customers and other financial institutions. They include demand liabilities (i.e. deposits that are payable on demand) and time liabilities (i.e. deposits that are payable after a specific period, otherwise than on demand).
Demand liabilities include savings bank deposits, overdue FDs, margins against LoC, etc. Time liabilities include fixed deposits, recurring deposits, certificates of deposit, etc.
Also read - What is information ratio (IR)?
What happens if SLR is not maintained?
If a bank fails to maintain the required Statutory Liquidity Ratio (SLR), it faces penalties from the central bank. Typically, the penalty involves paying interest at a higher rate for the shortfall amount, often known as the penal interest rate. Repeated non-compliance may lead to more stringent regulatory actions, such as restrictions on lending or other financial activities. Non-maintenance of the SLR can also indicate potential liquidity issues, risking customer deposit safety and disrupting the bank's stability. Ensuring the SLR is met is essential for maintaining trust in the banking system and safeguarding the financial sector's overall stability.
How does the SLR differ from the CRR
The cash reserve ratio or CRR is another monetary policy tool that ensures liquidity and solvency among commercial banks. It is often confused with the SLR, but the two ratios are different in many ways. Here is an overview of the key differences between the SLR and the CRR.
Particulars |
Statutory Liquidity Ratio (SLR) |
Cash Reserve Ratio (CRR) |
Meaning |
The minimum percentage of deposits that commercial banks should maintain |
The percentage of cash reserves that commercial banks must hold with the RBI |
Purpose |
To regulate the supply of credit in the economy during inflation and recession |
To promote liquidity among commercial banks in the country |
Assets in which funds are held |
Cash, gold, government bonds and other approved securities |
Cash only |
The entity with which the assets are held |
Eligible assets held with the commercial banks |
Cash reserve maintained with the RBI |
Interest earnings |
Banks earn interest or returns on the funds held to meet the SLR requirements |
Banks do not earn interest on the cash reserves |
Also read - What is an expense ratio?
Conclusion
Having a statutory liquidity ratio in place helps commercial banks maintain adequate liquidity. It also offers broader economic benefits by promoting growth or curtailing inflation as needed. To avoid the annual penalty levied in case of default, banks must adhere to the SLR set by the RBI.
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