Demystifying Statutory Liquidity Ratio (SLR) in Banking

6 mins read
by Angel One
The RBI uses multiple tools to maintain the stability of the Indian banking system. SLR is one such tool that is used to preserve liquidity in all Indian banks. Let us read about it in detail.

Introduction

In the intricate landscape of banking and finance, there are several key ratios and regulations that play a pivotal role in shaping the monetary system of a country. One such important parameter is the Statutory Liquidity Ratio (SLR). SLR is a vital tool employed by central banks to manage liquidity within the banking system, ensuring stability, security, and effective functioning.

In this blog post, we’ll delve into understanding what is Statutory Liquidity Ratio, exploring its significance, mechanisms, objectives, uses, components, and its impact on investors.

What is SLR?

The Statutory Liquidity Ratio (SLR) refers to the mandated percentage of a bank’s net demand and time liabilities that it must maintain in the form of specified liquid assets, such as cash, gold, or government-approved securities. This requirement is set by the central bank of a country, and it serves as a safeguard to ensure that banks have adequate liquidity to meet the short-term obligations of their depositors.

The following is the Statutory Liquidity Ratio formula –

SLR = Liquid Assets (e.g. cash, gold, g-secs)/Net Demand and Time Liabilities

The SLR is mandated by the RBI under Section 24(2a) of the Banking Regulation Act, 1949. It acts as one of the many regulatory ratios that RBI uses to tweak money supply and inflation in the country. As of August 9th, 2023, the SLR required stands at 18% of net demand and time liabilities. But the number is subject to change as per the decision of the RBI.

How Does Statutory Liquidity Ratio Work?

SLR acts as a cushion against liquidity risks. By maintaining a certain portion of their liabilities as liquid assets, banks can promptly meet unexpected withdrawal demands from their customers. 

The central bank utilises SLR to regulate the flow of credit and money supply in the economy. When the central bank wants to tighten liquidity, it can increase the SLR, thereby compelling banks to keep a larger proportion of their funds in low-yield liquid assets, which reduces the funds available for lending.

If a bank is found to be holding liquid assets below the SLR lower limit, then it is said to be violating RBI’s regulations and responses from RBI, including punitive actions, will follow.

Objectives of SLR

The primary objectives of SLR include:

  1. Ensuring Financial Stability: SLR helps maintain the stability of the banking system by guaranteeing that banks have enough readily available resources to handle fluctuations in demand and external shocks.
  2. Controlling Inflation: By modifying the SLR, central banks can influence the amount of money that banks can lend. A higher SLR reduces the lendable resources, curbing excess liquidity and potentially controlling inflation.
  3. Encouraging Prudent Investments: Banks are required to invest in safe and liquid assets, such as government securities. This promotes conservative investment practices, reducing the risk of potential defaults.

Uses of SLR

SLR serves various important functions in the financial ecosystem:

  1. Monetary Policy Implementation: Central banks utilise changes in SLR to implement monetary policy. By adjusting the SLR, they can regulate the availability of credit and influence economic growth.
  2. Bank Solvency and Stability: SLR acts as a safety net, ensuring that banks can meet their liabilities during times of financial stress. It enhances the overall solvency and stability of the banking sector.
  3. Government Borrowing: The SLR mandate necessitates banks to invest in government-approved securities, thereby facilitating government borrowing and funding public projects.

Components of Statutory Liquidity Ratio

SLR typically comprises a mix of high-quality assets that can be quickly converted into cash without significant loss. These assets include:

  1. Cash: Physical currency held by the bank.
  2. Gold: Valuable and easily tradable precious metal.
  3. Government Securities: Bonds and securities issued by the government, including ones under market stabilisation schemes, which are generally considered safe and low-risk.
  4. Others: These may include other government-approved securities.

Differences Between CRR and SLR

The Cash Reserve Ratio (CRR) is the minimum amount of cash, compared to the net demand and time liabilities, that a bank must hold at all times. Banks cannot hold this cash in the form of an investment, i.e. they do not earn any interest on that cash. This is in contrast to SLR, where the assets under SLR can be invested in certain types of securities. 

CRR’s sole purpose is to overcome any unexpected shortfall in hard cash that the bank may have at any moment. CRR is usually lower than SLR and hovers at around 4-5%. This is because banks should not be holding too much idle cash that is not invested. Also, a lower CRR means greater circulation of money in the economy.

The CRR and SLR are both tools employed by central banks to regulate liquidity, but they have distinct differences:

  1. Nature of Deposits: CRR is calculated as a percentage of total deposits, while SLR is calculated as a percentage of net demand and time liabilities.
  2. Purpose: CRR primarily ensures that banks can meet sudden requirements of cash, while SLR is meant to keep the overall risk levels low by investing in specified, low-risk liquid assets.
  3. Earnings: Banks do not earn any interest on funds held in the CRR, whereas they earn interest on funds invested in SLR assets.

Impact of SLR on the Investor

The influence of SLR on investors is indirect but noteworthy:

  1. Interest Rates: Changes in the SLR can impact the overall interest rate scenario in the economy. An increase in SLR may lead to reduced lendable resources, potentially leading to higher interest rates for borrowers due to lower supply of money.
  2. Systemic Stability: A strong banking system due to SLR adherence enhances investor confidence, contributing to the overall stability of the financial ecosystem.

Conclusion

In the complex realm of financial regulations, the Statutory Liquidity Ratio (SLR) stands as a crucial pillar of stability and prudent banking practices. By mandating that banks maintain a certain portion of their liabilities as liquid assets, SLR ensures that banks can weather storms and honor their commitments. With its far-reaching impact on monetary policy, economic growth, and investor confidence, the SLR exemplifies how a seemingly technical ratio plays a profound role in shaping the financial well-being of a nation.

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FAQs

How can changes in SLR affect my investments?

A higher SLR means lower liquidity in the economy as well as lower levels of earnings for the bank. Therefore, a higher SLR is likely to reduce prices in the stock market, including bank stocks. But a higher SLR also means less money supply and thus higher interest rates. Therefore, bonds with floating rate may become a more attractive option for investors.

Which banks have to follow SLR requirements?

All banks in India, including payments banks, regional rural banks, small finance banks, non-scheduled banks have to maintain SLR.

What are some of the main ratios that banks have to maintain?

Banks are required to maintain the Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) as per RBI. They also have to maintain a certain degree of Capital Adequacy Ratio following Basel-III.

What will happen if SLR is removed completely?

Without Statutory Liquidity Ratio (SLR), banks may hold too little liquidity in their hands, reducing their ability to tweak their investments as well as meet sudden requirements of cash. This may reduce the overall profits in the banking sector as well as endanger the financial health of many banks in times of recession or bank runs.