What do you know about SRR?

By Jagath Gamanayake

The COVID-19 pandemic brought the world’s economic system to its knees. At the height of the pandemic, some strident and triumphant voices proclaimed that the Central Bank has not done enough or anything to save the economy. However, later it was realised that the inaction was due to the communication gap between the parties concerned. Nonetheless, they have come up with various possible strategies within the scope of their legitimate framework. 

Out of the several remedial actions, one is the popular reduction of statutory reserve ratio (SRR). The writer thought that it is prudent to educate and improve the financial literacy of the general public about SRR, its history and its implications especially given the economic instability in light of the coronavirus outbreak. 

The technical definition of SRR

In terms of the provisions of Section 93 of the Monetary Law Act (MLA), licensed commercial banks (LCBs) operating in Sri Lanka are required to maintain reserves against all deposit liabilities denominated in Sri Lanka rupees. This is called the Statutory Reserve Requirement (SRR). The minimum reserve is generally determined by the central bank to be no less than a specified percentage of the number of deposit liabilities of the commercial bank owes to its customers. At present, demand, time and savings deposits of commercial banks are denominated in rupee terms and are subjected to the SRR.

SRR in the global and Sri Lankan context

SRR can complement and strengthen the monetary policy schemes of central banks and the SRR has been a commonplace tool used by central banks around the globe. Statistics revealed that the current practices on SRR are operated in 121 central banks out of which only nine do not rely on them. 

There is a large variation across countries when determining its reserves. In Sri Lanka, from 1950 up to 2008, it maintained an SRR of over 10%. Furthermore, their form has transformed from single uniform reserve requirements ratios on deposits to differentiated ratios by currency, maturity, and type of liability from time to time. The Central Bank of Sri Lanka had introduced maximum SRR during 1985, where demand deposits to reach 18%, and other deposits between 10-12%. If a country imposes different rates across different liabilities, the effective average ratio is calculated by averaging the different rates. However, from the latter part of 2008, the SRR has come down to a single-digit number, and in 2013 it reached 6% and at present to a mere 2%.

While some countries have set reserve ratios at 0.2%, while on the other extreme have set ratios of 90%. Some countries have a higher percentage of SRR, namely; Argentina for 41%, and Venezuela for over 90%, whilst Canada, UK, New Zealand, Australia, Sweden and Hong Kong have no reserve requirements.

Computation of SRR

The calculation of reserve value of deposit liabilities for SRR, is done on standard methods. Different methods are used in different countries. In the Sri Lankan context, CBSL use, lagged reserve requirement system (LRR). The process of reserve requirement consists of several components. Reservable liabilities; explains the type of deposit liabilities to be taken in to account for SRR. Percentage of such deposit liabilities are to be considered under reserve ratio. For reserve calculation and maintenance by LCBs, each calendar month is divided into two periods (i.e. Period A and Period B): Period A from the 1st to the 15th (both inclusive); and Period B from the 16th to the last day (both inclusive) of each month.

The reserves required to be maintained by LCBs for the reserve maintenance of Period A, of any month should be based on the average daily deposit liabilities of the Period A of the preceding month, while for the reserve maintenance of period B, of any month, such reserve should be based on the average daily deposit liabilities of the Period B of the preceding month. 

LCBs may maintain an amount over and above two per centum of the average deposit liabilities mentioned above but not exceeding four per centum thereof as a part of its required reserves in the form of Sri Lanka currency notes and coins. Such amount should be the average holding of Sri Lanka currency notes and coins calculated for the respective computation period. 

LCBs are not required to maintain a hundred per cent of their reserve requirement at all times, they are allowed to reduce their reserve requirement down to 90% during a day. However, at the end of a two-week reserve maintenance period, the average amount of reserve maintained should be 100% or above.

If any LCB has failed to maintain 100% of SRR at the end of a reserve maintenance period, such LCBs should pay CBSL an interest at the rate of one-tenth of one per centum (0.1%) on the amount of the deficiency in reserves, as a penalty.

What theory talks on SRR 

Three main motivators for traditional reserve requirements have been highlighted in the literature; a micro-prudential, a monetary control, and a liquidity management objective. Reserve requirements were first used for micro-prudential regulation purposes. Initially, they were ensuring that banks held a certain proportion of liquid assets as a buffer. Some have argued that as a series of supervisory and regulatory initiatives have been taken over the years with the aim of increased liquidity buffers in the system, this prudential purpose may now be outdated (Gray 2011).

Reserve requirements are also used for liquidity management purposes, whereby the central bank attempts to inject liquidity to the market or absorb liquidity from the market by changing the SRR ratio. When the central bank increases SRR ratio, commercial banks are required to keep more rupee deposit liabilities with the central bank limiting the ability of credit creation. This decreases the excess market liquidity. The reverse of this materialises if the central bank reduces the SRR ratio. If the market is in the excess liquidity position, the central bank can increase the SRR to absorb liquidity from the market and vice versa. 

There has since been a significant evolution over time regarding the role of reserve requirements – moving from a purely monetary policy instrument to a diverse set of uses including financial stability motivations. In many countries the traditional view no longer holds. Reserve requirements are no longer seen as a vehicle to directly control the money stock but rather as a vehicle to facilitate control over short-term interest rates, inflation and exchange rates targets. As such, depending on a country’s institutional framework, the role of the central bank to act as lender of last resort, there may be scope for reducing or even eliminating reserve requirements.

Some economists have argued in favour of eliminating SRR because they are the source of inefficiencies in the banking sector. Fama (1983) believed SRR was the source of unnecessary cost for providing banking services. SRR is considered tax that distorts financial intermediation, specifically the rate of return on deposits. Fama (1980) proposed that SRR is a tax on the return on deposits because other assets that have similar returns and risks do not have required reserves.

However, SRR may have a stabilising role in the economy. Ongoing research gives a macro-prudential role to SRR as a way to control systemic risk. Macroprudential policies can reduce systemic risk, strengthen the financial system against external shocks, and allow a fluid financial intermediation process. 

Implications of reduction of SRR

CBSL has cut its statutory reserve ratio (SRR) recently to 2%, releasing Rs. 115 billion into the banking system. This steep rate cut takes the CBSL to manage liquidity, to its lowest since 1950. 

Let’s look at how reducing SRR inject liquidity to the banking system (refer Figure 1);

From the first of July 20XX, due to the reduction in the reserve ratio (from H to I), the liquidity added to the banking system is calculated in billions of rupees.

When there is a serious crisis in this nature, monetary authorities should not hesitate to lower the reserve requirement radically. The low reserve requirement policy is used to make an impact on the liquidity of the banking system during the crisis, thereby been a predominant tool utilised by the CBSL. The reserve requirement policy affects the trending of lending interest rates. In theory, a lower effective rate of reserve requirement means lower costs for banks and thus they can reduce lending interest rates.

Conclusion

On the prudential side, reserve requirements are a way of making sure that banks have sufficient liquid resources to meet unexpected levels of deposit withdrawal. Minimum reserve requirements were fundamental to bank supervision, up until recently. Thus, in a crisis that threatens banks, one should not hesitate to apply this monetary policy instrument (significantly lowering of reserve requirement) as it is of great importance to providing liquid assets to the financial institutions.

Reducing SRR and printing money would increase the liquidity. However, CBSL warranted that given the lack of fiscal space to stimulate growth in economic activity at the moment a spike in inflation is not be considered. 

Factors such as customers not utilising the credit facilities for their business activities, loans being granted to wrong segments, documentation processing issues and banks not releasing credit adequately for various reasons may result in excess liquidity in the market.

Nevertheless, the domestic banks have stepped forward to fulfil its obligations and assist the government’s ongoing efforts to restart the Sri Lankan economy by introducing some catchy brand names for their credit ad campaigns, of course, reducing interest rates. But it should not only be confined to mere advertising or pleasing the authorities but it should be a ground-level activation.

(When compiling this article, the writer referred to the CBSL website, various research papers and articles. The writer can be contacted via jagath.jkg @gmail.com.)