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Central bank raps banks' knuckles over bond holdings

Under a regulation known as the SLR, banks are required to hold 25 per cent of their deposits in Govt bonds, bills and state loans.

india Updated: Feb 01, 2007 17:56 IST

Central bank told commercial banks on Wednesday to beef up their bond holdings rather than selling them to fund loans, a practice it said could compound borrowing problems when market conditions were tight.

Under a regulation known as the statutory liquidity requirement (SLR), banks are required to hold 25 per cent of their deposits in government bonds, bills and state loans.

Industry-wide bond holdings have dwindled to about 28 per cent from 43 per cent in April 2004 as banks offloaded securities to raise cash for more lucrative lending.

This has helped banks finance robust loan growth, but it has also reduced their capacity to swap bonds for funds at the central bank's daily money market operations.

"Banks need to recognise that shortage of SLR securities could constrain their recourse to (the central bank's liquidity window) which can turn adverse in critical times, forcing them to resort to uncollateralised exposures and attendant risks," the central bank said in its quarterly policy review.

It also warned banks against using its cash window as a means to get funds for lending on to customers.

"Accessing the Reserve Bank's window for funds should be for very temporary periods and for equilibrating very short-term mismatches," it said.

The central bank raised its key short-term lending rate by 25 basis points to 7.50 per cent earlier on Wednesday.

It raised the rate four times in 2006, and in December increased the amount of cash banks have to keep with it on deposit, leading to a sudden outflow of funds from the system.

Banks whose bond holdings had fallen close to the statutory limit had to rush to the unsecured overnight money market to meet their funding requirements. The overnight interest rate that commercial banks charge each other spiked to a nine-year high of 21 per cent from 8 per cent as a result.

The central bank, meanwhile, was lending at 7.25 per cent.

"Banks have been living on the edge for quite some time now when it comes to operating their SLR requirements," said Rupa Rege Nitsure, economist at state-run Bank of Baroda.

"The RBI is telling them to be prudent on their cash management skills and not rely on the central bank's daily fund management mechanisms to meet their long-term funding needs."

Some analysts said Wednesday's rate rise implied tight cash conditions would continue in the near term and banks would have to increase their bond holdings.

The central bank said bank credit growth was "clearly excessive" and toughened up requirements on provisions against lending for real estate, capital markets and to consumers.

"By tightening prudential norms they have sent a clear signal to banks that lending to certain sectors needs to be curbed," the head of corporate banking in a foreign bank said.

"If they are unable to do so, the RBI would make borrowing in the money market more expensive."

First Published: Feb 01, 2007 17:56 IST