After a long wait, the central government has approved a proposal to remove the lower cap on statutory liquidity ratio (SLR) to be maintained by banks. As per the existing provisions of the Banking Regulation Act, the floor for SLR is set at 25 per cent of total deposits of a bank. Once the ordinance is promulgated, the RBI would have full flexibility to fix the SLR as per its assessment of the overall liquidity condition.

Banking stocks have surged ahead today, following the government decision. Many large cap banking stocks like SBI, ICICI Bank, PNB and OBC have gained significantly by even up to 7 per cent. Are these gains justified or has the market over-reacted?

Banks have to keep a part of their total deposits in specified approved securities like government bonds and cash. The RBI specifies the SLR and the cash reserve ratio (CRR). Both these ratios are key policy tools available to the central bank to manage liquidity. These ratios also serve the purpose of protecting at least a part of the deposits from any indiscriminate lending by banks. Currently the SLR stands at 25 per cent while the CRR is at 5.5 per cent.

If the RBI decides to lower any of these reserve ratios, it would free up substantial amounts which the banks can lend to commercial borrowers. As the interest rates on commercial lending is much higher than the returns from government bonds and other approved instruments, any lowering of the reserve ratio would improve the net interest margins of the banking industry.

Going by the market reaction, it would seem as though the RBI has already acted on the regulatory change and lowered the SLR. But the central bank has done nothing of the kind, yet, and, going by its recent policy actions, it may not even consider any such move in the near future.

Despite the enormous political pressure to sustain the credit growth, to help sustain the economic growth momentum, the RBI has been extremely cautious in its policy actions. The central bank is very concerned about rising inflation and is always on the look out for any signs of overheating in the economy. In the recent past, it has issued many cautionary statements on the rapid growth in retail credit and the incredible rise in real estate prices.

The RBI hiked interest rates as many as four times last year to curb inflationary pressures and ended the year by announcing a 50 basis point hike in the CRR. Despite these measures, inflation continues to inch up and - as the latest available data reveals- has crossed the upper limit of 5.5 per cent targeted by the RBI. There are no signs of any deceleration in economic growth and industrial growth for the month of November topped 14 per cent with manufacturing growth above 15.5 per cent. Most analysts and economists expect the RBI to go in for an interest rate hike as early as next month.

Given this scenario and the RBI's current outlook, the possibility of an early cut in SLR looks very bleak. Though overnight call rates have climbed after the CRR hike and liquidity has tightened, the situation may ease as the government steps up its spending in the last quarter of the current financial year. So any easing of the SLR appears many months away, especially since it hiked the CRR just a month back. The most optimistic analysts are forecasting a very modest cut by the end of the first quarter of next financial year, if liquidity remains tight.

So why is the market so excited about the policy change? Apart from the obvious reaction from traders, there could also be some heavy short covering behind the sharp gains in banking stocks. Banking stocks had seen spectacular gains till December, but had been subdued thereafter. These stocks have been losing ground in recent weeks on expectations that the RBI would go on for a rate hike and short positions were building in these stocks. The strong market momentum and the policy announcement once again caught the bears on the wrong foot.