Aligning Priority Sector Credit To India’s Growth Needs

Reforms to PSL can have tremendous impact both on regional/sectoral development as well as improving the quality of bank assets.

Customers sit at a table inside a bank branch in the village of Khurana, Uttar Pradesh. (Photographer: Prashanth Vishwanathan/Bloomberg)
Customers sit at a table inside a bank branch in the village of Khurana, Uttar Pradesh. (Photographer: Prashanth Vishwanathan/Bloomberg)

Priority sector lending guidelines, in addition to branching norms, have been an important way in which policy-makers have embedded the social contract in the Indian banking system. These guidelines require 40% of net bank credit to be deployed in specific sectors including agriculture, MSME, and housing among others.

While there has been some dynamism to the sectors that are considered eligible, one glaring omission has been the absence of a regional lens. So, banks could be in full compliance with the requirements and yet leave entire parts of the country un-served. India’s top 10 districts account for more than 54% of all credit – Mumbai 22% and Delhi 13%. All of North-East India had a comparable amount of agriculture credit outstanding as Delhi. Bihar has a credit-to-GDP ratio of less than 20%.

While these skews are not entirely surprising given the underlying patterns of growth, the concern is that several districts of the country may be growth constrained precisely due to low levels of credit availability. In this context, the RBI announcement on August 6 that an incentive framework would be put in place to address regional disparities is extremely significant.

As details are awaited on the framework, we propose some design elements that may be considered. The overall guiding principle must be to encourage banks to build specialised under-writing capabilities: with respect to both sectors and regions. So, if a small finance bank is able to successfully develop models of farm lending in Bihar, that must be valued differently than say, lending to sugar cooperatives in Maharashtra which have significant exposures from the banking system already. In all cases, the guidelines must reinforce the need for high-quality origination and fair pricing.

Three New Design Elements

One important recommendation is from the RBI Committee on Comprehensive Financial Services for Small Businesses and Low Income Households (2013) which first recommended publishing differential weights for different regions and sectors depending on the shortfall experienced by the region or sector with respect to financial depth – the ratio of formal credit to the region or sector, to its GDP.

The underlying thought process here is that while credit depth will vary across regions based on growth impulses, there is a minimum threshold that may be thought of as enabling.

Accordingly, a benchmark credit-GDP target of 50% is assigned to significant sectors of the economy. Against this target, a relative shortfall in achievement is arrived at. A sector having a 20% credit-GDP would have a relative shortfall of 30% and hence, a sector weight as 1.30. Similarly, regional weights can be arrived at. A combined Region-Sector-Customer Segment Matrix of weights can be constructed to reflect combined relative shortfalls to the threshold and published by RBI periodically. This can serve to guide PSL strategies of banks.

Secondly, there must be a dynamic approach to regional and sectoral weights so that it captures the changes in the economic landscape. This requires good time-series data of district and sectoral GDP and periodic estimation of growth elasticities. In the short-term, a simplified district-sector-weighting mechanism is a good starting point but must be refined over time. RBI can consider building start-of-the-art capabilities that allow it to have a much more sensitive ‘finger on the pulse’ of state- and district-level economies. While RBI is taking steps to enhance credit monitoring of all banks, prioritising this will enable it to have a complete and dynamic picture of incremental credit flows and how it maps against regional and sectoral capacities to absorb credit depending on economic and other development-related parameters.

Finally, care must be taken to ensure that the mechanism does not penalise banks for lending to ‘easy’ districts and sectors. For a credit-starved economy like ours, this would be an error. PSL has for too long been equated to own origination by banks alone. A markets approach here is long overdue given the changing nature of Indian banks and differentiated licenses.

Banks must be free to lend to those sectors and geographies where they have an advantage and ‘sell’ their excess PSL to other banks to cover their deficit, and vice versa.

RBI has made progress on several of these fronts, particularly PSL certificates, co-origination with NBFCs, and the new draft frameworks for sale of loans and securitisation transactions. Some frictions remain. Co-origination partnerships rely on NBFCs’ underwriting and servicing capabilities for building loan books for banks. Price caps applicable on securitised PSL loans discourage NBFCs and banks from participating in securitisation markets of PSL loans. Such price caps are not applicable to bank-originated PSL loans and must be removed.

Reforms to PSL can have tremendous impact both on regional/sectoral development as well as improving the quality of bank assets and balance sheets. RBI’s announcement holds tremendous promise in this regard.

Deepti George is Head of Policy, and Bindu Ananth is Chair, at Dvara Research.

The views expressed here are those of the authors and do not necessarily represent the views of BloombergQuint or its editorial team.