Q. Discuss if it is the time to do away with Priority Sector Lending (PSL) norms. (250 words)

Model Answer :

Approach:

• Why in news?
• PSL – Brief Introduction
• Arguments in Favour
• Arguments in Against
• Way forward
• Conclusion

Why in news?

The Reserve Bank of India (RBI) has recently tightened priority sector lending (PSL) norms for foreign banks in India.

In a recent report the IMF, raising concerns regarding the role of the public sector in the financial system, has advised the RBI to review its PSL policy to allow for greater flexibility in meeting targets. It also suggests a gradual reduction in PSL as a means to move funds into “more productive activities”, and greater participation of the private sector in capitalizing public sector banks, together with full capitalization.

PSL – Brief Introduction

Priority Sector Lending is an important role given by the RBI to the banks for providing a specified portion of the bank lending to few specific sectors (Priority Sectors). This is essentially meant for an all-round development of the economy as opposed to focusing only on the financial sector.

As per the RBI circular, there are eight broad categories of the Priority Sector Lending. They are: (1) Agriculture (2) Micro, Small and Medium Enterprises (3) Export Credit (4) Education (5) Housing (6) Social Infrastructure (7) Renewable Energy (8) Others.

The others category includes personal loans to weaker section, loans to distressed persons, loans to state sponsored organisations for SC/ST.

Arguments in Favour

• The recent IMF reporton the Financial System Stability Assessment (FSSA) for India pointed out that since all banks need to follow guidelines and meet targets on PSL, it compromises their independent, risk-based credit allocation policies and strategies.
• At a time when non-performing assets (NPAs) are weighing heavily on banks’ balance sheets, the PSL norms poses a challenge to attract credit to productive sectors and enterprises that the economy desperately needs.
• Given how stressed the banks are on their balance sheets, there is not enough space for the credit and investment growth.
• Due to PSL norms, foreign banks have exhibited a reluctance to extend their bank branches, with the number of foreign bank branches in India falling to 286 on 31 January 2018, compared to 317 in FY 2016. This hampers the financial inclusion in India.
• Banks fetch lower interest than could be earned by deploying the funds for lending purposes, other than PSL.

Arguments in Against

• Priority sector loans have contributed far less to the gross non-performing assets (NPAs) than non-priority sector loans. Non-priority sector loans contributed to 82% of NPAs in the case of private sector banks in 2017, against the 18% of NPAs in the case of priority sector loans. While priority sector loans constitute 24.1% of NPAs in public sector banks in 2017. Thus, priority sector lending may not be responsible for compromising banks’ credit risk minimization strategies, or risk accumulation.
• One of the major problems with priority sector loans is the lack of understanding of the sub-sectoral target groups by banks, especially agriculture and the small and medium sector. A foreign bank, desirous of opening a bank branch in some remote area to service agricultural borrowers, neither understands its borrower, nor is clearly aware of the legal provisions to recover stressed assets.
• PSL serves the purpose of directed credit within a developing country like India therefore it must stay for an all-round development of the economy as opposed to focusing only on the financial sector.

Way forward

Apart from introduction of the scheme of priority sector lending certificates (PSLC) to facilitate the achievement of PSL targets by banks to incentivise banks having surplus in their priority sector lending to sell this surplus to peers that are falling short, there may be other alternatives such as –

• One option could be the creation of a development finance institution that would provide a mix of grants and loans to under-served sectors and geographies. The new institution can raise capital from commercial banks through existing innovative instruments like the PSL certificates, specify minimum sectoral disbursement targets and choose projects based on independent risk assessment and intended outcomes. This will support the policy objectives of increased credit and reduce systemic risk, making PSL work in the long run.
• As the IMF report suggests, sectoral lending targets should be in the exclusive domain of specialised institutions such as NABARD, regional rural banks, small finance banks and other development finance institutions, and not general commercial banks as is currently the case.
• The government may rely on specialized institutions such as the National Bank for Agriculture and Rural Development (Nabard) to fulfil sectoral lending targets, while at the same time ensuring structural reforms in these sectors to make lending to them more viable. 

Conclusion

Given the importance of PSL norms for developing country like India, it should stay however with greater flexibility and alternatives as discussed above.

Not part of Question but important piece of information - 

Currently, banks having any shortfall in lending to priority sector have to contribute to the Rural Infrastructure Development Fund (RIDF) established with Nabard and other specified funds.

As per the RBI’s report on ‘Trend and Progress of Banking in India, 2016-17’, while private banks on aggregate basis were able to meet their priority sector lending target under the MSME, public sector banks have fallen short of the 7.5 per cent target.