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Priority Sector Loans: A history worth knowing

Summary:
RBI in its recent monetary policy announced review of priority sector loans (PSL). Dr. K.C Chakrabarty, former Deputy Governor of RBI in a 2012 speech defined PSL as “Priority sector refers to those sectors of the economy which, though viable and creditworthy, may not get timely and adequate credit in the absence of this special dispensation.” Under the new guidelines, RBI will allocate higher weight to regions with lower credit flow and lower weight for regions having higher flow of credit. This review marks nearly 60 years of evolution of PSL from it merely starting as an idea to becoming one of the most integral component of Indian banking. This piece reviews history of PSL and how it became such a centre piece of Indian banking. Germination of the idea Post-independence, the

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RBI in its recent monetary policy announced review of priority sector loans (PSL). Dr. K.C Chakrabarty, former Deputy Governor of RBI in a 2012 speech defined PSL as “Priority sector refers to those sectors of the economy which, though viable and creditworthy, may not get timely and adequate credit in the absence of this special dispensation.”

Under the new guidelines, RBI will allocate higher weight to regions with lower credit flow and lower weight for regions having higher flow of credit. This review marks nearly 60 years of evolution of PSL from it merely starting as an idea to becoming one of the most integral component of Indian banking. This piece reviews history of PSL and how it became such a centre piece of Indian banking.

Germination of the idea

Post-independence, the Government made lending to agriculture and rural sectors as one of its priorities (without calling it a priority sector).  The All India Rural Credit Survey had identified serious funding gaps in the two sectors. This led to nationalization of SBI and making cooperatives the incharge of rural lending. However, the lending to these sectors was merely a trickle.

In 1961, RBI conducted a review of commercial bank loans to cooperatives and small scale industries and found just 3.5% of bank credit was accorded to these two sectors. In order to incentivize credit towards these ‘priority or preferred sectors’, RBI allowed commercial banks to refinance credit towards these sectors at Bank rate. Gradually, the priority list was expanded to credit for financing defence production, industries producing essential goods, and exports.

National Credit Council and Bank Nationalisation

Despite these policy pushes, lending to these sectors did not increase. The talks of nationalizing banks was thick in policy circles. Deputy PM and Finance Minister Mr Morarji Desai was sentimental to the cause of bankers and wanted a middle path of social control of banks. In early 1967, Desai appointed a one-man committee under Dr VA Pai Panandiker to study the prospects of social control of banks.  Panandiker’s report pointed that banks were not channeling their credit to priority sectors, some of the banks had businesspersons on the Board who directed funds towards their large industries and RBI had little authority over lending operations of banks. RBI presented its defense against these criticisms but cast was laid for social control of banks.

Based on the report, Desai was convinced that social control will achieve the objective of channeling the credit to priority sectors and nationalization would not be needed. In a later speech, Panadiker discussed how the report took him to banks in South Canara partcularly Syndicate Bank who were basically giving credit to priority sectors without much ado. On hearing their story, Mr Desai had quipped to other bankers in the meeting room: “if Syndicate Bank can do it, why can’t you?”

By Dec-1967, the policy of social control of banks was ready. Under social control, the task of planning of credit was given to a new body named National Credit Council (NCC) which obviously frustrated RBI as its powers were diluted. However, in order to balance powers, RBI was given wider powers to appoint and dismiss Directors of the commercial banks.

The NCC was constituted on 1-Feb-1968 and was based on a similar institution in France. The main function of NCC was to be like a Planning Commission for finance where it was supposed to assess the credit demand from various sectors and allocate the same with priority sectors getting preference over others. In the first meeting of NCC on 16-Mar-1968, eminent economist D.R. Gadgil made a case for priority sector. He said that despite the progress made in equating resources across a highly unequal society, “the basic inequality is still large”. The main objective of social control “would appear to be that of more evenly spreading available credit over different areas and categories and relatively lowering the cost of credit to small operators.” In a later report in Oct-1968, Gadgil added that modern banking had evolved catering to needs of commerce and trade and thus it “had a pronounced urban orientation in their development and did not encompass the rural areas to any significant extent”.

The NCC had advocated that banks should allocate 15% of their deposits towards agriculture and 31% towards small-scale industry. There was confusion whether these targets were on absolute or incremental deposits.

However, the social control experiment could barely last for 1.5 years as PM Indira Gandhi nationalized 14 major banks in July-1969 undoing all the efforts of Morarji Desai. Post-nationalisation, Priority Sector policy got wings. After all, increased lending to priority sectors was one of the key goals of Nationalisation. In her radio broadcast, PM Gandhi listed five objectives of nationalization with one them being “provision of adequate credit for agriculture, small industry and exports”.

1970s: PSL gets defined

Banks became an instrument for reduction in inequality and lower concentration of economic power. The higher lending to priority sectors also involved higher risks for the banking system. This was mitigated by setting up of Credit Guarantee Corporation in 1971 which guaranteed against defaults from such loans.

In 1972, Priority sector was defined and in 1974, the government advised that priority sector loans should constitute 33% of total loans by public sector banks by next five years which also coincided with the fifth plan period.  The government asked banks to adopt another target of achieving credit–deposit ratio of 60% in rural and semi-urban branches separately to ensure deposits from rural are not siphoned to urban areas. In 1979, these targets were applied to private sector banks as well.  As a result of this policy push, the share of priority sector loans increased from 15% of advances in 1969 to 25% in 1974 and 33% by 1979. In the 1970s, government also pushed lead bank scheme and regional rural banks which also pushed priority sector lending seperately. RBI’s inspecting officers were also asked to assess how sincere banks were in giving loans to the priority sector.

1980s: PSL Problems

In 1980, the priority sector target was raised to 40% of total advances to be achieved by 1985. It was also decided that of this 40%, 16% of the target be reserved for agriculture sector alone.  In 1982, NABARD was established to further give thrust to rural lending. In 1985, Chakrabarti committee noted that multiple concessional interest rates were impeding monetary transmission. The committee recommended just two interest rates: a basic rate and another one lower than basic rate. The banks continued to lend to priority sectors and by 1989 share of priority sector in advances was 44.6% higher than the prescribed target of 40%. This along with loan melas and all kinds of reckless lending had broken the banking system completely with return on assets at nearly 0% by the end of 1980s.

1990s: PSL streamlined during reforms

Post-1991 crisis, Narasimham Committtee recommended that the priority sector be redefined and credit target for this redefined priority sector should henceforth be fixed at 10% of aggregate credit. The sectors which would be excluded from newly defined priority sector would get refinancing window from RBI. However, RBI disagreed with this recommendation and said that that such a drastic cut-off would lead to shortage of resources for the erstwhile priority sector. Moreover, refinance facility from RBI will lead to creation of reserve money and fuel inflation. Thus, it was decided to keep PSL at 40%. The concessional finance was only available for loans less than Rs 2 lakhs and banks were free to charge interest rates linked to Prime Lending rate. In 1993, foreign banks which were out of purview of priority lending were now included and given a lower target of 32%. By the eight plan (1992-97), share of PSL in credit was 41.7%.

Despite years of pushing and nudging, some public and private banks could not achieve PSL targets. In 1995, Rural Infrastructure Development Fund was established where such shortfalls were parked

In 1998, Narasimham Committee II suggested to keep 10% of PSL towards weaker sections which includes all small and marginal farmers, all IRDP and DRI borrowers, borrowers under SUME. It also suggested to remove all interest rate ceilings including for loans under Rs 2 lakhs. RBI had acceded to both these recommendations and announced gradual  deregulation of interest rates in PSL.

2000s: Several Committees relook at PSL

In early 2000s definition of SSI was broadened and with it scope of PSL also increased. The banks loans to NBFCs which in turn were given to SSI were also included in PSL.

The period of 2008-14 also saw spate of committees which made recommendations on PSL. The first was Raghuram Rajan Committee on Financial Sector Reforms (2008) which suggested that entities which give PSL should be given PSL Certificates which could then be traded and bought by entities which have been deficient in PSL. This would enable the most efficient PSL player to participate aggressively in this sector while allowing the inefficient lenders to achieve their PSL mandates.

In 2012, a Committee was appointed by RBI (chair: MV Nair) to review the PSL norms. The Committee noted that despite years of policy push, small and marginal farmers which form more than 80% of total farmer households in the country are not covered by formal financial channels. The Committee retained the aggregate 40% target for PSL but changed the within categories: 18% towards agriculture of which 9% to small and marginal farmers, 7% towards micro enterprises, 10% towards weaker sections and 5% towards NBFCs who in turn lend to NBFCs.

In 2014, Nachiket Mor Committee on Comprehensive Financial Services for Small Businesses and Low Income Households recommended increasing PSL to Adjusted PSL of 50%. It pointed that public sector banks are better at meeting agricultural PSL targets where as private banks do better at MSME targets. The banks could achieve their APSL targets by concentrated origination in a sector of their choice or through market purchases of qualified assets. There is also huge regional disparity as Southern India received 37.6% of agricultural credit which only for 18.7% of India‘s gross cropped area. On the other hand, Central India received only 13.2% of agricultural credit with 27.2% of gross cropped area. It suggested giving higher weights to regions getting lower PSL credit and lower weights to those getting higher PSL credit.

In 2015, RBI formed an internal working group to review PSL guidelines (chair: Lily Vadera). The Group broadened the categories of PSL to include housing, education, renewable energy and social infrastructure (school, water, sanitation etc.). The Group also suggested that foreign banks with 20 or more branches to have similar targets. The group also recommended that the various loan limits, targets and sub-targets should be reviewed once in three years. The lending to agriculture sector was re-defined to include (i) Farm Credit (ii) Agriculture Infrastructure and (iii) Ancillary activities. Idea of PSL certificates was revisited and RBI finally introduced them in 2016 in four categories: General, Agriculture, Small and Marginal Farmers (SMF) and micro-enterprises. By Mar-2019, nearly Rs 3.27 lakh PLCs were traded of which General and SMF comprised nearly 75% of the total volumes.

The Group also revised the targets which were accepted by RBI and continue till today.

PSL by Banks (As on Mar-2019)
  Target Public Sector Banks Private Sector Banks Foreign banks
Overall PSL Target 40% 42.6 42.5 43.4
   Agriculture 18% 18.1 16.3 20.1
       Of which Small and Marginal Farmer 8% 8.8 6.9 9
   Micro enterprises 7.5% 7.3 7.9 8.4
   Weaker Sections 10% 11.7 10.6 11.6
Source: RBI’s Trend and Progress of Banking in India

In the latest guidelines, RBI has gone ahead with Mor Committee recommendations by reducing regional disparities PSL, giving higher weightage to districts with lower PSL. The new PSL guidelines has also doubled credit targets for renewable energy and health infrastructure under Aayushmann Bharat. There are new categories under PSL namely installing of solar power plants for solarisation of grid connected agriculture pumps, setting up Compressed Bio Gas plants and establishing start-ups.

Conclusion

This evolution of PSL has been a long and winding journey and is integrally connected to political economy of Indian banking over last 60 years. PSL started as an informal idea to push lending to neglected sectors but quickly transformed to a formal policy which has gone through multiple changes and tribulations. PSL is often criticized for poor performance of banking sector especially public sector banks. However, it is interesting to note that the PSL-NPAs have averaged around 2% to 2.5% of total advances whereas non-priority sector NPAs have averaged 7% to 9%. Infact the bigger criticism of PSL is that despite many decades, it has continued to underserve the priority sectors. With increased usage of technology in banking, one is hopeful that PSL reaches the last mile and serves the purpose for which it was conceptualized.

Amol Agrawal
I am currently pursuing my PhD in economics. I have work-ex of nearly 10 years with most of those years spent figuring economic research in Mumbai’s financial sector.

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