One size will not fit all

The Reserve Bank of India’s committee on comprehensive financial services for small businesses and low income households, headed by RBI’s central board member Nachiket Mor, has suggested that priority sector lending (PSL) by banks be raised to 50 per cent, against the current 40 per cent.

To achieve this, the committee has recommended assigning weights to districts and sectors on the basis of constraints faced in reaching them, and that banks must extend credit to these district-sector combinations, keeping the associated weights into account, to meet the 50 per cent target.

The committee has further suggested broadening the scope of PSL: treating loans extended to small and marginal farmers and landless labourers; banks’ investments in institutional bonds and guarantees; equity investments in infrastructure such as godowns and silos; and so on.

In addition, the committee has suggested giving freedom to banks to use relatively risk-free trade in PSL certificates to meet targets.

Helpful suggestions These suggestions, when accepted by the RBI and implemented properly, may help small and marginal farmers get out of the clutches of moneylenders and simultaneously provide some cushion to banks in deciding their priority lending portfolio. A pertinent question now is will private and foreign banks also be required to meet the increased PSL target?

According to the guidelines revised by the RBI in 2012, all public and private banks, and foreign banks with 20 and more branches, have to lend 40 per cent of their adjusted net bank credit to six priority sectors defined by the central bank.

Going by this, it appears that PSL lending of 50 per cent will have to be followed by private and foreign banks (with 20 branches or more) also.

The question then is, will such a move be efficient for private and foreign banks which have different business models and objectives and have no provisions of capital infusion by the government to cushion against non-performing assets (NPAs), unlike public sector banks (PSBs)?

Recent study A recent study by Nathan Economic Consulting India submitted to the British High Commission as part of its prosperity fund has concluded that mandating all kinds of banks, public, private and foreign, to extend PSL to specific sectors such as agriculture and related activities may not yield efficient results for the banking industry and the economy as a whole.

The study has suggested that increasing credit availability in the export sector as also in micro and small enterprises (MSEs) can actually boost the economy.

The findings The study focused on three of the six priority sectors defined by the RBI — agriculture, export and MSE.

It reveals that a 100 per cent increase in PSL to the export sector increases export GDP by 76 per cent.

The same increase in PSL to the MSE sector increases manufacturing GDP by 41 per cent. However, in the case of agriculture, a 100 per cent increase in PSL increases agricultural GDP only by 11 per cent due to factors such as dependence on the monsoon and excessive land fragmentation. This indicates that the export and MSE sectors offer better buoyancy to PSL.

The study has also found that the cost of lending to priority sectors is higher compared to non-priority sectors.

Two separate regressions, using PSL loans and NPAs from PSL in the first regression and non-PSL loans and non-PSL NPAs in the second regression respectively showed that a 1 per cent increase in PSL lending leads to a 0.22 per cent increase in NPAs in priority sectors.

A 1 per cent increase in non-PSL loans leads to a 0.17 per cent increase in NPAs in the non-PSL category.

This indicates that the cost that PSL loans impose on banks in the form of NPAs is higher compared with loans extended in the nonpriority sectors.

Learning from the experience of countries such as Korea, Japan, China, Brazil and Thailand, the study further highlighted that directed lending programmes might not always be the most efficient way of making finance available to certain sectors, because of the high costs of implementing such programmes.

The consequence In the absence of provisions for capital infusion in private and foreign banks, continuous increase in PSL targets (from 32 per cent to 40-50 per cent for foreign banks) can prove detrimental to the bottomlines of these banks.

Since the RBI has shown its inclination to provide operational flexibility to private and foreign banks through a more liberalised policy, besides relying on them for better efficiency in the sector, should stringent PSL norms be imposed upon them?

According to the discussion paper, ‘Banking Structure in India: The Way Forward’, published by the RBI in August 2013, revenues from wholesale banking, dominated by foreign banks and ‘new generation private banks’ are expected to double by 2015 compared to what they were in 2010.

According to the paper, wholesale banking revenues in India account for around 30 per cent of total banking revenues and are pegged to double from around $16 billion in 2010 to over $35 billion by 2015.

The paper also highlights that foreign banks’ participation is significant in increasing competition and introducing sophisticated financial services and risk management methodologies in the Indian banking system.

Their expectations, in turn, are governed by profits and opportunities in host countries.

Setting targets for these banks to lend to sectors such as agriculture is, therefore, not efficient.

Rather, their strengths — sophisticated products and sourcing foreign capital — should be utilised to propel the growth of the economy, more so, when foreign banks have far lower concentration in rural areas.

As of May 2013, out of the 333 branches of 43 foreign banks, 331 were in urban and metropolitan areas.

(Singh is Principal Economist and Jain is Senior Economist, Nathan Economic Consulting India. The views are personal.)

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