In line with its recent credo of easing regulatory curbs on credit, the Reserve Bank of India (RBI) has proposed a significant relaxation in its rules governing small finance banks (SFBs). Beginning this financial year, SFBs will be required to meet a priority sector lending (PSL) target of only 60 per cent compared to the 75 per cent in place until last year. As with other classes of banks, small finance banks must continue to extend 40 per cent of their net credit to agriculture, micro enterprises, weaker sections, affordable housing, renewables and other designated priority sectors.

Earlier they were required to earmark an additional 35 per cent towards any one of these segments — this has now been reduced to 20 per cent. This relaxation may not materially hurt credit flow to the targeted sectors as SFBs account for less than 5 per cent of outstanding priority sector credit from scheduled commercial banks. SFBs have been exceeding their PSL mandates and can now take up such lending based on commercial logic. The relaxation of PSL norms for SFBs is positive on three counts. For one, with 15 per cent of their available credit now released from PSL obligations, SFBs can now pursue more diversified lending opportunities, reducing loan book concentration. Rising stress in microfinance loans for instance, has been a key concern for SFBs lately. The relaxed PSL quota would allow them to prune microfinance exposure and step up lending to secured segments such as affordable housing loans, loans against property or gold loans.

Two, with 40 per cent (25 per cent earlier) of their credit flow now freed up, SFBs can flexibly switch between their traditional lending segments and newer ones like retail loans to the salaried, and expand their presence in markets where there are deposit-taking opportunities. Three and most important, a diversified loan book will smoothen the transition of established SFBs into mainstream banks. While RBI has allowed SFBs to apply for universal banking licences, very few of them have taken up the option with their concentrated exposures acting as an impediment. Given the snail’s pace at which RBI has handed out new universal bank licences in recent years, SFBs converting to universal banks can inject much-needed competition into the banking sector. The 60 per cent PSL mandate also aligns SFB lending mandates with UCBs (urban co-operative banks) reducing the regulatory arbitrage between the two types of banks.

For a while now, RBI has been trying to push the lightly regulated UCBs with high failure rates to apply for SFB licences. So far, the higher PSL norm apart from tighter prudential norms on capital adequacy and accounting have proved a deterrent. In recent years, RBI has had to make one too many tweaks to its PSL quotas and definitions to keep up with evolving credit markets. Micro-management of credit flow impedes loan availability to deserving borrowers, while promoting lazy banking.

Published on June 25, 2025