Banks & Priority Sector Lending

As we know the commercial banks have to meet the RBI guidelines of 40% net advances of their Adjusted Net Bank Credit to the priority sectors. In case you are wondering what all sectors come under this ‘priority’ list they are- advances for agricultural sector, small & micro enterprises, retail trade, education, housing, Differential rate of interest scheme (there are various sub-targets apart from this overall 40% as well, but we won’t get into those details now). In case a bank fails to meet these targets they face penalty which is- Contribution by banks to Rural Infrastructure Development Fund (RIDF) or Funds with other Financial Institutions, as specified by the Reserve Bank. The term, interest and size of such deposits are dictated by the central bank from time to time. In logical conclusion the returns from such deposits are not favorable for the banks and so they try to avoid it, you will see banks going on PSL spree in the last quarter of the year trying to close down the gap.

So the question is why do banks have to struggle to meet these targets & sub-targets, why don’t they lend enough to these sectors themselves??

The Raghuram report on financial reforms identifies the reasons as-

“Interest rate ceilings (either imposed by the centre or the state) make priority sector lending unprofitable, and ensure that the banker attempts to recover his money through hidden charges in the loans that are made, or that he does not lend so the poor are driven to the moneylender. The Committee believes a better way to proceed is to liberalize interest rates while increasing safeguards that prevent exploitation.”

The committee goes further to recommend

–          Liberalization of interest rates charged on these PSL to ensure that the credit reaches the poor.

It also suggests having a system in place, to ensure-

–          Lenders disclose the total cost being charged on such advances

–          Periodic public disclosure of maximum and average interest rates charged by the lenders.

–          Only loans that stay within a margin of local estimated costs of lending to the poor be eligible for PSLCs.