Priority sector lending (PSL) is one way to channel credit to sectors otherwise neglected by institutional lenders but is it worth it? This study by Nathan India evaluates the impact of PSL on India’s banks and agriculture, micro and small enterprise, and export sectors, and examines new guidelines from the Reserve Bank of India.

Major findings:

• Experience suggests that PSL programs are costly and not efficient in directing credit.
• From 2011 to 2012, the compound annual growth rate for PSL to the agriculture sector in India increased 25 percent, to small enterprises 23 percent, and to exports 20 percent.
• Agriculture does not yield returns commensurate with its supply of preferred credit, mostly because of sector-specific factors like monsoons and fragmentation of land holdings.
• The distinct business models of public sector, private sector, and foreign banks influence their ability to achieve PSL targets.
• PSL is costly for banks relative to returns generated. For small loans, the difference between returns and cost is (-) 27.6 percent for public sector banks, (-) 12.7 percent for private sector banks, and (-) 11.7 percent for foreign banks.
• Computing a bank’s PSL target based on its previous year’s adjusted net bank credit or credit equivalent amount of the off balance sheet exposure is a perverse incentive for banks to hold down overall lending lest they end up raising their PSL targets.

These findings suggest that PSL policy should take into account banks business models and that revitalizing cooperative societies and regional rural banks might be the best way to meet certain credit needs in the long run. In light of this, the study recommends the following:

• Reset PSL targets based on banks’ business models.
• Minimize risk in agriculture by improving rural infrastructure, promoting contract farming, agro processing, and agricultural insurance.
• Use market-driven instruments, such as tradable priority sector lending certificates, to make credit available to priority sectors while preserving the viability of commercial banks.
• Strengthen cooperative banks, regional rural banks, and microfinance institutions for last mile connectivity.
• Develop an extensive credit information system.
• Use technology to reduce the cost of providing credit to priority sectors.