It has the potential to increase efficiency in banking without sacrificing on larger inclusion and equity goals
A bee-keeping farmer can be given Rs.2 crore in loans but a paddy farmer can only get Rs.50 lakh. For buying a home in a town with a population of more than a million, exactly Rs.28 lakh as a home loan is allowed but only if the overall cost of the house is less than Rs.35 lakh. Rs.10 lakh in an education loan or the same amount to install a solar panel in a home will also qualify.
Bankers in India have to contend with 20 pages of such rules and restrictions on a daily basis. These form the basis for “priority sector lending”, or PSL, norms laid out by the Reserve Bank of India (RBI) as a diktat for all banks in the country. Directed lending through a PSL framework has been in existence since the 1970s in India. All banks in India have to lend up to 40% of their total loan book in eight defined priority sector categories with a quota for each category and subcategory. Interest rates for loans to these sectors are as per RBI’s directives.
To be sure, India is not the only country to have such directed lending norms, but the baffling complexity of the rules is perhaps unique. For all its pretensions about being a glamorous profession, 40% of all banking in India is merely about wading through these maze of rules. It is not hard to fathom how lending to bee farmers in Ludhiana needs a somewhat different skill set than lending to, say, airline entrepreneurs in Bengaluru! Yet, much to their chagrin, every bank in India is forced to be versatile in order to comply with PSL regulations.
Thankfully for bankers, all this is about to change. RBI issued a notification on 7 April permitting the issue and trading of PSL certificates. This means that bank A which has a comparative advantage in, say, bee-farming loans and is required to lend, say, Rs.50 crore as per its PSL guidelines, can now lend Rs.100 crore to bee farmers. It can then sell the extra Rs.50 crore as PSL certificates to banks B and C that have to meet their quota of such loans but don’t have the skills to do so.
More importantly, banks B and C will not be responsible for a sudden downturn in honey demand in the country that will impact the recovery of these loans. That is entirely bank A’s responsibility. In effect, the larger social objective of loans to priority sectors and weaker sections of society will be met without burdening each bank with the specific responsibility of doing so. There is a certain laudable, Ricardian elegance to this initiative of the central bank.
I am certain that RBI is wary of unintended consequences of the creation of such new markets and will be watchful. The introduction of currency derivatives by RBI in 2008 has not lived up to its original intent. Exchanges today serve more as a platform for small currency speculators than for genuine hedging requirements.
In the PSL certificate market as conceived by RBI, the buyer of these certificates has almost no downside risk. The buyer does not carry the risk of the loan nor is its capital blocked for the loan amount. The pay-off matrix for the buyer will now be: cost of PSL lending versus penalty of non-compliance versus purchase cost of the certificate.
Given this skewed balance, with risk loaded on the seller and virtually riskless for the buyer, there is a likelihood of adverse selection. Those banks that wish to be large sellers in this market are perhaps the ones that RBI should be cautious about to begin with. It is conceivable that, at least in certain categories, there will be more buyers than sellers of these PSL certificates.
For example, one systemic risk can be that bank A, with its unique skill set for bee-farming loans, has a perverse incentive to dole out far greater such loans than is prudent, in order to maximize its fee income by selling these extra bee-farming loan certificates. Specifying position limits on individual banks to trade in PSL certificates can be one solution if this becomes an identified risk.
RBI has also allowed “margin trading”—i.e., bank A can now sell bee-farming loan certificates to other banks even without actually making these loans, up to a certain limit. It is understandable that RBI has allowed this to promote liquidity in the PSL certificate market and appropriate precautions have also been taken in terms of quarterly limits.
Care is to be taken to not spawn a buccaneering culture among bankers chasing fee income through excessive focus on PSL trading. It appears that RBI has not permitted secondary trading of these PSL certificates among banks, which is perhaps a good thing to begin with.
RBI has also indicated a quarterly review of PSL compliance of banks vis-à-vis an annual review. This will certainly serve as early warning signals for any PSL certificate market malfunction.
RBI’s move on PSL certificates is an extremely innovative initiative, and one that was long pending—it was first mooted in the Raghuram Rajan committee report of 2008. It has the potential to usher in large efficiencies in Indian banking, without sacrificing on any of the larger inclusion and equity goals. This piece is merely to highlight some warning signs from recent experiences of creating new markets in India that have often resulted in a case of unintended consequences of perverse incentive behaviour by market participants.
Published on 22 April, 2016 in Mint