Praveen Chakravarty  writes in Mint that priority sector lending "has the potential to increase efficiency in banking without sacrificing on larger inclusion and equity goals".

Excerpts below:

"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...

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... 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...

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...

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...

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..."