Directed credit: Our response to Nair Committee

By Deepti George, IFMR Finance Foundation

The Committee to Re-examine the Existing Classification and Suggest Revised Guidelines with regard to Priority Sector Lending Classification and related Issues chaired by Shri. M.V. Nair (the Nair Committee) recently submitted its recommendations. Our principal observation on the Report is vis-à-vis the role of non-bank intermediaries in the achievement of priority sector policy objectives. In addition to that, we make some minor observations on biases inherent in the definition and implementation of priority sector rules. The full response is attached here.

Strong Bias towards Direct Origination/Intermediation by Banks

One of the important terms of reference of the Committee was to “consider if bank lending via financial intermediaries for eligible categories of borrowers and activities could be classified under the priority sector and if so, to lay down the conditions subject to which this classification would be admissible.” The background to this is an increasing anxiety about the growth of specialised lenders like Micro Finance Institutions (MFI) and gold loan companies fuelled by access to priority sector funding from Banks. In fact, with effect from April 1, 2011, lending through intermediaries is not considered as priority sector lending.

The Committee recommends that:
“Keeping in view the role of non-bank financial intermediaries like Primary Agricultural Cooperative Societies (PACS), Cooperative Banks, NBFCs, HFCs and MFIs in extending the financial services to the last mile, bank loan sanctioned to non-bank financial intermediaries for on-lending to specified segments may be reckoned for classification under priority sector, up to a maximum of 5 per cent of Adjusted Net Bank Credit (ANBC), subject to adherence to the terms and conditions stipulated…”

Elsewhere in the report, the Committee also states that:

“The ultimate objective for banks is to create last mile connectivity through either opening branches or BCS in a defined time manner. Therefore, it is desirable to phase out in a time bound manner the intermediary channel that banks use for reaching out to diverse priority sector segments”

While the Committee’s position on intermediaries is more flexible than current norms, it reinforces the policy direction of strongly disincentivising banks from partnering with specialised originators/intermediaries such as NBFCs while nudging banks to open their own branches and originate through their own staff or agents, despite all the issues noted with this approach elsewhere in the report including sharply rising NPAs. With only 30% of the commercial bank branches being in rural areas and with only 61% of the country’s population having bank accounts despite decades of efforts by the banking sector, there is strong reason to question an exclusive reliance on bank-led approaches. In its report, The Raghuram Rajan Committee says: “The focus should be on actually increasing access to services for the poor regardless of the channel or institution that does this—large banks may or may not be the best way to reach the poor, and while the mandate may initially force them to pay for expanding access, others may be able to offer the service more efficiently”.

This is also a systemically riskier approach. For example, when a bank directly provides farm loans on its balance sheet, it is protected merely by its own capital against potential losses. On the other hand, when a bank lends to a specialised financial intermediary who then provides farm loans on its balance sheet, the bank is buffered by the capital of the intermediary to some extent. By phasing out non-bank financial intermediaries, this additional layer of capital protection for priority sector lending will disappear, thus transferring more risk directly to balance sheets of banks. This in turn will translate into higher capital infusion commitments by the Government into state-owned banks or alternately creating fiscal mechanisms such as the Credit Guarantee Fund, as envisaged by the Committee for lending to small and marginal farmers.

This has systemic consequences. We need more institutional heterogeneity in the Indian financial system and room to innovate without directly putting depositor money and fiscal resources at risk, as implied by pure bank-led approaches. This then implies the urgent need for the growth of non-deposit taking institutions that have the expertise and capitalisation to operate in specialised markets and robust partnerships between these institutions and the banking sector.

Policy must focus on outcomes and be agnostic to the different routes in which it can be achieved or the nature of institutions involved. For example, if the outcome of interest is increasing access to crop loans for small farmers, it should not matter whether this loan was provided by a bank, a non-bank or a cooperative, everything else being equal. The only criteria to determine whether an asset must qualify for priority sector is if the underlying purpose of the loan is consistent with the stated goals of priority sector policy. This implies that if the crop loan is seen as fulfilling policy objectives, there must be no distinction made between a crop loan advanced directly by a bank or a crop loan advanced by a non-bank using wholesale funding from a bank. Making this distinction admits of lack of competitive neutrality. Conversely, if a gold loan is viewed to be not welfare-enhancing, it must not be accommodated in the priority sector framework at all, irrespective of whether the gold loan is advanced by a bank or a non-bank. Current policy places too much onus on the channel, rather than the ultimate outcome.

  • anuj

    well said and analysed! In your own assessement, are there political compulsions and considerations that continue to treat ‘Banks’ as the ultimate solutions for financial inclusion in a vast country like India? Also, does this also affect the lending to SHGs and Federations, which in essence, are also intermidiary, though of different nature?
    Great to see this comentary, thanks,

  • S Santhanam

    On 07 April 2012, in an interview to CNBC, Mr Vijay Mahajan of Basix mentioned that credit for the poor comes as the fourth item of priority. First comes the safe keeping of money, second comes housing, third comes insurance and fourth comes credit.  This fourth item in the line of priority  is provided by the MFIs. So, this is the least one needed for the poor and priority sector loans are not only for poor but also for others. This is one situation. Banks, particularly, the new generation banks have innovative ways of increasing their priority sector lending portfolio thro’ structured financing of loans to  MFIs. From the recommendation of the Nair Committee for considering loans to MFIs as part of PSL one gets a feeling that the particular TOR of the committee was created to come with a positive recommendation and used the committee to give a stamp of approval. If we look at the history of PSL which came after the social control of  private banks followed by nationalisation of the first batch of banks, one can find that there was genuineness in RBI’s action to make the banks to do that social banking. But, somewhere down the line, various sub-sectors were added and virtually the PSL was diluted so much. Still, banks do not respond positively. Even assuming that banks are allowed to take credit for PSL for financing to MFIs, what is the guarantee that they will fulfill the PSL target. What are we trying to achieve through PSL? Are we keen to achieve the target or are we keen to ensure that adequate credit goes to such vulnerable sections and sectors? It looks that all efforts are to see that somehow the targets under PSL are achieved and not the concern for ensuring credit to reach such sectors which need funds. Banks are prepared to convert a part of their loans to King Fisher airlines (which is now over Rs.6000 cr +) in to equity at a superficially hiked price of Rs.60+ per share which is quoting now at <Rs.20 a share thus lost 66% of their debt (which is depositors' money) not to speak of interest loss on the debt conversion. With higher debt on account of KFA, the govt had to infuse more capital to these banks. Still, no lessons learnt. But, when it comes to financing a needy sector we are talking of capital erosion. Let us stop talking semantics.

  • Bhuvarahans

    That is a good article.  NBFCs are being put to the mat instead of taking them as part of the efforts in reaching the unreached !. All the commercial banks are giving crop loans as Agriculture Jewel Loans (Reak KCC card holders are not even 5% of the Agri Jewel Loan accounts) and RBI is not the least bothered about this.  RRBs are virtually Gold Banks on par with Muthoot or Manappuram.  But RBI is not perturbed.  Now RBI has cracked the whip by bringing all the NBFC Gold Loans on par with commercial banks by putting a limit of 60% of value.  RBI is not the least bothered about the small number of KCC holders when compared to the Agri Jewel Loan Accounts in the Commercial Banks that it monitors.  Now Commercial Banks are on par with NBFCs and the Govt. banks can go ahead with increasing their AJL portfolio.  Great idea by RBI

  • suranbs

    Cannot understand ! There is mismatch in understanding, what intermediary are we talking off? There are already many institutions which are affiliated and serve as intermediaries to banks, hope the author is aware of such non-mF institutions and weekly collectors ? how can a MFI provide KCC like product ? if its a seasonal loan when repayments come in after harvest ? do they provide pledge loans ? key loans ?

    To the G man who said there are more gold loan than KCC, would suggest him to visit 20 branches of rural or Semi urban branches and take a look at the loan portfolio and see for himself ? who say the no. Of branches is 16,000 only , did u forget to count semiurban branches which serves pop
    above a low limit ?

    All writings continue to be institution focused and not client centric ….god bless!


  • Ganesh Narayanan

    In my last 10 years of experience in handling rural markets, i feel that both banks and NBFC’s have a significant role in enabling financial services in rural India. The best results are seen when both entitities compliment each other and work towards a common goal. With increased involvement of both parties to ensure that fair practices are followed, adequate information is captured, required precautions are taken to ensure that right type of loans are classified as priority sector and enough documentary evidence is collected to support the claim can go a long way to repose faith in the system that extending financial services through intermediaries is the right thing. We have enough and more proof already to confirm that NBFC’s have a better risk apettite and required skills at the right cost to scale up the rural financial services initiative. We are seeing a few new NBFCs trying this approach in the recent times and i am very hopeful that these initiatives will see scale and sustainable success.