How to lend more to the poor

Why should India’s largest banks fall short of their priority sector lending targets? By law they are required to lend 40% of their net credit to the priority sector. Even the State Bank of India fell short of its target in 2005-06. As a group, the public-sector banks failed to meet the sub-targets for agriculture and weaker sections in that year. None of the private-sector banks (barring Ganesh Bank of Kurundwad) met the subtargets for agriculture and weaker sections either.

Have some people, who ought to have got credit at a reasonable interest rate, been denied it? While farmer suicides are an extreme manifestation of the problem of inadequate priority-sector lending, there must be millions of our fellow citizens who are condemned to misery due to acts of omission.

The question is: Do we reward banks for lending to the priority sector? This article is an attempt to suggest a way in which lending to the priority sector is possible, with returns commensurate with the risks associated with it. Banks should exceed targets by design, and not by chance!

We first need to appreciate that different entities have different core competencies. Logically, a bank should work in an area where it has a clear comparative advantage. Consider a case where there are two assets: ‘X’ is a part of an agricultural lending portfolio while ‘Y’ is in trade finance.

Let’s assume that their values are perfectly correlated. In other words, their risk-return profiles are identical. Even in such a case, a bank that has a comparative advantage in trade finance (that is, a comparative advantage in origination and servicing of assets in this area) should create assets like ‘Y’, and not ‘X’, if agricultural lending is not where it has a comparative advantage.

How can this be done? The solution lies in letting the banks that are lending to the priority sector earn a return commensurate with the risk associated with it, while those opting to stay away from it incur a cost for the discharge of this social obligation.

The banking system as a whole can efficiently (and even profitably) meet its priority-sector target (whatsoever is deemed fit by the stakeholders: 35%, 40% or even 45% of net bank credit), thereby discharging the social obligation to all stakeholders in a manner which utilizes financial and human capital optimally.

One way to do this is through social credits, which I shall now explain.

What are social credits? Banks with a comparative advantage in lending to the priority sector should earn social credits while those falling short of the target would be required to buy social credits.

Banks would then find it profitable (commensurate with the risks borne) to lend to the priority sector. Banks would like to capitalize on their core competency and, more importantly, enhance their competency (or build it from scratch). They will also have an incentive to improve the quality of human capital.

Here is a detailed plan on how tradable social credits can be designed for the Indian banking system. About Rs100 of credit could correspond to one social credit. These credits would be priced by the market. The basic framework for pricing social credits would incorporate the risk-free rate, default rate and cost of operations. It is essential that each bank’s data on default rates on different sub-portfolios in priority-sector lending is released on a regular (say, quarterly) basis.

The number of credits earned should be determined by the outstanding balance of the priority-sector portfolio in the previous year and they should expire one year later. A social credit without expiry cannot correspond to the additional return (to the seller) for the risk taken, as the risk exposure is for a definite period of time i.e. the tenor of the loan. Besides, the ‘Time Value of Money’ concept dictates that credits of today and some years hence are unequal. Social credits may be used in conjunction with Inter Bank Participation Certificates or securitization of priority-sector lending portfolios. To deal with sub-targets, we could have a few types of social credits: For agriculture, small-scale industries and the weaker sections.

A forward market for social credits will help banks to focus and plan better.

It will help serve customers better, as an enabling environment, which has incentives for developing new delivery models, would exist. The objective is not to replace the moneylender for ‘replacement’ sake, but outperform the moneylender by meeting the needs of the customer better.

If it is inevitable to have subsidies to make priority-sector lending viable, then the government can intervene by buying the social credits in the market this would push up the price. The subsidy should be for those who need it and not for funding the inefficiencies of a bank.

The carrot should be flanked by the stick. We could impose large monetary fines and/or partially revoke banking licences if a bank does not reach its targets.

When the price of a social credit is close to zero consistently, then we know that targets are not needed!

A.M. Godbole is an executive assistant, A.V. Rajwade & Co. These are his personal views. Your comments are welcome at theirview@livemint.com