Srikanth Vadlamani, Vice President - Senior Analyst, Moody's Investors ServiceLast Tuesday, a panel advising the Reserve Bank of India (RBI), the country's central bank, released recommendations to improve financial access to under-banked segments in India and tackle regulatory inefficiencies in the so-called priority-sector lending (PSL). Deregulating interest rates on PSL loans so that banks have the flexibility to price risk as they deem appropriate is one of the key recommendations in the report and is credit positive for India's banks, all of which are mandated to allocate 40% of their loans to PSL. Public-sector banks especially would benefit from the reforms because they historically have much higher nonperforming ratios in their PSL loan portfolios than private-sector banks.
Banks must lend to the PSL segment, three quarters of which is agriculture and micro and small enterprises. Because interest rates are capped, banks cannot always charge an interest rate in line with the riskiness of the borrower.
Additionally, the government has historically granted loan waivers or other forms of relief to agricultural-sector borrowers, resulting in the moral hazard that even borrowers who could afford to service their loans would sometimes opt to wait for relief instead. As a result, Indian banks' priority-sector lending has had a higher ratio of nonperforming assets (NPAs) to total assets than loans overall.
Although we believe that the probability of full implementation of the recommendations is low because of political resistance, nevertheless the report increases the probability of some reform.
If policy distortions were removed, we believe agricultural and other PSL segments would be an attractive sector for certain banks that have the capability to profitably originate such loans. The proposals include measures to improve banks' access to PSL borrowers since some banks currently find it difficult to meet the 40% PSL loan origination requirement. These proposals also include allowing bonds or pass-through certificates to be classified as part of the banking book based upon the declared intent (and hence could qualify as PSL), restoring tax benefits to securitization and allowing investments in bonds of banks focused on PSL.
The panel also recommends that the government directly grant relief to borrowers instead of using banks as a channel to do so. For risk management, the panel proposes making it mandatory for banks to share data on their PSL borrowers with the central credit bureau.
Overall, the recommendations in the report, if fully implemented, would be a significant credit positive overhaul of the Indian banking system. The key issue, of course, is its implementation, since some of these issues are politically controversial. However, we believe that these recommendations fit very well with the general direction of banking reforms that RBI Governor Raghuram Rajan has been articulating since he took office in September 2013.
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