Priority sector lending must reflect India's changing economy

Priority-sector lending (PSL) has long been one of India’s central instruments in financial inclusion. In this regard, a recent working-paper released by the Economic Advisory Council to the Prime Minister (EAC-PM) evaluated whether directed lending still produced meaningful developmental outcomes. The study, based on district-level quarterly data between 2020 and 2025, covering more than 95 per cent of scheduled commercial-bank credit, has pointed to sharp regional imbalances in such lending. Fewer than 10 per cent of districts accounted for over 45 per cent of all priority-sector advances. Credit remains heavily concentrated in relatively developed states and urbanised districts, while large parts of eastern India, the Northeast, and Himalayan regions continue to remain underserved. Importantly, the study also found that the districts with the lowest existing PSL penetration show the weakest economic response to additional lending. In other words, simply pushing more credit into lagging regions may not automatically generate growth when infrastructure, connectivity, and administrative capacity are weak.

 

The findings also reveal significant institutional differences in PSL delivery. During the study period, small finance banks, on average, extended 100 per cent of their adjusted net bank credit (ANBC) directly to priority sectors, while the State Bank of India’s direct PSL exposure remained around 26.5 per cent, with greater reliance on indirect instruments such as “Priority Sector Lending Certificates” (PSLCs). Banks falling short of target also put in money in the Rural Infrastructure Development Fund (RIDF) of the National Bank for Agriculture and Rural Development, which helps support critical infrastructure. Nationalised banks exceeded PSL targets directly, whereas private banks depended more heavily on market-based compliance mechanisms. These facts are not new. Since the M Narasimham Committee in 1991, banking-reform committees have repeatedly argued that rigid directed-credit mandates distort loan allocation, weaken profitability, and burden banks with politically sensitive sectors that often carry higher default risks. The Raghuram Rajan Committee in 2008 pushed for greater flexibility through the introduction of PSLCs, allowing banks to trade PSL obligations rather than fulfil them entirely through direct lending. The logic was simple. Some institutions are better equipped to serve certain segments, and forcing uniform compliance may create inefficiency rather than inclusion.

 

The debate has evolved because the Indian economy has changed. Agriculture still receives 18 per cent of PSL even though its contribution to gross domestic product has fallen. In fact, in 2025-26, micro and small enterprises, for the first time, overtook agriculture as the single-largest component of PSL. Meanwhile, sectors that are central to India’s future growth, including digital infrastructure, green energy, health care, and logistics, remain outside the PSL architecture. The mismatch calls for a periodic recalibration of the framework. The EAC-PM paper does well to point towards a more pragmatic middle path. It recommends strengthening market-based instruments such as PSLCs, allowing banks to specialise in terms of comparative strength, improving district-level targeting, and combining credit expansion with investment in infrastructure and institutional capacity. Clearly, there is a case for reviewing the PSL framework.