Archive for category: Priority sector lending

-Harshita Malik (finserv@vinodkothari.com)

Background

The Reserve Bank of India (RBI) has, after almost five years, updated its Priority Sector Lending (PSL) norms that prescribes the PSL limits for banks. PSL targets ensure an adequate flow of credit from the banking system to sectors of the economy that are crucial for their socio-economic contributions, with a focus on specific segments whose credit needs remain underserved despite being creditworthy. 

On March 24, 2025, the RBI issued Master Directions – Reserve Bank of India (Priority Sector Lending – Targets and Classification) Directions, 2025 (‘New Directions’), in supersession of the 2020 Master Directions of Priority Sector Lending (PSL)- Targets and Classification, prescribing higher loan limits for housing and other loans, expanding eligible purposes for PSL classification, removing the interest rate limits caps in case of securitisation and transfer of loan exposures and including an increased list of eligible borrowers under certain categories. While these measures are expected to help banks achieve their overall targets, the limits and restrictions that persist within sub-categories often require banks to adjust underwriting standards to meet PSL requirements. The revised loan limits offer banks flexibility to address these challenges, while also providing room for growth acceleration.

Effective Date

The New Directions shall come into effect on April 1, 2025 and shall supersede the erstwhile directions on the subject, namely, the Reserve Bank of India (Priority Sector Lending – Targets and Classification) Directions dated September 04, 2020 (‘Erstwhile Directions’).

Further, all loans eligible to be categorised as PSL under the Erstwhile Directions (updated as on March 25, 2025) shall continue to be eligible for such categorisation under the New Directions, till their maturity.

Applicability 

The New Directions are applicable to all commercial banks, Regional Rural Banks (RRBs), Small Finance Banks (SFBs), Local Area Banks (LABs), and Primary (Urban) Co-operative Banks (UCBs), excluding Salary Earners’ Banks. 

Bank-NBFC Partnerships for PSL

Achieving PSL targets has always been an uphill task for banks, especially those without a strong retail branch network. PSL typically involves bite-sized/ small ticket loans to the last mile borrowers that come with borrower proximity, geographical presence, strong operational abilities and tailored recovery strategies, making it less appealing for banks to dive in wholeheartedly.

To add to the predicament, these sectors tend to bear higher risk compared to traditional borrowers, leading to a greater chance of defaults. Delinquencies in the early buckets—0+ and 30+ days past due – increased by approximately 110 basis points (bps) and ~55 bps, respectively, during the first quarter of fiscal 2025 compared to the preceding March quarter¹. This indicates a rising rate of defaults in the microfinance sector, making banks naturally reluctant to adopt the “ekala chalo re” model in priority sector lending.

When banks fall short of meeting their PSL targets, they turn to alternative methods to bridge the gap. One notably effective approach has been partnering with Non-Banking Financial Companies (NBFCs), a strategy that has seen increasing acceptance with most of the banks.

Figure 1: Bank-NBFC Partnership for Priority Sector Lending

When we talk about Bank-NBFC partnership, the same can broadly be undertaken in the following four ways:

1. Banks lending to NBFCs/HFCs for on-lending to priority sector borrowers;
2. securitisation;
3. Transfer of Loan Exposure (‘TLE’); and
4. Co-lending.

Banks Giving Loans to NBFCs or HFCs for On-lending Under the PSL Category

NBFCs have broader customer coverage across priority sectors, particularly in PSL categories such as agriculture and MSMEs. By channeling funds to NBFCs with defined end-use restrictions and lending terms, banks can achieve indirect exposure to the PSL sector. While the on-book exposure remains on the NBFC, the underlying loans are directed towards the priority sectors thereby enabling banks to benefit by fulfilling their PSL target. Bank loans provided to NBFCs/HFCs for on-lending are further classified into the following three categories:

1. Bank loans to MFIs (NBFC-MFIs, Societies, Trusts, etc.)

This category of loans remains unchanged, with the framework detailed as follows:

Attributes	Particulars of the framework
Borrowers	Registered NBFC-MFIs and other MFIs (Societies, Trusts, etc.) that are members of RBI-recognised Self Regulatory Organisation (SRO) for the sector
Eligible underlying loan	Loans eligible for categorization as priority sector advances under respective categories viz., Agriculture, MSME, Social Infrastructure and Others
Purpose of loan	On-lending to individuals and members of SHGs/JLGs
Conditions to be adhered	MFIs to adhere to the conditions prescribed under SBR Master Directions and MFI Master Directions
Cap on quantum of loans	Not specified
Maximum ticket size of underlying loans	Not specified

2. Bank loans to NBFCs (other than MFIs)

This category of loans remains unchanged; however, it has been clarified that the 5% cap on bank credit to NBFCs for on-lending is calculated based on the bank’s total PSL in the previous financial year. Further, compliance with the cap is to be ensured by averaging the eligible portfolio across four quarters of the current financial year. For instance, if the on-lending proportion for a particular quarter is more than 5% and then due to amortisation of the loan pools the same comes to below 5% in the remaining quarters, the limit shall be seen by averaging the exposure across all quarters in a particular financial year. The updated framework is detailed as follows:

Attributes	Particulars of the framework
Borrowers	Registered NBFCs other than MFIs
Eligible underlying loan	Loans eligible for classification as priority sector lending under the respective categories, viz., Agriculture and Micro & Small enterprises
Purpose of loan	On-lending to respective categories of priority sector lending, viz., Agriculture and Micro & Small enterprises
Conditions to be adhered	Banks to maintain disaggregated data of such loans in the portfolio.
Cap on quantum of loans	5% of individual bank’s total priority sector lending of the previous financial year Banks shall determine adherence to the caps prescribed by averaging the eligible portfolio under on-lending mechanism across four quarters of the current financial year.
Maximum ticket size of underlying loans (per borrower)	Agriculture: Upto Rs. 10 lakhs in respect of ‘term lending’ component under this categoryMicro & Small Enterprises: Upto Rs. 20 lakhs

3. Bank loans to HFCs

Under the New Directions, this category of loans has been explicitly designated as part of the ‘Housing’ category with the updated framework detailed as follows:

Attributes	Particulars of the framework
Borrowers	HFCs approved by NHB for refinance.
Eligible underlying loan	Loans eligible for classification as priority sector lending under the ’Housing’ category
Purpose of loan	On-lending for:Purchase, construction, or reconstruction of individual dwelling units.Slum clearance and rehabilitation of slum dwellers
Condition	Banks must maintain borrower-wise details of the underlying loan portfolio
Cap on quantum of loans	5% of individual bank’s total priority sector lending of the previous financial year Banks shall determine adherence to the caps prescribed by averaging the eligible portfolio under on-lending mechanism across four quarters of the current financial year.
Maximum ticket size of underlying loans (per borrower)	Aggregate limit of Rs. 20 lakhs

Securitisation

The New Directions streamline the eligibility criteria by removing interest cap-related provisions. This is a significant change and aligns with the fact that no such lending rates are prescribed by RBI for direct lending exposure by the banks or the NBFCs. Earlier, the RBI had also removed such lending rate restrictions in the case of microfinance loans. The removal of capping would allow originating NBFCs to focus on the other terms of loans and the end use to classify as PSL. 

While the removal of the net interest margin cap allows substantial flexibility to the NBFCs, by way of downside, it may also allow NBFCs to charge higher interest rates to ultimate borrowers. The outlined changes might encourage banks to invest more in Securitisation Notes, as they would have fewer restrictions. However, it could also lead to a shift in focus away from the priority sector’s socio-economic objectives, as higher interest rates might deter borrowers from accessing these loans. 

Further, the general conditions for investments in Securitisation Notes and explicit exclusion of loans against gold jewellery originated by NBFCs have been retained. The New Directions focus solely on ensuring that underlying loan assets are eligible for priority sector classification before securitisation, without the additional conditions that were there in the Erstwhile Directions. 

Now, the investments by banks in ‘Securitisation Notes’ representing loans by banks and financial institutions to various categories of priority sector, except ‘others’ category, are eligible for classification under respective categories of priority sector depending on the underlying assets subject to only the following two conditions:

1. Assets are originated by banks and financial institutions and are eligible to be classified as priority sector advances, prior to their securitisation, and the transaction is in compliance with the RBI Guidelines on ‘securitisation of Standard Assets’ as updated from time to time; and
2. Loans against gold jewellery originated by NBFCs as underlying, are not eligible for priority sector status.

Transfer of Loan Exposures

The New Directions streamline the eligibility criteria for assignment/outright purchase of asset pools by banks, in the same manner as in the case of ‘investments by banks in Securitisation Notes’. 

Now the assignment/outright purchase of the pool of assets by banks representing loans under various priority sector categories, except the ‘others’ category, will be eligible for classification under the respective categories, subject to the following conditions:

1. Assets are originated by banks and financial institutions and are eligible to be classified as priority sector advances prior to the purchase and fulfil the RBI guidelines on ‘Transfer of Loan Exposures’;
2. Banks shall report the outstanding amount actually disbursed to priority sector borrowers and not the premium embedded amount paid to the seller; and
3. Loans against gold jewellery acquired by banks from NBFCs are not eligible for priority sector status.

Co-lending

Banks collaborate with other financial entities through lending partnerships, leveraging their partners’ origination expertise to gain exposure in the PSL segment. These co-lending arrangements involve a structured sharing of risk and reward, with specific lending process functions distributed between the co-lenders. As a result, banks are able to meet their PSL targets proportionate to their share in the loans facilitated under these partnerships. 

The New Directions eliminate the temporary allowance for continuing old co-origination arrangements and clarify the eligibility of loans under these arrangements for priority sector classification, limiting it to their repayment or maturity timeline. 

Scheduled Commercial Banks can co-lend with registered NBFCs (including HFCs) for priority sector lending, as per the guidelines issued on November 5, 2020. Loans under the earlier co-origination guidelines (September 21, 2018) will remain eligible for priority sector classification until repayment or maturity, whichever is earlier.

Comparison at a glance

	On-lending	Securitisation	TLE	Co-lending
Capping on exposure	5% of individual bank’s total priority sector lending of the previous financial year	No cap	No cap	No cap
Loan size caps	Loan size caps exist on the loan by the NBFC, e.g. Rs. 20 lakhs in case of home loans and Micro & Small enterprises loans, and Rs. 10 lakhs in case of agriculture loans.	The same loan cap that would have applied had the portfolio been originated by the bank for e.g. loans to individuals for educational purposes, including vocational courses, not exceeding Rs.25 lakhs	The same loan cap that would have applied had the portfolio been originated by the bank for e.g. loans to individuals for educational purposes, including vocational courses, not exceeding Rs.25 lakhs	The same loan cap that would have applied had the portfolio been originated by the bank for e.g., loans to individuals for educational purposes, including vocational courses, not exceeding Rs.25 lakhs
Credit exposure of the bank	On the borrower i.e. NBFC	On the pool of loans, though credit enhanced by the NBFC	On the pool of loans	On the pool of loans
PSL loans originated in the books of	NBFCs (including MFIs and HFCs)	NBFC (originator)	NBFC (transferor)	Banks (to the extent of share in the loan)
Additional compliance requirements	–	SSA Directions	TLE Directions	Co-lending Guidelines of 2020

Conclusion

The New Directions on PSL provide a significant update to the framework, aiming to enhance the flow of credit to priority sectors while making the process more efficient for banks and financial institutions. By clarifying the eligibility criteria for various mechanisms like bank-NBFC partnerships, securitisation, transfer of loan exposures, and co-lending, these amendments create a more streamlined and transparent approach for meeting PSL targets. The removal of certain provisions, such as interest rate caps and exemptions for MFIs, reflects a shift towards more simplified criteria that ensure compliance while maintaining focus on supporting critical sectors like agriculture, MSMEs, and housing. The clear guidelines on the involvement of NBFCs, HFCs, and other financial entities in PSL activities are expected to strengthen the collaborative efforts between banks and non-banking institutions, ultimately contributing to the economic growth and financial inclusion of underserved communities. As the revisions come into effect from April 1, 2025, banks and other eligible financial institutions must adapt their strategies to leverage these opportunities and fulfill their PSL obligations efficiently.

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1. https://www.crisilratings.com/en/home/newsroom/press-releases/2024/09/for-mfis-asset-quality-hiccups-to-lift-credit-cost-curb-profitability.html ↩︎

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Refer our related resources below:

• RBI revises Priority Sector Lending Norms
• The new PSL Master Direction and its Impact on NBFCs
• Meeting priority sector lending shortfalls: One more option
• PSL guidelines reviewed for wider credit penetration
• Reckoning banks’ loans to NBFCs for on-lending to priority sectors for PSL targets