Priority Sector Lending Certificates (PSLCs)

What are Priority Sector Lending Certificates (PSLCs)?

These certificates advance comparative advantages among banks while they meet their priority sector lending obligations in India. They are also called “social credits.”

Foreign readers might not be familiar with these certificates or the reason they’re commissioned. So here, we’ll give you a little background.

1. Priority Sector Lending (PSL)

It is ordered by the Reserve Bank of India (RBI), India’s central bank. It requires all banks to offer a set fraction of their loans to particular sectors.

These loans are extended to sectors that benefit the country and those that need additional support. Normally they lend loans to the minority population and areas that are vulnerable.

Such lending guarantees that the market foundation will be strong and promotes employment. 

The RBI commands that PSL should represent almost half (around 40%) of adjusted net bank credit (ANBC) or off-balance-sheet credit exposure, whichever is higher.

PSL is required for every domestic and foreign bank (with national bonds) with 20 branches or more branches.

2. Social credits

Another name for the certificates given against priority sector loans for banks. Purchasing these certificates helps banks meet their priority sector lending targets and sub-targets without extending loans. 

For example, banks can claim up to Rs 50 million for every borrower engaged in setting up schools, drinking water offices, and disinfection offices, including at the family level.

Who issues PSLCs?

Reserve Bank of India (RBI) issues the notification on “Priority Sector Lending Certificates” and the directions on trading or exchanging in PSLCs.

In April 2016, the RBI launched the PSLC platform. This platform allows banks to trade these certificates to meet sub-sector lending targets. 

The idea originated from the Planning Commission Committee on Financial Sector Reforms.

You may be familiar with California’s cap-and-trade program for reducing carbon emissions and that emissions permits can be traded. Firms that don’t pollute and have extra permits can trade theirs to firms that otherwise aren’t compliant with state regulations. 

Likewise, banks that exceed their priority sector lending requirement can trade certificates to banks that have not met it. 

Generally, these are issued against the underlying assets or resources; however, in any case in the transaction, there is no transfer of risks or loan assets from the seller to the purchaser.

Banks can issue certificates worth up to 50% of the previous year’s priority sector lending without underlying assets. However, the banks must eventually issue enough loans or hold enough certificates to meet the PSL target.

Priority Sector Lending Certificates Types

As Priority sector lending has sub-focuses along with a general objective, there are four types of these certificates.

• Agriculture: PSL Certificates for agriculture lending sub-target.
• Small and Marginal Farmer: PSL Certificates for small and marginal farmers lending sub-target.
• Micro Enterprises: PSL Certificates for micro-enterprises lending sub-target.
• General: PSL Certificates corresponding to the overall priority sector lending target.

According to the RBI circular released in 2016, there are eight general classifications of private sector lending:

Priority Sectors include the following categories:

1. Agriculture
2. Micro, Small, and Medium Enterprises (MSME)
3. Export Credit
4. Education
5. Housing
6. Social Infrastructure
7. Renewable Energy
8. Others

The other class incorporates individual credits to weaker areas, advances to distressed people, and credits to state-supported associations for scheduled castes and scheduled tribes.

Thus, priority sector lending banks help the government support the development of key areas by providing much-needed funds.

Furthermore, the RBI is opening up additional assets for loans to new businesses through these measures. However, new businesses can have difficulty accessing lending because they often can’t meet standard lending requirements. 

This will be a boon to domestic entrepreneurs and startups, as accessing financing to create a business and expand it can otherwise be difficult. 

How do Priority Sector Lending Certificates work?

The RBI listing out ‘priority’ sectors that banks must essentially lend to has been one standard technique. But as this technique is often criticized for interfering too much in the operations of banks, banks have been permitted another way to meet this obligation. 

The RBI orders banks to loan at least 40% of their total loans to priority sectors like agriculture, schooling, public housing, and SMEs. Besides the general objective, banks are additionally expected to meet sub-sector requirements. 

Like all businesses, banks have varying strengths as well. For example, not all banks are great at reaching or extending loans to each category of priority borrower.

Purchasing these certificates permits banks that can’t reach certain borrowers to meet their priority sector lending obligations without actually making those loans. 

On the other hand, banks that exceed the target for certain priority sectors can take advantage of this and sell excess certificates.

PSLC Trading

On 7 April 2016, the RBI issued instructions on trading in priority sector lending certificates. RBI has also launched a platform to verify the certificates from its Core Banking Solution (CBS) portal. 

The certificates will have a standard lot size of Rs 2.5 million and multiples of that value. 

All scheduled commercial banks, including regional rural banks, urban cooperative banks, small finance banks, and local area banks, have become eligible or qualified to participate in the trading.

According to the RBI, the complete trading volume of PSLCs expanded from Rs. 498 billion (6.1 billion USD) at the end of March 2017 to Rs. 5,890 billion (73.7 billion USD) at the end of March 2021. 

Buyers rush to meet quarterly PSL targets when trading volumes generally peak in the last month of each quarter. 

The most traded certificates are general, small, and marginal farming certificates.

Typically, public sector banks (PSBs) and private banks are the major purchasers and sellers of the certificates. Additionally, More than 15% of this certificate trade is conducted by Small Finance Banks (SFBs).

However, if you’re looking at net volumes, private and foreign banks emerge as top buyers, with public sector and regional rural banks as top sellers.

Tax treatment 

A goods and services tax (GST) used to be levied on the selling bank. The tax rate is 12% and was previously on a forward charge basis (meaning the supplier paid it). 

Why is it privy to GST and not a financial tax? The Indian government treats the supply of these certificates as a stock of products in interstate commerce. 

Therefore, since the exchange of these certificates by banks is considered a type of interstate commerce, the integrated goods and services tax (IGST) applies. 

However, in past cases where banks paid the central goods and services tax, state goods and services tax, or union territory goods and services tax on the certificates instead of the IGST, the IGST tax was forgiven.

According to the guidelines of GST-Vide notification no. 11/2018-Central Tax (Rate) as of 28 May 2018, GST payable on Priority Sector Lending Certificates uses a Reverse Charge Mechanism.

As a result, the purchasing banks are responsible for paying the tax on certificates.

Priority Sector Lending Certificates Market Price

Their price is determined by the risk-free rate, default rate, and cost of daily operations. 

While calculating progress towards PSL lending, deficiencies in and surplus lending for each quarter will be observed independently.

Everything being equal will show up and be considered for calculating general deficiencies or excess toward the year’s end goal.

Since prices depend on credit risk, these certificates are a credit derivative. India Ratings, an Indian credit rating agency, “expects these certificates to be priced between 1 percent to 3 percent annually based on the PSL sub-segment deficit of the purchaser.”

If the Indian government set fines to less than the price of these certificates, the pricing models would depend on that fine cost. 

Therefore, the government has to set heavy fines and sometimes deny banking licenses to incentivize banks to meet priority lending requirements or purchase certificates.  

This is to prevent a situation in which banks pay fines or penalties rather than follow the rules governing lending to priority sectors and keep credit flowing to those sectors.

Priority Sector Lending Certificates Example

Here’s a simple example of how certificate trading works between two banks, Bank X and Bank Y.

Bank X has issued loans totaling Rs. 2 billion, Rs. 1 billion of which counts as priority sector lending. Given the 40% requirement for PSL, Bank X has excess PSL loans of Rs. 200 million:

2 billion in total lending * 40% = 800 million PSL requirement

1 billion in PSL loans - 800 million PSL requirement = 200 million excess

Bank Y has loaned Rs. 1 billion, and twenty percent of these loans count as PSL - or Rs. 200 million.

To meet the PSL requirement, Bank Y needs to make additional PSL loans worth Rs. 200 million (20% of total loans of Rs.1 billion).

1 billion total lending * 40% PSL requirement = 400 million

400 million PSL requirement - 200 million lent = 200 million

Now both banks can benefit from the use of these certificates. 

Bank X can sell certificates worth Rs. 200 million PSL loans and earn extra income. 

Bank Y can buy Rs. 200 million of the certificates and fulfill its RBI requirement for PSL. Bank Y would also pay the tax on this certificate, totaling Rs. 24 million. 

Priority Sector Lending Certificates Pros

Some of the benefits are:

• It assists in channeling credit to the vulnerable or weaker section of society.
• PSL promotes financial inclusion.
• PSL offers higher social returns on lending.
• It assists in the diversification of the credit portfolio of the government.
• Credit formalization helps break the hold of larger lenders, especially in rural areas.
• Trading these certificates also helps banks reach their target even when they can’t find borrowers for all the target sectors.
• It allows credit penetration in credit-deficient regions.
• It is responsible for the increase in the valuation of public sector banks.
• Certificate trade also generates massive tax revenues for the government.
• It is designed to advance the development of weaker sections in the country, thereby supporting the economy in India.
• One more advantage of this plan is that it would permit the best lenders to give loans to those in need while helping banks unable to reach or lend to target groups comply with lending requirements. 

Priority Sector Lending Certificates Cons

The downsides are as follows:

• Many non-performing assets, or loans that have gone into default, have come from PSL. 
• The majority of banks seem reluctant to lend to the designated priority sectors.
• The loan given to farmers under PSL increases productivity but is used for unproductive purposes like marriages and other social obligations.
• Lending can be unfair, such as favoring rich farmers over poor farmers.
• Some consider that the banks, not the priority sectors, have benefitted from the PSLC scheme.
• With an increasing incidence of unproductive loans and excessive external interference, bankers’ excitement to loan to the priority sector makes many banks miss the specified targets.

Researched and authored by Spoorti Biradar | LinkedIn

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