Where Angels Prey

Where Angels Prey is a novel by Ramesh S Arunachalam. Please refer to www.whereangelsprey.com for more information

Wednesday, December 29, 2010

Should Indian MFIs Have Access to Priority Sector Funds?

Ramesh S Arunachalam
Rural Finance Practitioner

Introduction: Priority sector lending is the public face of the policy support to financing low income people and sometimes, it gets more attention than required, and perhaps for the wrong reasons. My views on priority sector lending are given below…

Policy Context – Directed Credit and Financial Inclusion: However, before looking at the priority sector funds issue, it seems important to look at the overall policy environment in which priority sector financing is a major tool - for enhancing access of low income people to financial services - under the long standing directed credit paradigm, now subsumed by recent financial inclusion paradigm. A critique and analysis of the same is provided below…

In India, typically, financial inclusion (FI) is presently characterized by:

F  Preoccupation With Opening of Savings Accounts: The jist of this approach is that it deals with enabling low-income people to have access to bank accounts and remittance services. Thereafter, it is assumed that, many benefits will automatically follow – often proved to be killer assumption, in development parlance

F  Large Focus on Consumption Credit and Small Production Loans: While institutions (mostly MFIs) have provided low-income people and women with access to financial services, the focus has largely been in terms of delivery of credit. And within credit, the focus, at least over the last few years, has largely tended to be on consumption loans - small production loans do exist but appear rather small in number (pun intended), especially in relation to consumption loans. This constitutes the bulk of what we typically call as priority sector financing with regard to MFIs, often coming under the micro-credit category[i]

F  Low Outreach with Regard to Vulnerable Groups in Agriculture: Further, with the
priority sector financing, there are three other major issues: a) In many states, the Priority Sector Lending norm of 18% advances to Agriculture includes in majority, many of the non-poor (non BPL households); b) the share of agriculture in Priority Sector Lending (PSL) is not met in some states and it has been going down in few other states; and c) the thrust of the financial inclusion drive, while good, must be properly interpreted - not all excluded people are poor and vulnerable and not all included stay that way.

F  Lack of Suitable and Affordable Risk Management Services: In reality, several critical financial needs are yet to be satisfied for low income people.  I would put these under two major categories: a) formal/flexible voluntary savings[ii] (the most basic ‘insurance’ product); and b) health, asset, accident and life insurance tailored to client needs rather than insurer abilities – I will post separately on this. While there have been some attempts to innovate with regard to different types of insurance, there are few issues that deserve mention here: a) these innovative insurance services tend to be closer to the service providers abilities rather than clients’ actual needs; b) they are not affordable in many cases; and c) they often tend to be available to a small sub-section of people.

F  Lack of Appropriate Livelihood Financing: Yet another financial service that has been in short supply is ‘larger production and livelihood credit’, especially with a focus on post harvest/ production financing. While there have been some attempts to innovate with regard to livelihood financing, three aspects deserve mention here: a) where available, these services tend to be standardized services tailored to service providers abilities rather than clients’ actual needs; b) they are not affordable in several cases; and c) at best, they tend to elude a vast large majority of clients[iii].

The above two aspects of Lack of Suitable and Affordable Risk Management Services and Lack of Appropriate and Affordable Livelihood Financing are note worthy aspects because they again show the huge gaps between a great vision and intended strategy (The Recommendation of The Well Intentioned Financial Inclusion Committee) and actual implementation on the ground, which is narrowly focused on consumption and small production credit

Hence, from the above, we can understand that priority sector is (perhaps) used by banks to provide consumption and/or small production credit through MFIs to end users (low income people). And the AP crisis reveals some impact of the misuse of such financing…multiple lending…indebtedness…inability to repay etc…

Hence, from the above, we can understand that priority sector is used primarily[iv]  used by banks to provide consumption and/or small production credit through MFIs to end users (low income people). And the AP crisis reveals some impact of the misuse of such financing…multiple lending…indebtedness…inability to repay etc…

Access to Priority Sector for MFIs: Having set the broad present day context[v], and given today’s micro-finance crisis in India, the larger is question is whether MFIs should be allowed access to priority sector financing?

To clarify the specific provisions under priority sector, I reproduce the relevant sections from the RBI circular[vi] below:

After the Andhra Pradesh crisis, it is very tempting to argue that MFIs should not gain access to priority sector funds. Without question, it is perhaps true that the availability of abundant (and non supervised) priority sector financing helped MFIs to grow in an unhealthy and inorganic manner and there by resulted in higher levels of indebtedness among the target groups.

However, making MFIs ineligible for priority sector financing (even under these circumstances) seems to be an easy way out - one that will incentivise banks and financial institutions to further lend the savings of the poor to the corporates and others. Therefore, I am very clear that priority sector financing for MFIs must stay – in other words, MFIs must continue to have access to priority sector lending (PSL) funds, subject to certain conditions enumerated below. Also, these PSL funds need to be properly monitored and supervised by the regulators and other entities like banks involved. In my opinion, the lack of sufficient supervision and monitoring[vii] is as much a cause for the present micro-finance crisis as other critical factors and I will post separately on issues related to supervision and monitoring of priority sector funds

Therefore, knocking off MFIs from the priority sector list is inappropriate as it will permanently shut the formal financial services door to low income people and in fact, push them further into the hands of the informal financiers (broadly defined)…That said, we also need to ask the question as to why was priority sector lending established in the first place. Quotations from voluminous reports apart, priority sector financing was established to ensure flow of funds from formal institutions (mainly banks) to people and sectors who did not have access to these funds. And priority sector must continue to do that and more…as suggested below

Some Suggested Proposals:  Here are some initial proposals towards that…and much of the detailing would need to be done…


First, under the micro-credit category[viii], priority sector must continue to provide access to basic consumption credit, but subject to a ceiling. The current upper limit of Rs 50,000 per client does not seem appropriate – in the light of the recent experiences, it may be appropriate for RBI to set a limit to consumption credit thorough priority sector and I would be inclined to fix it at Rs 25,000 per client – Rs 15,000 for consumption purposes and Rs 10,000 for emergency purposes.

Second, under the same category, it must continue to provide access to basic (small) production and livelihood credit, subject to the existing limit of Rs 50,000 and this must be verifiable (if required) – both for purpose as well as end user. This limit could be in addition to existing consumption loan limit, but loans must made on a case by case basis, after judging loan absorption capacity of clients. And the sum total of all loans (consumption and livelihood) should not exceed Rs 50,000 at any point in time.

Third, provisions for larger and specialized livelihood credit, perhaps exist under the agriculture finance (direct and indirect) section of the priority sector and this can be continued but again verifiability and other aspects articulated below are critical

Thus, to summarise, priority sector funds could be used to incentivise the micro-finance industry as follows:

Additionally, the above priority sector funds could be accessible to all MFIs (not-for-profit, mutual benefit and for profit), subject to their meeting some (enforceable) minimum standards with regard to certain non-negotiables – governance and related issues, systems (HR, Portfolio Management, MIS, Finance and Accounting, Internal Audits, Internal Controls etc), client protection/literacy and other aspects (as may be required from time to time). Relatively small and nascent MFIs could have voluntary minimum standards to comply with and the real evaluations for gaining access to priority sector funds could be applied to growing and mature institutions, irrespective of legal form.

The RBI and the Malegam committee would need to devise a method for operationalising the above and it could be a third party audit/rating (without any conflict of interest) or other appropriate mechanisms including due diligence by the lenders forum or bankers association. It would have to be a yearly exercise, at the least and should not be cumbersome given that the number of growing and large MFIs are still few in number.

A final aspect where priority sector could be used to incentivise the flow of funds are the underserved areas and backward districts in India. Special recognition of MFIs that operate in such areas could be another instrument in the overall evaluation of MFIs suggested above…

These are just some initial thoughts and I will post again on the aspect of supervision of priority sector funds as well as the evaluation of MFIs suggested above…I really hope that RBI and the Malegam Committee do not take the easy way out and knock off MFIs from the priority sector list. That would be a huge disservice to the poor and low income people of India…

[i] http://www.rbi.org.in/Scripts/BS_ViewMasCirculardetails.aspx?id=5818. There could be more sections relevant depending on quantum of loan but these are the broad and most frequently used categories
[ii] By and large, in many cases that I have seen, the no frills accounts remain dormant and are rarely used.
[iii] While innovative MFIs/FFIs have tried to delivered such services to select clients, the larger and wider penetration of these services is still quite minimal.
[iv] I say primarily because there could be other categories used by banks under priority sector
[v] I have refrained from getting to issues related to origin of priority sector – the word first came to be used in the Indian Parliament by Former Prime Minister and Late Shri Morarji Desai in 1967, who was answering a question relating to investment in certain sectors
[vi] http://www.rbi.org.in/Scripts/BS_ViewMasCirculardetails.aspx?id=5818. There could be more sections relevant depending on quantum of loan but these are the broad and most frequently used categories
[vii] Again, this is an honest observation and my intention is not to find fault with any one. Rather, I think we must all objectively look at existing weaknesses and strengthen supervision/monitoring of priority sector funds
[viii] Micro Credit: Provision of credit and other financial services and products of very small amounts not exceeding Rs. 50,000 per borrower, either directly or indirectly through a SHG/JLG mechanism or to NBFC/MFI for on-lending up to Rs. 50,000 per borrower, will constitute micro credit.


  1. hi Ramesh, relevant thoughts. i agree with your point that while continuation of the PSL status for micro credit should continue it shoudl be with added supervision of its end use. also currently the banks lend to MFIs at a very high rate of over 13 to 15% while for all other PSL loans, banks typically earn less than 9%. the banks should also be compelled to lend at around 8 - 9% only to MFIs sot hat their lending rates can also proportionately go down

  2. Hi Ramesh!

    As usual a very incisive analysis. I do not think priority lending should continue to for-profit MFIs unconditionally other than the elements you mentioned.

    They should be certain caveats that offers affordable credit for consumption and viable interest rates for petty businesses. Despite "voluntary" reduction of interest rates by MFIs, these are still way too high.

    Secondly, priority lending is basically tax payers money and it should not be used as a means for profiteering so that an Akula can make himself overnight a multi-billionaire and PEs and VCs a quick rich route at tax payer's expense.

    I do not see why a SKS with sufficient PE/VC investments and IPO funds, should receive priority lending status. It creates an unlevel field since they use the latter as leverage to corner the most benefits of priority lending.

    What we need is several small MFIs working locally rather than a few large MFIs that work nationally for microfinance to be really micro oriented. If these few get rotten, as the present case, it threatens the entire sector.

    With your permission I like to republish this article in my own blog


  3. Dear Rajan Ji

    Thanks for your kind words

    Yes, I am for priority sector but with good supervision to ensure end use and end users and also prevent the profiteering of the kind you mention.

    My subsequent posts will provide more details on this and thankls for your feedback

    Please publish the post, as requested by you

    Warm Regards

  4. Ramakrishnan VenkateswaranDecember 30, 2010 at 11:28 AM

    Relevant analysis for Priority Sector Status to continue. However, would like to add that it will not make much relevance to the Bankers. Out of the total Bank Credit to Commercial Sector only 0.80% is the exposure to the MFI segment and out of the priority sector of 40% of total credit, only 2% is towards the MFI segment. Since the PSL norms have lot many areas under its purview, micro credit is of very little relevance to the Banks except to adjust shortfalls under the weaker section category which otherwise also gets addressed through various other programs of the Banks. This leaves all of us to wonder whether after the A.P crisis, how many banks would be interested to continue lending even at 15% considering the huge event risk involved in the business and which is likely to be played by different actors at different times suitable to them?