New Delhi: India’s decades-old priority sector lending regime, long defended as the backbone of financial inclusion, is facing renewed scrutiny after a government-backed study found that expanding directed credit alone may not significantly accelerate economic growth in poorer districts.
The Economic Impact Analysis of Priority Sector Lending, released as part of the EAC-PM Working Paper Series, arrives at a politically and economically sensitive moment for India’s banking system, where lenders are under pressure to balance inclusion mandates with profitability and capital efficiency. The report examines district-level data between 2020 and 2025 and assesses whether priority sector advances (PSAs) and Priority Sector Lending Certificates (PSLCs) are materially improving output growth.
The policy on priority sector lending has been in place in India for almost five decades and banks are required to direct at least 40% of their overall credit towards the priority sector. The priority sector encompasses a broad range of economic activities such as the provision of credit to small and marginal farmers, micro enterprises and weaker sections aiming to address systemic equity gaps. Growth considerations are also addressed through this policy as the priority sector includes activities that serve as economic multipliers like exports, medium enterprises and corporate farmers.
At the heart of the findings is a nuanced conclusion: while directed lending remains critical for addressing structural inequities in access to finance, simply diverting more bank credit into underserved geographies does not automatically translate into stronger economic output.
“Results show that an increase in PSA growth rate does not significantly impact a district’s output over a two-year horizon… Heterogeneity was noted among districts in terms of elasticities of output. The bottom 10 percentile of districts (in terms of outstanding PSAs) had the lowest elasticity as compared to other district tiers,” says the report.
That finding is likely to sharpen debate inside policymaking circles over whether India’s directed lending architecture needs redesign rather than expansion.
The study highlights that less than 10% of districts account for more than 45% of overall PSAs, underlining the geographical concentration of formal credit. Northeastern states, eastern India and Himalayan regions continue to remain underserved despite decades of mandated lending targets.
The report observes, “A pure top-down bank mandated diversion of credit to the poorest districts will be inefficient and may fail to serve the social and economic mandate of priority sector lending. Instead, holistic interventions that address binding development constraints, of which finance is one component, may give better outcomes.”
Banking Model Shifts
The study also offers a rare inside look into how different categories of banks are adapting to the evolving economics of priority sector compliance.
State Bank of India and private sector lenders remain below the mandatory 40% target through direct lending and increasingly rely on indirect instruments such as PSLCs to bridge the gap. By contrast, nationalised banks and small finance banks overshoot their targets and emerge as net sellers of these instruments.
According to the report, SBI directly extended an average 26.46% of its ANBC (Adjusted Net Bank Credit)to priority sectors during the study period, while private banks averaged 37.90%. Nationalised banks stood at 44.36%, while small finance banks crossed 100%.
The report says, “PSLCs help mitigate bank profitability risks from PSAs by allowing banks to trade the fulfilment of priority sector obligations at a market determined rate without trading the underlying asset or risk.”
The PSLC market, introduced by the Reserve Bank of India in 2016, is emerging as one of the most significant structural shifts in India’s directed lending framework. The mechanism effectively allows banks with surplus priority lending to monetise that excess by selling certificates to banks struggling to meet regulatory thresholds.
“The data shows that PSLCs allow banks to lend as per their expected specialisations without altering regional distribution of PSAs or output growth. Small finance banks and nationalised banks are net sellers of PSLCs while the State Bank of India is a net purchaser. Indian private banks sell PSLCs for micro enterprise PSAs and purchase agricultural PSLCs,” says the report.
That evolution signals a broader transition in Indian banking from compliance-led lending to market-calibrated portfolio management. Banks are increasingly aligning lending behaviour with operational expertise rather than merely pursuing regulatory targets.
The study also revives concerns around systemic inefficiency within directed lending models. It notes that large banks inherently prefer lending to larger firms because of better accounting transparency, lower transaction costs, and reduced monitoring burdens. Smaller firms, farmers and weaker sections remain disproportionately vulnerable to information asymmetry and institutional lending biases.
Inclusion Versus Efficiency
The report ultimately frames priority sector lending as a balancing act between social equity and economic efficiency — a debate that has shaped Indian banking policy since the late 1960s.
“Directed lending policies represent one category of credit market interventions. They address the problem of asymmetric allocation of credit by mandating or incentivising financial institutions to dedicate a portion of their credit to marginalised and weaker sections,” the report says.
At the same time, the paper cautions against romanticising directed credit as a universal growth engine. It points to evidence that excessive diversion of capital into lower-yielding sectors can weaken productivity and strain banking balance sheets. “In the presence of a credit market failure, initial gains in a recipient sector will outweigh the combined decline in other sectors and the inherent efficiency losses of the policy. However, as the volume of diverted credit increases, gains in the recipient sector eventually fall short of aggregated efficiency loss due to diminishing marginal returns.”
Importantly, the study does not call for dismantling the priority sector regime. Instead, it argues for sharper calibration, better targeting and complementary development interventions beyond credit alone.
That distinction matters. India’s priority sector lending architecture remains one of the world’s largest state-directed credit systems, spanning agriculture, MSMEs, education, housing, weaker sections and renewable energy. The framework has historically been credited with improving rural credit penetration, reducing poverty and supporting small enterprise formation.
Yet the report makes clear that future policy design may need to move beyond headline lending targets toward outcome-based frameworks that measure productivity, regional impact and long-term sustainability.
For policymakers and bankers alike, the message is increasingly difficult to ignore: inclusion without efficiency can strain the financial system, but efficiency without inclusion risks deepening structural inequality.