The Reserve Bank of India’s (RBI’s) relaxation of priority sector lending (PSL) norms for small finance banks (SFBs) — reducing the overall PSL target from 75 per cent to 60 per cent — will provide operational flexibility to these lenders, enabling them to diversify and derisk their loan books by venturing into segments they had previously stayed away from.
This regulatory dispensation is expected to free up around ₹40,000 crore for SFBs, which can now be deployed in lower-rated risk, secured assets, said industry players and experts.
With the relaxation, SFBs can channel funds into segments such as loans against property (LAP), personal loans, vehicle loans, and loans against mutual funds, they added.
According to RBI regulations, an SFB was required to extend 75 per cent of its adjusted net bank credit (ANBC) to sectors eligible for classification as PSL. While 40 per cent of the ANBC was to be allocated to different sub-sectors under PSL in line with the extant PSL prescriptions, SFBs were allowed to allocate the balance of 35 per cent to one or more sub-sectors where they have a competitive advantage.
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Now, the RBI has said that the additional component (35 per cent) of PSL will be reduced to 20 per cent, making the overall PSL target 60 per cent of ANBC or the credit equivalent of off-balance sheet exposures, whichever is higher.
According to Ajay Kanwal, managing director (MD) and chief executive officer (CEO) of Jana SFB, the RBI’s relaxation of PSL norms is likely to benefit those banks that may have felt constrained by the earlier requirements. With greater flexibility, these banks could now see an opportunity to diversify their loan books. “The eased norms may encourage more non-banking financial companies to consider applying for an SFB licence. That said, we do not foresee any immediate impact on our profit and loss (P&L) from this regulatory change,” he said.
Some of the areas where SFBs can now beef up lending are automobile loans, LAP, loans against shares, and personal loans.
While diversification may not come into play in the current financial year (2025–26/FY26), going forward, the banks can now plan for the next two to three years on how they will diversify their business with the extra room that the RBI has provided, said bankers.
According to R Baskar Babu, MD and CEO of Suryoday SFB, the diversification in loan books will pave the way for SFBs to prepare themselves for converting into universal banks. While diversification in the loan book will not necessarily mean higher margins, it would certainly provide comfort on asset quality, as most SFBs have a sizeable microfinance portfolio that gets impacted due to various reasons at regular intervals.
The regulator has already announced a norm for SFBs that can be eligible to voluntarily convert into universal banks. Currently, there are 11 SFBs in the country, and three of them have applied for conversion.
“This is the vision the RBI had while issuing the differentiated SFB banking licences. This will help add new asset classes and new geographies for the SFBs,” said Inderjit Camotra, MD and CEO of Unity SFB. “It will enable SFBs to deploy this 15 per cent towards diversifying their present base,” he said.
The new norms, which come into effect from the current financial year (FY26), would aid SFBs in earning profit by selling priority sector lending certificates (PSLCs) in the small and marginal farmer segment to other banks that fall short of the target.
Under the 40 per cent mandatory PSL target, banks are required to allocate funds to sectors such as agriculture, small and marginal farmers, non-corporate individual farmers, microenterprises, and weaker sections. While most of these segments do not yield sizeable profit through the sale of PSLCs, the small and marginal farmer segment offers some profitability, which SFBs can now strategically leverage to earn extra income.
“The relaxation in PSL norms for SFBs by the RBI provides these banks with greater operational flexibility to diversify their loan books. According to our estimates, around 15 per cent — or over ₹40,000 crore — could be freed up for deployment in lower-rated risk assets, potentially improving their cost of funds. However, this move is unlikely to have a major impact on their P&L in the near term,” said Sanjay Agarwal, senior director, CareEdge.
