Impact of Liberalization on Rural Banking in India

IMPACT OF FINANCIAL LIBERALIZATION ON RURAL BANKING

Impact of Financial Liberalisation on Rural Banking





Presented By –

Nimit Jain & Rahul Bammi

Shaheed Sukhdev College of Business Studies

Current Scenario of India


India is the 11th largest economy in the world in terms
of GDP, and 4th in terms of purchasing power parity.



The growth of the economy is equally impressive with
an average of over 8.0% during the last decade.



However, in terms of GDP per capita, India ranks a
lowly 160th among other nations.



Within the country, there is a stark divide in the
incomes of urban and rural areas.



The average monthly per capita consumption
expenditure (MPCE) in urban India is almost double that
of rural India.


Problems Faced by Indian Economy

POLICY PARALYSIS

TWIN DEFICIT :FISCAL AND
CURRENT
ACCOUNT DEFICIT

URBAN – RURAL
DIVIDE


NO INCLUSIVE
GROWTH

REGIONAL
DISPARITIES

Solution


What is Banking?
A bank is a financial institution that


accepts deposits and



channels those deposits into lending activities.

A bank is the connection between customers that have
capital deficits and customers with capital surpluses.


Miracle of Banking


Banking Policy of India
(1969 – Till Present
Stage I – Social and Developmental Banking


Nationalization of India‟s 14 major commercial banks in 1969 during the
early phase of the „green revolution‟ with the objective that the state
will gain access to new liquidity, among rich farmers.



The objectives of the new policy with respect to rural banking were –

1.

To provide banking services in previously unbanked or under-banked
rural areas;

2.

To provide substantial credit to specific activities, including
agriculture and cottage industries;

3.

To provide credit to certain disadvantaged groups such as, for
example, Dalit and Scheduled Tribe households.



In 1975, the Government established by legislation a new network of
rural financial institutions called the Regional Rural Banks (RRBs).



The institution of Regional Rural Banks (RRBs) was created to meet the
excess demand for institutional credit in the rural areas.



The number of such banks expanded rapidly, and covered 476 districts
by 1987.


Stage II – Creation of Employment


Major instruments of official anti-poverty policy were programmes for
the creation of employment.



Two strategies for employment generation were envisaged, namely wage
employment through state-sponsored rural employment schemes and
self-employment generation by means of loans-cum-subsidy schemes
targeted at the rural poor.



Thus began a period of directed credit, during which credit was directed
towards “the weaker sections.” The most important new scheme of this
phase was, of course, the Integrated Rural Development Programme or
IRDP, a scheme for the creation of productive income-bearing assets
among the poor through the allocation of subsidized credit.



Both the IRDP and the RRBs proved to be failures. The IRDP‟s failed to
create enough long term assets and the RRBs proved to be unviable as
they incurred losses due to low interest rate, easy regulations, willful
default etc.



In 1989 for the first time, the entire structure of Regional Rural Banks
was challenged by the Agricultural Credit Review Committee (Khusro
Committee).



But such a policy move was politically unthinkable, so the Reserve Bank
and the Government of India quite prudently pushed the Committee
report under the carpet without a public debate.


Stage III – Financial Liberalization


With the neo-liberal economic reforms and the liberalization of
the financial system, the RRBs came under the scanner once again.



The Committee on Financial Systems, 1991 (Narasimham
Committee) stressed the poor financial health of the RRBs to the
exclusion of every other performance indicator. 172 of the 196
RRBs were recorded unprofitable with an aggregate loan recovery
performance of 40.8 percent. (June 1993)



In order to impart viability to the operations of RRBs, the
Narasimham Committee suggested that the RRBs should be
permitted to engage in all types of banking business and should
not be forced to restrict their operations to the target groups, a
proposal which was readily accepted. This recommendation
marked a major turning point in the functioning of RRBs.



It also recommended that interest rates be deregulated, that
capital adequacy norms be changed, that branch licensing policy
be revoked, and that the part played by private Indian and foreign
banks be enlarged.


Rural Banking and Financial Liberalization


In the Report of the Committee on the Financial System, M. Narasimham (RBI, 1991). In its very first paragraph, the
report called for “a vibrant and competitive financial system…to sustain the ongoing reform in the structural
aspects of the real economy.” The Committee said that redistributive objectives “should use the instrumentality of
the fiscal rather than the credit system” and, accordingly, that “directed credit programmes should be phased out.”
It also recommended that interest rates be deregulated, that capital adequacy norms be changed (to “compete with
banks globally”), that branch licensing policy be revoked, that a new institutional structure that is “market-driven
and based on profitability” be created, and that the part played by private Indian and foreign banks be enlarged.



The Indian financial reform strategy at the beginning of the 1990s involved four major initiatives.



First, in order to increase the credit creating capacity of banks reductions in the statutory liquidity ratio and cash
reserve ratio were effected.



Second, in order to increase competition among FIs, structural changes were brought in. This included broad banding of
financial services by commercial banks, allowing entry to private and foreign banks and raising the cap on foreign direct
investment in private banks.



Third, banks were given greater freedom in determining their asset portfolio. They were permitted to breach the
firewall that separated banking sector from stock market and also allowed a greater leeway in altering priority sector
lending targets.



Fourth, in order to protect the system from destabilizing forces concomitant with deregulation, the government
specified new capital adequacy norms for banks, prescribed guidelines for bad debts, and injected massive funds
towards the recapitalization of public sector banks.



Overall financial reform measures were supplemented by a `reversal’ of rural banking policies.



The definition of priority sector was diluted by raising the credit ceiling limit, and by widening the coverage to include
many hitherto non-priority sector heads. At the sametime, non-fulfilment of priority sector target was overlooked and
commercial banks were provided the easy option of meeting the shortfall in priority sector target by investing in special
bonds issued by certain specialized institutions.



Rural banking in India now had to compete on an equal footing on market principles as commercial
banking.

Impact of Financial
Liberalisation on Rural Banking


Before the 1990s, the banking system was open to much criticism,
particularly of its bureaucratic failures, its insensitivity to the
social and economic contexts in which it functioned, and class and
regional inequalities in lending patterns. The reforms proposed in
1991, however, were not attempts to bring rural banking closer
to the poor, but to cut it back altogether and throw the entire
structure of social and development banking overboard. These
overall financial reform measures were supplemented by a
`reversal’ of rural banking policies. The definition of priority
sector was diluted by raising the credit ceiling limit, and by
widening the coverage to include many hitherto non-priority sector
heads. At the same time, non-fulfilment of priority sector target
was overlooked and commercial banks were provided the easy
option of meeting the shortfall in priority sector target by investing
in special bonds issued by certain specialized institutions. Except
for the narrow segment of small borrowal accounts, interest rate
regulations under the priority sector were removed. Branch
licensing policy instrumental in the expansion of commercial bank
branches in rural areas was modified to allow banks to rationalize
their branch networks. Thus, the objective of allocative efficiency
of investment in the economy, the guiding principle behind social
and development banking, was replaced by the objective of
operational efficiency of individual FIs.


Sectoral and Regional Distribution
of Credit in the Post-Reform Era


The analysis, based on macro-level data, unequivocally indicates that
banking sector liberalization has resulted in a reversal of the process of
balanced development of banking in India.



Accordingly, the annual growth in agricultural advances was 17.22 percent
between 1975 and 1980, and 8.84 percent between 1980 & 1990. During
the 1990s, annual growth of agricultural advances fell to an abysmal 2.2
percent.



Commercial banks over the same period also reduced their credit exposure
as a share of total earning assets (credit and investment) means that the
agriculture sector received a lower share from an overall shrinking pie.
Another disturbing trend has been the low, and even negative growth of
term-lending to the farm-sector.



Such severe credit starvation of agriculture has no doubt significantly
intensified the agrarian crisis in the postre form period with its features of
low sectoral GDP growth, low employment growth, stagnation of
investment and extreme distress of the marginal and small cultivators.



Reverse flow of financial resources from backward states to the more
developed states as well as from rural & semi urban areas to urban and
metropolitan centers became a leading feature of rural banking in the
post-reform era.

Rationalization of Branch
Network


Policy provided an opportunity to the RRBs to shift
branch premises to more commercially promising areas
from localities where they had incurred sustained
losses.


Permission to lend to others
outside Target Groups and
Deregulation of Interest Rates


Before the initiation of banking reforms, lending from
the RRBs was largely restricted to the priority sector.
From September1992 onwards, the RRBs were allowed
to finance non-target groups to the extent not
exceeding 40 percent of their incremental lending. This
limit was subsequently enhanced to 60 percent in 1994.
As a result, the RRBs diversified into a range of nonpriority sector (NPS) advances, including jewel and
deposit-linked loans, consumer loans and home loans.


Rising investments in banks’
portfolios


The Rural Banks in following the trend set by the commercial banks
increased the share of investment assets in the portfolio. Not only
did the share of investments in government securities increase
beyond the SLR norms, simultaneously there was a diversion of an
increasing share of the investment portfolio into other approved
securities such as PSU bonds and debentures. This reversed flow of
funds from the rural to the urban areas.
Graph 1
35
30
25
20
15
10
5
0

Investment a nd Deposits of RRBs
(as on e nd March)

100
80
60
40
20
0

Investment-Deposit Ratio


Share of G-Secs in Total Investment (Right Axis)

Meagre Growth of Credit
Advance


Notwithstanding the few new instruments of credit
delivery, the growth of credit disbursements by the
RRBs dipped to very low levels in the 1990s. During the
first half of the decade, credit growth fell from an
annual rate of around 20 percent in the eighties to
negligible levels, and remained at below 10 percent
level during the rest of the decade. As noted above, in
order to cut costs and improve the profitability of their
operations, the RRBs were restricting credit advances,
particularly advances to the target group borrowers,
and instead investing in risk-free government and other
approved securities. In fact, credit-deposit ratio of the
RRBs, which in 1990 stood at more than 80 percent, fell
to 43 percent by the year 2002-3!


Inequities between Regions and
Borrower-types in the Distribution
of Credit


Two underlying tendencies of the rural
disintermediation phenomenon have been: the growing
credit exclusion of low income clients with small loan
accounts; and the rising regional imbalances in credit
distribution.



More than 99 percent of the account-holders with the
RRBs have traditionally been small borrowers – loan
accounts with credit limit of Rs 25,000 or less. These
borrowers have accounted for nearly as much of the
outstanding credit. All through the nineties, there‟s
been a marked stagnation and decline in the number of
small borrowers‟ credit accounts with the RRBs.


Solutions
MICRO-CREDIT AND SELF-HELP GROUPS



The Government envisages only one major policy instrument to fill the gap left by the
formal credit sector in the countryside: the establishment of micro-credit projects in rural
India.



The micro credit approach is viewed as being able to rectify the major weaknesses of the
banking system itself, most notably the “twin problems of non-viability and poor recovery
performance” of existing rural credit institutions.



Micro-credit is the favoured alternative to the present system because, first, it is assumed
that the transactions costs of banks and other financial institutions can be lowered
significantly if these costs are passed on to NGOs or self-help groups, and secondly, because
NGOs are expected to perform better than formal-sector credit institutions in respect of
the recovery of loans.



Micro-credit, is associated with the following features:

•

very small loans,

•

no collateral,

•

borrowers from among the rural and urban poor,

•

the formation of borrower groups, and


Suggestions


Grass root Level Organizations: Involvement of grass root level organizations like farmers‟ club and
NGOs would lead to inclusion of the disadvantaged as they ensure local participation and help farmers
in gaining access to credit and technology. A vibrant extension machinery would enhance farm
productivity and hence, greater demand for banking activities in rural areas. For example, NABARD has
28,226 Farmers‟ Club (as on 31 March 2008) spread over various villages in the country. These clubs
need to be envisaged as touch points by the banks and can be utilized in the task of financial inclusion.
The main advantage in involving such grass root organization is the large multiplier effects they
generate along with the positive „demonstration effects‟ among the target groups.



Rural Infrastructure: Infrastructure development is an essential prerequisite for attaining greater
inclusive growth. Adequate rural infrastructure facilities and improvements in terms of availability of
electricity, improved connectivity through provision of rural roads and telecommunications,
construction of warehouses and market infrastructure are expected to lead to efficient supply chain
management in agriculture and hence greater demand for banking activities in rural areas.



Financial Education: Lack of knowledge is an important reason for financial exclusion. Financial
education is required to ensure that large sections of population in urban and rural areas that do not
have access to formal banking and financial services are educated of the advantages of coming into the
fold of such services. It would help in building informed consumers and would result in a win- win
situation for all. Setting-up of credit counseling centre by banks, which would advise public on gaining
access to the financial system would help in this regard.



Deceleration in Agricultural Growth: The yield of most of the agricultural commodities is low leading
to less demand and supply of credit. For instance, the cultivation of commercial crops requires more
funds due to increased cost of production. Similarly, irrigation also enhances the level of production.
Hence, increase in area under commercial crops and increase in irrigated area to gross cropped area is
expected to positively determine the supply of credit. Moreover, large investments in infrastructure are
required for increased agricultural growth, which will also generate employment for semi-skilled
workers.




Mobile Banking: As elaborated in the section on role of technology, banks need to aggressively adopt
mobile banking as a strategy for increasing their outreach in the rural areas. This would offset the decline
in number of rural branches of schedule commercial banks, a trend visible post 1995. In our country where
the majority of the population lives in rural areas, the mobile phone can be converted into a „virtual bank‟.
To operationalise mobile banking, banks need to negotiate with mobile operators and arrive at a mutually
agreeable solution (with regard to the technology platform to use, security concerns, etc.).
Further, regulatory mechanism to support mobile banking with cash in/ cash out facilities also need to be
put in place as early as possible



Inefficient Financial Sector: Problems in credit access are routed in institutional weaknesses like absence
of good credit appraisal, risk management tools in banks, etc. An efficient and organized financial sector
contributes to growth by mobilizing savings for capital formation and investment and optimizes the capital
allocation, which results in productive activities in the economy. Technology and computerization can
reduce the operational cost in rural areas for public sector banks and customer friendly bank products can
be developed with the helpof technology. Improvements in credit delivery system by extending timely and
adequate credit is also required. There are lots of challenges in reducing the adverse consequences of
exclusion and including large sections of the society. The productivity of the small and marginal
farmers, rural non-farm enterprises and other vulnerable groups is required to be sustained with viable
economic activities. Rural banking needs to be friendly to small and marginal farmers and other vulnerable
groups to make inclusive finance successful. A specific type of organisational ethos, culture and Govt.)
participating in inclusive growth.



Technology: As elaborated earlier, technology is the key to providing low cost financial services in rural
areas. It can reduce transaction costs sharply and time taken by banks in processing
applications, maintaining accounts and disbursing loans. It has the potential to address the issues of
outreach and credit delivery in rural areas, in a cost effective manner. However, from the standpoint of
„inclusive banking‟, it needs to be realized that technology per se is not an end in itself. For it to be
effective, it has to aid the reform process, which intends to strengthen the co-operative banks, revitalizing
the omnipresent primary co-operative credit society, addressing the problems of RRBs, etc. The point is
that technology should not be seen as a panacea for all ailments affecting the banking sector



BC/BF Model: Banks are showing keen interest in pursuing the BC/ BF model for attracting new customers.
Banks should ensure that the banking awareness created and potential identified by BFs get translated into
business propositions by providing suitable banking services in the area. One way of doing this is to provide
mobile outlets, which could visit the various locations, as per a schedule programme, so as to purvey
banking services to the excluded.

Conclusion


Despite the laudable achievements in the field of rural banking,
issues such as slow progress in increasing the share of institutional
credit, high dependence of small and marginal farmers on noninstitutional sources, skewed nature of access to credit between
developed regions and less developed regions loom larger than ever
before. Therefore, the key issue now is to ensure that rural credit
from institutional sources achieves wider coverage and expands
financial inclusion. For achieving the current policy stance of
“inclusive growth” the focus on financial inclusion is not only
essential but a pre-requisite. And for achieving comprehensive
financial inclusion, the first step is to achieve credit inclusion for
the disadvantaged and vulnerable sections of our society.



The state has to play an important role in financial markets. The
role itself is necessitated due to pervasive market failures which in
the current globalised scenario is not a rare occurrence. In
developing countries both market and government as institutions
have their limitations, but it is necessary to design government
policies that are attentive to those limitations. Financial Inclusion is
one such intervention that seeks to overcome the frictions that
hinder the functioning of the market mechanism to operate in
favour of the poor and underprivileged.


Impact of Liberalization on Rural Banking in India

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