Published on February 15, 2014
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. Impact of Financial Liberalisation on Rural Banking
Problems Faced by Indian Economy POLICY PARALYSIS TWIN DEFICIT :FISCAL AND CURRENT ACCOUNT DEFICIT URBAN – RURAL DIVIDE Impact of Financial Liberalisation on Rural Banking NO INCLUSIVE GROWTH REGIONAL DISPARITIES
Solution Impact of Financial Liberalisation on Rural Banking
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. Impact of Financial Liberalisation on Rural Banking
Miracle of Banking Impact of Financial Liberalisation on Rural 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. Impact of Financial Liberalisation on Rural Banking
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. Impact of Financial Liberalisation on Rural Banking
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. Impact of Financial Liberalisation on Rural Banking
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
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. Impact of Financial Liberalisation on Rural Banking
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. Impact of Financial Liberalisation on Rural Banking
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. Impact of Financial Liberalisation on Rural Banking
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. Impact of Financial Liberalisation on Rural Banking
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 Impact of Financial Liberalisation on Rural Banking 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! Impact of Financial Liberalisation on Rural Banking
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. Impact of Financial Liberalisation on Rural Banking
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 Impact of Financial Liberalisation on Rural Banking
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. Impact of Financial Liberalisation on Rural Banking
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. Impact of Financial Liberalisation on Rural Banking
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 Financial Liberalisation on Rural Banking
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