RurAl CreDit FinAl

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Chapter 1

Introduction to Rural Credit

Rural credit is any type of lending program or line of credit that is aimed at

impacting a rural population in some manner. There are banks and cooperatives

that specialize in extending this type of credit to farmers and others engaged in the

agricultural task. Depending on the nature of the organization, credit plans may

focus on providingmortgageassistance, securing new equipment, or even funds to

support research into various aspects of land development within a rural

community.

Individuals have access to rural credit options under certain circumstances. For

example, novice farmers and ranchers may be granted a loan or line of credit to

manage the acquisition and upgrade of an existing farm operation, or the

establishment of a new one. Farmers and ranchers are sometimes extended credit of

this type when some sort of natural disaster has ruined crops and threatens the

ongoing operation of the ranch or farm. Some lendersspecialize in farm loans that

offer highly competitive fixed and variable mortgage rates which make it possible

to refinance a farming operation for the purpose of acquiring new machinery or

meet some other pressing need relevant to the operation.

Businesses can also secure rural credit under specific situations. This includes theacquisition or establishment of a commercial farming operation, or a commercial

ranch. A business may also obtain funds earmarked for development, assuming that

the project concerned will benefit the rural community where it is based.

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In many countries, rural credit is extended under the auspices of national

government programs. Often, these programs are focused on enhancing the

agricultural effort within the country as a means of bolstering the economy. With

government sponsorship, farmers and ranchers can often obtain resources that

make it possible to sustain their productivity through growing seasons, than repay

the loans once livestock and crops are sold. It is not unusual for rural credit of this

type to be extended as a means of keeping a balance between imports and exports,

by assuring that a certain percentage of crops and other rural products are produced

domestically.

Along with government funded programs, rural credit is sometimes obtained from

organizations that are founded by and for farmers, ranchers, and dairy operators.

Local cooperatives often provide much-needed credit to farmers and others,

allowing them to receive what they need to operate theirfarms, effectively running

a tab until the current round of crops are sold. Banks created to assist rural

communities will often underwrite loans that can be used for everything from

building improvements to purchasing large quantities of seeds or other elements

required to produce a substantial crop. As with any type of credit option, anyone

who wishes to obtain rural credit must meet the basic criteria of the lender, and

demonstrate a reasonable ability to repay the amount of the loan or the funds

borrowed on a line of credit.

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Agricultural Credit:-

Agricultural credit is a financial term that refers to loans and other types of credit

extended for agricultural purposes. Many regions have agricultural credit systems

that promote the expansion and continued survival of farm &livestockoperations.

In some cases, agricultural credit can be used by farmers to purchase non-farm

items, such as housing and infrastructure.

Providing food is one of the major pursuits of any successful country; a country

that cannot feed itself is eternally dependent on external sources which may cost

more and may plunge a region further into debt. In recognition of the valuable and

critical work done in the agricultural industry, many governments oversee

special credit divisions that deal solely with farming and related pursuits. India,

Russia, most European nations, Canada, and the United States all have long

histories with agricultural credit systems.

Depending on the region, there are several different types ofagricultural

credit available. Some loans are geared specifically toward new farmers and

ranchers that are opening a new farming business and need start-up capital for land,supplies, and wages. Others are meant for established agricultural businesses that

are looking to expand on the present level of operations.

Some agricultural credit loans are emergency loans extended after natural disasters

to help make fast repairs and restore a farm or ranch to operating conditions. Loans

may also be available to young farmers, or those considered socially disadvantaged

due to racial or gender prejudice.

There are necessary requirements that must be met for agricultural credit extension,

just as with any loan. Borrowers agree to a repayment length, must make regularly

scheduled payments, and usually pay an interest rate on the loan. Since

these credit programs exist to help farmers continue to grow and succeed and are

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usually in the interest of the region, interest rates on agricultural loans may be

lower than on loans from private banks. Information and forms for agricultural

credit application can usually be found on government agricultural websites.

In the days of an expanding global community, many non-profit and government

organizations are attempting to spread the idea ofagricultural credit to developing

nations. By helping a poor nation improve farming and infrastructure, starvation

levels may go down, employment rates may increase, and developing regions may

become more self-sufficient. Often, these subsidies and loans come with certain

requirements, such as adherence to labor practices and environmental standards.

Some non-profits have even set up programs known as micro loans, which allow

wealthier donors to loan a specific amount of money to a farmer in a developing

nation for a short period of time.

Evolution of the Rural Credit System in India:-

Rural financial market development is a complex process .The creation of the

formal credit structure for financial agriculture and other rural activities

commenced in India in the early part of this century with the introduction of co-

operatives. It received a big push during the plan era. The All India Rural Credit

Survey Committee (AIRCS) 1954 forms the edifice for the policy towards the

development of the Institutional credit structures. The committee highlighted the

awful inadequacy in the supply of institutional credit to the rural sector and

proposed an integrated scheme of reorganization many more committees and

recommendations. Priority sector lending, lead bank scheme, services area

approach, setting up of NABARD, are some of the outcomes of the repeated

scrutiny of the system.

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Coming to the recent committees, the Agriculture Credit Review Committee

(ACRC) 1989 examined the existing rural credit system in detail. It highlighted the

yawning gap between income generated and costs incurred by rural credit

institutions, necessitating external assistance. The committee recommended greater

autonomy for commercial banks; the weakness of RRBs were seen as endemic to

the system with non-viability built into them. Co-operatives were sought to be

strengthened through thrust on deposit mobilization and reduction of political

interference. The Narsimham Committee on Financial Sector Reforms 1991,

among other things, recommended a redefinition of priority sector, gradual phasing

out of directed credit programmes to 10% of aggregate bank credit and

deregulation of interest rates.

Looking at the situation today, the exercise seems to have resulted in a scenario

where "an imposing superstructure of credit institutions has been built which one

committee after another has kept reshuffling or adding to" (Dandekar, 1993).

Commenting broadly on the exercise in developing countries (to which the India

experience seems to be no exception), Braveman and Guasch, 1986, see most ofthe changes in institutional design as largely superficial, window dressing type

rather than substantial. "The institutions have been perceived more like a welfare

agency than a commercial undertaking. There seems to be little effort to integrate

deposit taking activities or to generate saving mobilization-a vital activity for the

long run success of a credit institution. No provisions were made to deal with non-

compliance, or to implement a reasonable system of incentives to both lenders and

borrowers to induce the desired objectives."

The major problems of the rural credit system thus evolved are as follows:

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1. It has not produced desired results in terms of the direction, quantum and

quality of the flow of credit.

2. It is afflicted by alarming high overdue, bad debts, loan defaults,

unavailability, low profitability, overburdening of staff, declining control and

deteriorating customer services. It is estimated that the over dues of credit

institutions have increased from Rs. 2,818 crores to Rs. 9,661 crores during 1983-

93.

3. The complex tiring of funds through RBI-NABARD-Commercial Banks-

State Cooperative Banks (SCBs)-District Co-operative Banks (DCBs)-Primary

Agricultural Credit Societies (PACS), has tended to unduly increase the cost of

banking.

4. Features of rural credit markets in developing countries may be understood

as responses to the problems of adverse selection, moral hazard and enforcement.

Imperfect information in this sense creates problems from the perspective of

constrained Pareto efficiency. In Indian case too, information imperfections have

contributed to inefficiencies like high transaction costs and low recycling of credit.

5. From the institutional perspective, role of an appropriate institution as an

enforcer and transmitter of incentives and motivator and inducer of saving is

essential for development. The institutional design should serve to promote and

facilitate functioning at the levels of both the leaders and borrowers. This factor

seems to have been largely overlooked in the Indian case. Motivating to perform

has not been given due importance.

6. Directed credit program and subsidized lending have badly affected viable

functioning of credit disturbing units. The entire exercise has largely come to be

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characterized by tiring of funds from above to borrowers who often tale as a gift

that need not be returned.

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Chapter 2Rural financial services

PURPOSE

The purpose of this chapter is to examine the particular features of rural financial

services that need to be considered in deciding what forms of, and approaches to,

decentralization may be appropriate.

KEY POINTS

Credit is a private good but the fact that it involves an exchange of access to

resources now for an undertaking to repay in the future makes it different to

other services. This generates screening, incentives and enforcement

problems for those supplying loans.

Centralized and directed credit provision was based on the misconceptions

that the priority need for rural borrowers was to finance agricultural

production and that farmers were too poor to pay market rates for credit.

The new paradigm advocates the development of rural financial systems and

the decentralization of rural credit provision through a variety of institutional

and organizational devices.

An important policy setting and regulatory and promotional role remains for

central government.

The most far-reaching objective of decentralization of rural financial

services is to mobilize the potential of rural financial markets.

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The nature of rural financial services

The risks of credit provision

Rural financial services are nowadays concerned with a variety of services

including not only agricultural lending but lending to farm households for non-

agricultural production and consumption purposes, loans made to non-farm rural

firms, rural savings deposit services and other financial services such as insurance.

However, this Chapter mainly focuses on the provision of agricultural credit.

Broadly speaking, the provision of credit in the form of loans allows uneven

income and expenditure streams to be smoothed out. Credit provision is a private

good as it is excludable and rivalrous. However, it is a different type of service to

others discussed in this Sourcebook as a loan involves an exchange of access to

resources now for an undertaking to repay at some future date. In effect, a property

right in current consumption is exchanged for a property right in future

consumption. From the lenders point of view this involves two risks, namely, that

the borrower will be unable to repay (the use made of the funds is less productive

than anticipated perhaps due to unfavorable weather or lower market prices) or that

they will be unwilling to repay (opportunistic behavior due to asymmetric

information).

In total, the lending activity entails:

a. Exchange of consumption today for consumption in a latter period

b. Protection against default risk

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c. Information acquisition regarding characteristics of loan applicants

(the screening problem)

d. Measures to ensure that borrowers take those actions that make repayment more

likely (the incentives problem)

e. Actions to increase the likelihood of repayment by borrowers who are able to do

so (the enforcement problem).

This risk of non-repayment means that the private sector is usually unwilling to

provide credit unless collateralis available or the lender has particular ties to the

borrower. The high transaction costs associated with imperfect information (search,

monitoring and enforcement), and risk, increase the costs of credit transactions and

lower the effective demand. The dispersed nature of rural populations increases the

transaction costs of servicing rural areas compared to urban areas for many credit

providers. In principle, the government should be a more willing lender than the

private sector as it is less risk-averse and has greater powers of coercion and hence

ability to obtain repayment. However, it is generally disadvantaged relative to the

private sector in terms of local knowledge and loyalty from borrowers, leaving it

exposed to an adverse selection problem and unwillingness by borrowers to repay

loans.

The demand for and supply of rural financial services

The effective demand for rural credit

Many of the problems relating to rural financial services have derived from a

misunderstanding of the nature of the effective demand for these services. The first

misconception was that farmers and other rural dwellers mainly needed credit for

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agricultural production purposes. In fact, an effective demand for credit, backed up

by a willingness and ability to pay, can exist to smooth out a variety of situations

where income and consumption streams are poorly phased. Credit for non-

agricultural purposes may be as important as agricultural loans. Indeed, for many

rural dwellers the most important reason for demanding credit is as a consumption

loan to meet the costs of living in the months before the next harvest is due, not to

purchase inputs to raise agricultural productivity. The second misconception was

that the majority of poor farmers were too poor to pay for credit, which is, there

was a need for credit but little effective demand. The evidence now is that poor

households are both willing and able to service loans if they borrow for their own

perceived needs and are adequately screened and monitored.

The paradigm of directed credit provision

These misconceptions led to agricultural credit policies during the 1960s and 1970s

that were based on a paradigm summarized in. The policy implications of the

paradigm were that:

It was the function of the central government (normally of the Ministry of

Agriculture, or those acting on delegated authority to government-owned

financial institutions) to decide:

- What farmers should do with credit?

- What the cost of credit to rural borrowers should be

- Who should actually benefit from the loans?

- What the total amount of agricultural credit should be.

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It was the central government function to provide:

- Savings mobilization mechanisms in rural areas

- lending facilities on a subsidized basis.

Responding to farmers demand for credit for other purposes than

agricultural production was not a government priority.

The paradigm of centralized and directed agricultural credit policies

Agriculture is a major source of livelihood and the main engine of economic

growth in developing countries therefore the development of agricultural

production is a public priority

Technology innovations and more input use are essential to increase

production

Farmers need more financial resources to adopt technology innovations

Most farmers are poor, hence there is a gap in cash resources which blocks

the adoption of new technologies and credit is needed to fill the gap

Agricultural production is a risky business; returns in agriculture are less

than in the other sectors of the economy

Market interest rates reflect opportunities in other sectors: the market cost of

money is too high for farmers to borrow for productive purposes

Government must intervene with subsidized lending (seeking no profit,

amortizing high transaction costs, spreading the risk on a national basis)

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Subsidies are justified if loans aim at specific government objectives

Therefore agricultural loans must be targeted to selected crops and

technologies of interest to government

Loan repayment capacity is shown by viable crop/farm budgets models

To extend subsidized credit for specific purposes, specialized government

financial institutions must be established and financed with public funds

Specialization advises that the savings collection and the lending function of

financial intermediation are kept distinct

Since most borrowers in rural areas are small farmers (i.e. poor), low cost

credit responds to poverty alleviation considerations as well

Subsidized credit also compensates farmers for high taxation of agriculture

(such as price control on basic grains, export taxes, artificial exchange rates,

etc.).

The supply of rural financial services

Unique problems of supplying agricultural finance

FAO/GTZ (1998b) discusses a series of special factors that are likely to influence

the supply of agricultural finance. These include:

The high financial transaction costs of attending dispersed and small farm

households

The seasonality and the importance of opportune timing of on-farm finance

for cultivation practices, input application, harvesting (and related output

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marketing), the heterogeneity in farmers lending needs (seasonal and term

lending) and the relative long duration of agricultural lending contracts

The dependence on sustainable natural resources management and the

relative low profitability of on-farm investments

The various weather and other production risks, together with marketing

risks related to agriculture, that require appropriate risk management

techniques, both for producers and financial intermediaries

The limited availability of conventional bank collateral that farm households

can offer, that highlights the need to increase the security of existing loan

collateral or develop appropriate collateral substitutes

The reality that farm households are confronted with emergency needs and

that their loan repayment capacity is highly dependent on consumption and

social security contingencies

The need for adequate training of both bank staff and farmer clients.

The formal sector

In most developing countries there are typically two types of suppliers or financial

intermediaries. The formal sector consists of bank and non-bank financial

institutions that provide intermediation services between depositors (or the

government) and borrowers and, as they fall under the banking law, are regulated

and supervised. As noted above, in the past these typically charged relatively low

rates of interest that were usually subsidized by the government. The flow of funds

in a typical centralized and directed agricultural credit system is shown. In many

cases little attention was paid to voluntary savings mobilization in rural areas as

small farmers, being poor, were considered to have a low propensity to save.

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The informal sector

The informal sector typically comprises private individuals - professional

moneylenders, traders, commission agents, landlords, friends and relatives - who

lend money generally out of their own equity and are not regulated or supervised

by the national monetary authorities. One of the major differences between these

two types of supplier is the mechanisms used for dealing with the screening,

incentives and monitoring problems with the informal sector relying much more

heavily than the formal sector on their intimate knowledge of their clients toovercome these problems.

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The flow of funds in the centralized and directed agricultural credit system

Crowding out the informal sector

Informal financial markets have always existed in rural areas, but were ignored by

government policy for a very long time. The agricultural credit paradigm (Box 8.1)

excludes informal markets from playing a role on two grounds. First, that the

operators in informal financial markets do not share the same commitment as

government to promoting agricultural production. Second, they would charge

exorbitant interest rates which, allegedly, agricultural producers could not afford to

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pay. In many countries and for almost 30 years, governments hindered the

spontaneous development of informal financial intermediaries by occupying,

through subsidized operations, the market space that informal operators could have

exploited and developed. This has been defined as the crowding out effect of

government agricultural credit policy.

Appropriate forms of decentralization

Introduction

With few exceptions, the consequences of the centralized and directed approach to

agricultural credit were catastrophic. A fair number of agricultural credit banks

were liquidated during the 1980s and early 1990s across the world, when it became

clear that governments could not afford to:

Continue to subsidize low interest lending rates

Make good poor loan recovery

Compensate for very high operating costs and overheads.

In addition, the results achieved in terms of impact on agricultural production were

rather modest. This situation has prompted the elaboration of alternative policies

based on a very different paradigm. Liberal economics and decentralization

principles inspire the reform of the rural financial sector. Box 8.2 briefly states the

new paradigm.

The major objectives of decentralization of rural financial services are to:

Bring about closer links between service providers and beneficiaries

Respond to the demand for a variety of financial services by the rural people

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Improve the transparency and accountability of financial institutions dealing

with rural people

Reduce the high costs and risks of financial transactions in rural areas.

The paradigm of decentralized rural financial services

Demand for credit is one thing, demand for agricultural technology is

another: they may or may not coincide for individual borrowers

Borrowers are willing to service loans if they borrow for their own perceived

needs

Banks must lend to creditworthy clients responding to clients independent

assessment of their own requirements and preferences

Only those loan officers who know their clients well can effectively identify

creditworthy borrowers

Market-determined interest rates ration the demand for credit and provide

incentives for savings deposits

Competition among financial services providers improves efficiency and

lowers the cost of lending

Access to local financial services/institutions reduces transaction costs to

clients and improves lenders contacts with clients

Sustainable banking is based on savings mobilization

Financial institutions that offer local savings facilities at competitive and

appropriate conditions are more likely to mobilize enough deposits to support

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a sound lending policy

Financial institutions which lend to creditworthy clients recover all the loans

made, and can earn enough interest to cover their cost hence they are

sustainable

Sustainable institutions will grow in the course of time

Sooner or later, non-sustainable institutions will fail completely

Prospects of profitability and sustainability and growth encourage private

and voluntary sector enterprises to develop financial service institutions.

Reform of government-owned institutions

Two approaches to decentralization of rural financial services can be distinguished.

One approach involves a drastic reform or restructuring of government-owned

financial institutions operating in rural areas, by shifting power away from the

centre and changing responsibility and accountability systems through a

combination of deconcentration and devolution measures.

Diversifying ownership

The other approach aims at diversifying the ownership of the financial institutions

operating in rural areas. This objective can be achieved in three major ways:

Changing the capital structure of government-owned agricultural

development banks by selling a controlling interest to the private sector

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Encouraging the development of private banks and by eliminating subsidies

and liquidating, restructuring or reducing the scope of operations of banks

retained in the public sector

Promoting and regulating the emergence of new types of grassroots-based

rural financial intermediaries.

Naturally, all these ways of diversifying ownership can be implemented at the

same time. When many service providers operate in capital markets a multiplicity

of services delivery channels, distributing the power and influence associated with

the control of financial flows, is created. Competition and a variety of policies, new

financial technologies and products are introduced.

Each of these approaches will be considered in the ensuing sections.

The new role of central government

Different strategies, different actors

In rural areas, the starting point for elaborating the policy implications of the new

paradigm is a clear separation of the agricultural credit and the extension functions.

Promoting the adoption of new agricultural technologies is the task of extension,

not of credit. There is a strong case for governments to decentralize their rural

financial services, let rural financial services develop in the private and non-profit

mutualistic sectors and, where and when appropriate, reduce the overwhelming

presence of public financial institutions. Decentralized and private and voluntary

sector financial institutions are better placed to respond to peoples preferences, to

identify creditworthy borrowers, and to introduce effective mechanisms for savings

mobilization. The new role of government is thus support of institutional

development, rather than promotion of targeted incremental crop production

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through financial intermediation. This new role embraces the setting of a

favorable environment, the introduction of appropriate legislation, a regulatory role

and, perhaps, financial and technical support to promote new organizations.

Regulation of rural MFIs

As the importance of rural micro-finance institutions (MFIs) in the local capital

markets increases , their functions become diversified and not directly connected

with agricultural production. The need then arises for government to deal with

them in similar terms to those used for formal institutions. The monetary

authorities thus increasingly assume responsibility for the supervision of theiractivities, with a view to sound management of money, rather than Ministries of

Agriculture whose primary interest is agricultural production.

The promotion of rural MFIs raises questions such as:

What rules should govern the operations of decentralized rural financial

institutions?

What form, content, and degree of control should apply to ensure that the

rules are respected?

Who should exercise the control?

Regulation and supervision may cause more problems than those they are intended

to overcome. For example, regulations related to registration, licensing, and

inspection may offer opportunities for interference and corruption and supervisors,

in addition to their task of overseeing banks, may not devote enough staff and time

to inspect adequately a large number of new types of small rural financial

institutions. Rules and controls of financial institutions normally:

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Concern the technical aspects of national money management

Are designed to establish good governance in the institutions

Aim at sound and prudent banking practices and respect, by the

management, of the law and of the by-laws of the institutions as set by the

shareholders.

Such rules deal with problems common to all financial institutions, and must be

respected by all. Detailed regulations, however, differ depending on the nature of

the regulated institutions. The main objectives of the monetary authorities control

over financial intermediaries are to:

Manage the national money supply: this requires the continuous verification

of the level of the financial aggregates such as money in circulation and

volume of credit, and taking measures to influence their trend

Protect the interest of depositors and the stability of the overall national

financial system: this requires ensuring that the administrators of financial

institutions act in accordance with the law and with sound banking practices

Promote efficiency in the national financial markets.

Accordingly, the main objectives of the rules and controls over decentralized rural

financial institutions should be to ensure that:

The decision-making and accountability procedures of the organizations are

in accordance with the law and with the by-laws of each organization and

that management follow them properly, for instance, ensuring that accurate

and timely banking records are kept, etc.

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Accounting and audit procedures are transparent, adequate, properly and

timelessly followed by the management, and that shareholders have access

to independent internal and external audit reports.

Lending and savings mobilization policies, procedures, and management are

conducive to financial sustainability, and minimize the risk of fraud and loan

delinquency.

Responsibility for regulation

The elaboration of such rules, and the controls required for their enforcement, is

not in the field of competence of Ministries of Agriculture, but is in the naturaldomain of the monetary authorities. Rules need to be established centrally, whereas

controls can either be centralized or delegated. One option is for the central

monetary authorities to take over direct responsibility for inspections of rural

MFIs, as they do in the case of banks and other formally-established financial

intermediaries. Another option is to delegate the control of decentralized financial

service institutions to the apex body of cooperatives or MFIs. The latter would, in

turn, be directly controlled by the monetary authorities, and would be responsible

to them for controlling their member MFIs. A special opportunity for delegation is

presented when MFIs are promoted and supported by a commercial or a

development bank. In these cases, the commercial or development bank, which is

under the control of the national monetary authorities, will supervise in its own

interest the operations of the MFIs that they help to develop.

Financial support

Expenditure of public money may be necessary to support new institutions of the

cooperative bank type, which emerge in the private or non-profit or mutualistic

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sector. Subsidies would assist primarily with capacity building aimed at increasing

the staff and managerial skills of the new institutions. These subsidies may be

justified on the grounds that institutional development and diversification of

service providers are public goods that help to deal with financial market failures.

They are not intended to fill gaps in operating income or interfere with interest

rates and the free play of market forces. Support activities eligible for subsidies

would include:

The initial help to groups wishing to start a savings and loans association

(spontaneous groups animation, market studies, help to define by-laws, help

with registration procedures, etc.)

Experimentation/adoption and training in new financial technologies and

products and better banking practices for financial officers of emerging

institutions

Initial assistance in keeping adequate accounts and drafting balance sheet

and income statements

Initial free assistance in routine inspection and audit of accounts.

Loans, but not grants, at market or near market terms to the new rural financial

institutions, may also be justified (providing banks follow normal risk assessment

practices in making loans) with a view to expanding their operations beyond the

resources that they are able to mobilize by way of savings deposits.

Governments may also support the start-up process of designing innovative creditguarantee approaches for banks (FAO, 1998b). However, banks ought to assume a

good share of the risk in order to ensure that they assess their clients effectively.

Sustainability requires financial institutions, irrespective of their size and nature, to

respect sound banking practices. They should not borrow funds that they may not

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be able to remunerate at market rates of interest. The market will determine to what

extent MFIs are sufficiently creditworthy customers for higher level and larger

financial intermediaries to lend money to them.

Diversifying ownership

Privatization of agricultural banks

Several new liberal governments have tried to privatize government-owned

agricultural banks. In practice, there have been many difficulties due to the

problem of capital valuation and to the poor expectations of profit from future

operations. Short of outright fraud, government banks are in financial trouble for

two main reasons:

Excessive operating costs (overstaffing, unprofitable branches, low staff

productivity, wrong personnel policies, inadequate spread between active

and passive interest rates, etc.)

The poor quality of their portfolio (high loan delinquencies).

Excessive operating costs can eventually be corrected by new management,

provided labour legislation does not impose too much rigidity, but the poor quality

of the loan portfolio may often be difficult to remedy in the short- to medium-term.

Thus governments are unlikely to find a buyer for take-over unless they clear the

portfolio of bad loans. In some cases, the bulk of bad loans are held by bankrupt

government enterprises. However, buying out delinquent debtors is a poor solution,

because it does not establish an encouraging environment for making new loans.

Transferring non-performing assets to a separate company responsible for

recovering them has also been tried, but it did not always ensure the financial

recovery of the original lender.

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Liberalization of the formal financial market

The second option involves the liquidation of non-viable government banks,

coupled with allowing the entry of foreign capital and the encouragement of local

private groups to form joint ventures with foreign banking groups. Naturally,

private investors, particularly foreign capital, tend to be cautious given past

experiences with nationalization and political interference with staffing and lending

policy. However, in the short term, this option may not be a solution for rural areas

because private enterprises usually invest in commercial banking in urban areas

before expanding to rural areas. However, an important effect in rural areas would

be to restore lending to viable crop purchasing, equipment and input trading

enterprises. Part of the finance made available to input suppliers and traders is

likely to be passed on to farmers in the form of suppliers credit.

Micro-finance institutions

The most far-reaching objective of decentralization of rural financial services is to

mobilize the potential of informal rural financial markets and to rationalize their

operations. The operators in the informal market include all those intermediaries

who are not subject to the regulations and supervision of the monetary authorities,

such as money lenders, ROSCAS (rotating savings and credit associations),

informal savings groups, informal safe-deposit providers, village level savings and

loans associations, etc.

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The third option, then, is to encourage the expansion of MFIs in the voluntary or

mutualistic sectoras rural financial intermediaries. The common feature of mutual

or cooperative financial institutions is that their members own them. Members

savings are mobilized and people appointed and controlled by members oversee the

use of these savings. The cooperative nature of these institutions improves the

chances that loans respond to the borrowers requirements. Moreover, the loans are

made to borrowers who are well known to the institution and whose

creditworthiness most members of the institution can easily assess. In this case,

loan delinquency tends to be limited, since the social pressure to repay results from

lending the members own hard-earned savings. Safeguarding of ones own money

is a much stronger incentive for repayment than a generic sense of duty or interest

in becoming eligible for an additional loan. The social pressure for loan repayment

in classical group-lending schemes of agricultural development banks, where it was

the governments (or the donors) external funds rather than the members own

money that was loaned, in general has not worked. Experience suggests, however,

that even with own funds the group liability mechanism tends to weaken whenever

the local financial institution becomes too large or a large share of loan resources is

obtained from outside sources.

The role of NGOs

NGOs have played a significant role in promoting the development of informal

rural financial services. Although NGOs continue to play an important role in

promoting micro-finance in many developing countries, during the 1990s the

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growth of decentralized financial systems has evolved far beyond what NGOs

initiated. Professionalization and new actors coming into the picture have become

determining features. Some NGOs play a role in implementing a deliberate rural

financial services decentralization policy within the framework of more articulated

initiatives promoted by private banks, local interest groups, governments and

donors. The provision of both financial and non-financial support services, by the

same or by different organizations, as well as sustainability of the provided

services, has become main concerns. There are a wide variety of new approaches,

policies, objectives, and actors. Broadly speaking, four types of actors promote the

development of rural MFIs, besides NGOs acting on their own initiative:

Government agricultural development banks

Specialized cooperative finance development organizations of foreign origin,

contracted by donors or governments

Private commercial banks

Donor/government special programme units.

A well-established network of micro-finance cooperative institutions can change

the flow of financial resources in a very significant way. Figure 8.2 describes, in a

simplified manner, the transfer of resources and of decision-making power in

financial intermediation in the cooperative banking sector. The differences between

the flow shown in & that of should be evident.

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The flow of resources in a cooperative banking system

Apex organizations

The apex organizations of MFIs play a very important role. Accordingly,

encouraging the emergence of such organizations is an important component of

decentralization policy in rural financial markets.

Apex organizations help to provide a unified culture within member institutions,

which is a feature of social cohesion and a factor of success. They also provide

valuable technical support in the form of accounting, auditing, training and a

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central liquidity facility. They assist in securing lines of credit from commercial or

development banks and manage the liquidity requirements by transferring funds

from member MFIs with surplus deposits to member MFIs with an excess of

effective credit demand. Last but not least, they can join together with other apex

organizations to lobby politicians and influence government policy.

Conclusions

The paradigm of agricultural credit has changed fundamentally from a policy that

promoted centralized and directed agricultural credit to one that supports

decentralized rural financial services and rural financial markets and systemsdevelopment. The new paradigm emphasizes the distinction between the supply-

led finance of new agricultural technologies and the effective demand by rural

households for credit that can be used for their own perceived needs. It advocates

the decentralization of credit provision, the encouragement of competition between

loan services providers to lower the costs and risks of lending, and the use of

market rates of interest as a rationing device for credit allocation. It recognizes also

the importance of mobilizing local savings through offering competitive interest

rates and a variety of savings products and flexible procedures. In the new

paradigm the role of the government is to support institutional development, rather

than the promotion of targeted incremental crop production through involvement in

direct financial intermediation.

Support to institutional development and decentralization involves reformingpublic development banks, privatizing institutions that can perform better in the

private and mutualistic sectors, encouraging the growth of financial markets and

the development of sustainable rural financial services. Subsidies can be justified

for capacity building to increase competition. There are two approaches to

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decentralizing financial services in rural areas. One approach involves a drastic

reform or restructuring of government-owned development financial institutions

operating in rural areas. The other is to diversify the ownership and governance

structure of rural financial institutions by changing the capital ownership of

existing government institutions and/or by promoting the development of a

multiplicity of financial services providers belonging to different owners. This

includes the encouragement of the expansion of MFIs in the mutualistic sector.

The most far-reaching objective of decentralization of rural financial services is to

mobilize the potential of informal rural financial markets and to rationalize their

operations. This may lead to a fast growth of micro- financial institutions in the

rural areas and it is important to find effective ways of regulating them. Providing

appropriate methods are followed, considerable gains can be expected from

decentralization and a sustainable network of rural financial services providers may

emerge.

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Chapter 3

RURAL BANKING

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INTRODUCTION

Rural banking in India started since the establishment of banking sector in India.

Rural Banks in those days mainly focused upon the agro sector. Today,

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commercial banks and Regional rural banks in India are penetrating every corner

of the country are extending a helping hand in the growth process of the rural

sector in the country.

BANKS: FUNCTIONING FOR THE DEVELOPMENT OF RURAL AREAS

The area of operation of a majority of the RRBs is limited to a notified area

comprising a few districts in a State.SBI have 30 Regional Rural Banks in India

known as RRBs. The rural banks of SBI are spread in 13 states extending from

Kashmir to Karnataka and Himachal Pradesh to North East. Apart from SBI, there

are other few banks which functions for the development of the rural areas in India.Few of them are as follows.

Haryana State Cooperative Apex Bank Limited

NABARD

Sindhanur Urban Souharda Co-operative Bank

United Bank of India

Syndicate Bank

Co-operative bank

CO-OPERATIVE BANKS AND RURAL CREDIT

The Co-operative bank has a history of almost 100 years. The Co-operative banks

are an important constituent of the Indian Financial System, judging by the role

assigned to them, the expectations they are supposed to fulfill, their number, and

the number of offices they operate.

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Their role in rural financing continues to be important even today, and their

business in the urban areas also has increased phenomenally in recent years mainly

due to the sharp increase in the number of primary co-operative banks.

Co-operative Banks in India are registered under the Co-operative Societies Act.

The RBI also regulates the cooperative bank. They are governed by the Banking

Regulations Act 1949 and Banking Laws (Co-operative Societies) Act, 1965.

Co-operative banks in India finance rural areas under:

Farming

Cattle

Milk

Hatchery

Personal finance

Institutional Arrangements for Rural Credit (Co-operatives)

Short Term Co-operatives

Long Term Co-operatives

Short Term Co-operatives

|

District Central Co-operative Banks

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|

State Co-operative Banks

|

Primary Agriculture Credit Co-operative Societies

|

Branches

Long Term Cooperatives

|

State Agriculture & Rural Development Banks

|

Primary Agriculture & Rural Development Banks

|

Branches

Primary Agricultural Credit Societies (PACSs)

An agricultural credit society can be started with 10 or more persons normally

belonging to a village or a group of villages. The value of each share is generally

nominal so as to enable even the poorest farmer to become a member. The

members have unlimited liability, that is each member is fully responsible for the

entire loss of the society, in the event of failure. Loans are given for short periods,

normally for the harvest season, for carrying on agricultural operation, and the rate

of interest is fixed. There are now over 92,000 primary agricultural credit societies

in the country with a membership of over 100 million.

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The primary agricultural credit society was expected to attract deposits from

among the well to-do members and non-members of the village and thus promote

thrift and self-help. It should give loans and advances to needy members mainly

out of these deposits.

Central Co-operative Banks (CCBs)

The central co-operative banks are located at the district headquarters or some

prominent town of the district. These banks have a few private individuals also

who provide both finance and management. The central co-operative banks have

three sources of funds,

Their own share capital and reserves

Deposits from the public and

Loans from the state co-operative banks

Their main function is to lend to primary credit society apart from that, central

cooperative banks have been undertaking normal commercial banking business

also, such as attracting deposits from the general public and lending to the needy

against proper securities. There are now 367 central co-operative banks.

State Co-operative Banks (SCBs)

The state Co-operative Banks, now 29 in number, they finance, co-ordinate and

control the working of the central Co-operative Banks in each state. They serve as

the link between the Reserve bank and the general money market on the one side

and the central co-operative and primary societies on the other. They obtain their

funds mainly from the general public by way of deposits, loans and advances from

the Reserve Bank and they are own share capital and reserves.

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COMMERCIAL BANKS AND RURAL CREDIT

The commercial banks at present provide short term crop loans account for nearly

45 to 47% of the total loans given and disbursed by the commercial banks. Term

loans for varying periods are given for purchasing pump sets, tractors and other

agricultural machinery, for construction of wells and tube well, for development of

fruit and garden crops, for leveling and development of land, for purchase of

ploughs, animals, etc. commercial banks also extend loans for allied activities viz.,

for dairying, poultry, piggery, bee keeping, fisheries and others. These loans come

to 15 to 16%.

Commercial Banks and Small Farmers

The commercial banks identifying the small farmers through Small Farmers

Development Agencies (SFDA) set up in various districts and group them into

various categories for credit support so as to enable them to become bible

cultivators. As regard small cultivators near urban areas and irrigation facilities,

commercial banks can help them to go in for vegetable cultivation or combine it

with small poultry farming and maintaing of one or two milch cattle.

IRDP and commercial banks

Since October 1980, the Integrated Rural Development Programme (IRDP) has

been extended to all the blocks in the country and the commercial banks have been

asked by the government of India to finance IRDP. The lead banks have to prepare

banking plans and allocate the responsibility of financing the identified

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beneficiaries among the participating banks. Commercial banks have been asked to

finance all economically backward people identified by government agencies.

REGIONAL RURAL BANKS AND RURAL CREDIT

The Narasimham committee on rural credit recommended the establishment of

Regional Rural Banks (RRBs) on the ground that they would be much better suited

than the commercial banks or co-operative banks in meeting the needs of rural

areas. Accepting the recommendations of the Narasimham committee, the

government passed the Regional Rural Banks Act, 1976. The main objective of

RRBs is to provide credit and other facilities particularly to the small and marginalfarmers, agricultural laborers, artisans and small entrepreneurs and develop

agriculture, trade, commerce, industry and other productive activities in the rural

areas.

The progress of RRBs in the initial stage was quite rapid. For instance, the Sixth

Five-year plan (1980-85) had envisaged the setting up of 170 RRBs covering 270

districts by the end of March 1985.The target was exceeded. There are now 196

RRBs in 23 states of the country with 14,200 branches.

Structure of regional rural bank

The establishment of the Regional Rural Banks (RRBs) was initiated in 1975 under

the provisions of the ordinance promulgated on 26.9.1975 and thereafter Section

3(1) of the RRB Act, 1976. The issued capital of RRBs is shared by Central

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Government, sponsor bank and the State Government in the proportion of 50%,

35% and 15% respectively.

RRBs established with the explicit objective of:

* Bridging the credit gap in rural areas

* Check the outflow of rural deposits to urban areas

* Reduce regional imbalances and increase rural employment generation

Micro-Finance

Micro-finance is a novel approach to "banking with poor" as they attempt to

combine lower transaction costs and high degree of repayments. The major thrust

of these micro-finance initiatives is through the setting up of Self Help Groups

(SHGs),Non-Governmental organizations(NGOs),Credit Unions etc.

Kisan(Farmers') Credit Card

Another notable development in recent years is the introduction of Kisan Credit

Cards(KCC) in 1998-99.The purpose of the Kisan Credit Cards(KCC) scheme is to

facilities short term credit to farmers. The scheme has gained popularity and its

implementation has been taken up by 27 commercial banks, 187 RRBs and 334

Central cooperative banks.

Agricultural Insurance

As Agricultural is highly susceptible to risks such as drought, flood, pests etc. It is

necessary to protect the farmers from natural calamities and ensure their credit

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eligibility from the next season. Towards this purpose, the Government of India

introduced a comprehensive crop insurance scheme through the country in 1985

covering major cereal crops, oilseeds and pulses. Among commercial crops, seven

crops viz., sugarcane potato, cotton, ginger, onion, turmeric and chillies are

presently covered.

MARKETING OF MUTUAL FUND UNITS - RRBS

With a view to expanding the scope of business of RRBs and considering that

marketing of Mutual Fund (MF) units provides a profitable avenue for banks, it has

been decided by RBI on 17th May 2006 to allow Regional Rural Banks (RRBs) to

undertake marketing of units of Mutual Funds, as agents.

Accordingly, RRBs may, with approval of their Board of Directors, enter into

agreements with Mutual Funds for marketing their units subject to the following

terms and conditions:

* The bank should only act as an agent of the customers, forwarding applications

of the investors for purchase / sale of MF units to the Mutual Fund / Registrar

Transfer Agents.

* The purchase of MF units should be at the risk of customers and without the bank

guaranteeing any assured return.

* The bank should not acquire such units of Mutual Fund from the secondary

market.

* The bank should not buy back units of Mutual Funds from their customers.

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* The bank holding custody of MF units on behalf of their customers should ensure

that its own investment and investments belonging to their customers are kept

distinct from each other.

* Retailing of units of Mutual Funds may be confined to some select branches of

the bank to ensure better control.

* The bank should comply with the extant KYC/ AML guidelines in respect of the

applicants.

* The RRBs should put in place adequate and effective control mechanisms in

consultation with their sponsor banks.

CONCLUSION

RRBs' performance in respect of some important indicators was certainly better

than that of commercial banks or even cooperatives. RRBs have also performed

better in terms of providing loans to small and retail traders and petty non-farm

rural activities. In recent years, they have taken a leading role in financing Self-

Help Groups (SHGs) and other micro-credit institutions and linking such groups

with the formal credit sector.

RRBs should really be strengthened and provided with more resources with which

they can undertake more of these important activities. And most certainly they

should be kept apart from a profit-oriented corporate motivation that would reduce

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their capacity to provide much needed financial services to the rural areas,

including to agriculture. Ideally, the best use of the resources raised by RRBs

through deposits would be through extensive cross-subsidisation. This, in turn,

really requires an apex body that would cover and oversee all the RRBs, something

like a National Rural Bank of India (NRBI).

The number of rural branches should be increased rather than reduced; they should

be encouraged to develop more sophisticated methods of credit delivery to meet

the changing needs of farming; and most of all, there should be greater

coordination between district planning authorities, panchayati raj institutions and

the banks operating in rural areas. Only then will the RRBs fulfill the promise that

is so essential for rural development.

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4. Role of NABARD in Rural Credit

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ROLE OF NABARD IN RURAL CREDIT:-

NABARD is set up by the Government of India as a development bank with the

mandate of facilitating credit flow for promotion and development of agriculture

and integrated rural development. The mandate also covers supporting all other

allied economic activities in rural areas, promoting sustainable rural development

and ushering in prosperity in the rural areas.

With a capital base of Rs 2,000 crore provided by the Government of India and

Reserve Bank of India, it operates through its head office at Mumbai, 28 regional

offices situated in state capitals and 391 district offices at districts.

It is an apex institution handling matters concerning policy, planning and

operations in the field of credit for agriculture and for other economic and

developmental activities in rural areas. Essentially, it is a refinancing agency for

financial institutions offering production credit and investment credit for promoting

agriculture and developmental activities in rural areas.

NABARD today

Initiates measures toward institution-building for improving absorptive capacity

of the credit delivery system, including monitoring, formulation of rehabilitation

schemes, restructuring of credit institutions, training of personnel, etc.

Coordinates the rural financing activities of all the institutions engaged in

developmental work at the field level and maintains liaison with the government of

India , State governments, the Reserve Bank of India and other national level

institutions concerned with policy formulation

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Prepares, on annual basis, rural credit plans for all the districts in the country.

These plans form the base for annual credit plans of all rural financial institutions

Undertakes monitoring and evaluation of projects refinanced by it

Promotes research in the fields of rural banking, agriculture and rural

development

Functions as a regulatory authority, supervising, monitoring and guiding

cooperative banks and regional rural banks

Credit functions of NABARD:-

NABARD's credit functions cover planning, dispensation and monitoring of credit.

This activity involves:

Framing policy and guidelines for rural financial institutions

Providing credit facilities to issuing organizations

Preparation of potential-linked credit plans annually for all districts for

identification of credit potential

Monitoring the flow of ground level rural credit

Developmental and Promotional function:-

Credit is a critical factor in development of agriculture and rural sector as it enables

investment in capital formation and technological upgradation. Hence

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strengthening of rural financial institutions, which deliver credit to the sector, has

been identified by NABARD as a thrust area. Various initiatives have been taken

to strengthen the cooperative credit structure and the regional rural banks, so that

adequate and timely credit is made available to the needy.

In order to reinforce the credit functions and to make credit more productive,

NABARD has been undertaking a number of developmental and promotional

activities such as:-

Help cooperative banks and Regional Rural Banks to prepare development

actions plans for themselves

Enter into MoU(Memorandum Of Understandings) with state governments

and cooperative banks specifying their respective obligations to improve the

affairs of the banks in a stipulated timeframe

Help Regional Rural Banks and the sponsor banks to enter into MoUs

specifying their respective obligations to improve the affairs of the Regional

Rural Banks in a stipulated timeframe

Monitor implementation of development action plans of banks and

fulfillment of obligations under MoUs

Provide financial assistance to cooperatives and Regional Rural Banks for

establishment of technical, monitoring and evaluations cells

Provide organization development intervention (ODI) through reputed

training institutes like Bankers Institute of Rural Development (BIRD),

Lucknowwww.birdindia.org.in, National Bank Staff College,

Lucknow www.nbsc.in and College of Agriculture Banking, Pune, etc.

Provide financial support for the training institutes of cooperative banks

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Provide training for senior and middle level executives of commercial banks,

Regional Rural Banks and cooperative banks

Create awareness among the borrowers on ethics of repayment through

Vikas Volunteer Vahini and Farmers clubs

Provide financial assistance to cooperative banks for building improved

management information system, computerization of operations and

development of human resources

Supervisory functions:-

As an apex bank involved in refinancing credit needs of major financial institutions

in the country engaged in offering financial assistance to agriculture and rural

development operations and programmes, NABARD has been sharing with the

Reserve Bank of India certain supervisory functions in respect of cooperative

banks and Regional Rural Banks (RRBs).

As part of these functions, it

Undertakes inspection of Regional Rural Banks (RRBs) and Cooperative Banks

(other than urban/primary cooperative banks) under the provisions of Banking

Regulation Act, 1949.

Undertakes inspection of State Cooperative Agriculture and Rural Development

Banks (SCARDBs) and apex non-credit cooperative societies on a voluntary basis

Undertakes portfolio inspections, systems study, besides off-site surveillance of

Cooperative Banks and Regional Rural Banks (RRBs)

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Provides recommendations to Reserve Bank of India on issue of licenses to

Cooperative Banks, opening of new branches by State Cooperative Banks and

Regional Rural Banks (RRBs)

Administering Credit Monitoring Arrangements (CMA) in SCBs and CCBs.

Core Functions

NABARD has been entrusted with the statutory responsibility of conductinginspections of State Cooperative Banks (SCBs), District Central Cooperative

Banks (DCCBs) and Regional Rural Banks (RRBs) under the provisions of Section

35(6) of the Banking Regulation Act (BR Act), 1949. In addition, NABARD has

also been conducting periodic inspections of state level cooperative institutions

such as State Cooperative Agriculture and Rural Development Banks (SCARDBs),

Apex Weavers Societies, Marketing Federations, etc., on a voluntary basis.

Current Focus :-

Under the revised strategy, a sharper focus of the NABARDs inspection was

given on the core areas of the functioning of banks pertaining to Capital Adequacy,

Asset Quality, Management, Earnings, Liquidity, Systems and Compliance

(CAMELSC). Thus, NABARDs focus in its statutory on-site inspections is on

core assessments leaving the collateral appraisals to banks. The micro level aspects

are to be taken care of by the banks themselves by way of internal inspections or

by other agencies such as auditors. In this direction, through a series of workshops

and meetings held with the Chief Executives and the Chief Auditors of cooperative

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banks, NABARD has been attempting to ensure that the other areas, particularly

relating to the internal checks and controls, revenue and income realization by way

of interest on loans and advances, investments and other routine features of

carrying out general banking transactions were suitably taken care of by the banks

and their concurrent/statutory audit systems.

Institutional Building:-

Help cooperative banks and RRBs to prepare development actions plans for

themselves

Enter into MoU with state governments and cooperative banks specifying

their respective obligations to improve the affairs of the banks in a stipulated

timeframe

Help RRBs and the sponsor banks to enter into MoUs specifying their

respective obligations to improve the affairs of the RRBs in a stipulated

timeframe

Monitor implementation of development action plans of banks andfulfillment of obligations under MoUs.

Provide financial assistance to cooperatives and RRBs for establishment of

technical, monitoring and evaluations cells.

Provide organization development intervention (ODI) through reputed

training institutes like Bankers Institute of Rural Development (BIRD),

Lucknow, National Bank Staff College, Lucknow, College of Agriculture

Banking, Pune, etc.

Provide financial support for the training institutes of cooperative banks

Provide training for senior and middle level executives of commercial banks,

RRBs and cooperative banks

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Create awareness among the borrowers on ethics of repayment through

Vikas Volunteer Vahini/farmer's clubs

Provide financial assistance to cooperative banks for building improved

management information system, computerization of operations,

development of human resources, etc.

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Chapter 5

Case Study on Rural Credit

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CONCLUSION ON RURAL CREDIT

Rural credit given by bank is still not familiar with the farmers and also

accustomed to lending money without security. Rural clearly started to grow after

bank nationalization and it has been growing since then. Over the years there has

been a significant increase in the access of rural cultivators to institutional credits

and simultaneously the role of formal agencies, including money lender as source

of credit has declined.

A review of performance of agricultural credit in India reveals that though the

overall flow of institutional credit has increased over the years, there are several

gaps in the system like inadequate provision of credit to small and marginal

farmers, medium and long term lending and limited deposit mobilization and heavy

dependence on borrowed funds by major agricultural credit purveyors. These have

major implications for agricultural development as also the well being of the

farming community, Efforts are therefore required to address and rectify these

issues.

RurAl CreDit FinAl

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