Impact of financial liberalization on rural banking

Mehak MalikHans Raj College

What is Financial Liberalization?

• Reduction of any sort of regulations on the financial industry of a given country.

• Broadly defined: Financial system is the lending system.

• Financial Liberalization means lessening restrictions on various type of lending institutions and instruments.

1969-1975: The Era Of Social and Development Banking

• Nationalization of India’s 14 major commercial banks.

• This phase coincided with GREEN REVOLUTION.

• Objective: To gain access to new liquidity, particularly among rich farmers in the countryside.

1969-1975: The Era Of Social and Development Banking

OBJECTIVES OF SOCIAL BANKING:To provide banking services in previously

unbanked or under-banked rural areas.Provide substantial credit to specific activities,

including agriculture and cottage industries.To provide credit to certain disadvantaged

groups such as Dalit and Scheduled Tribe Households.

1969-1975: The Era Of Social and Development Banking

IMPACT OF SOCIAL BANKING: Entailed a radical shift from prevalent practice in the

objective and functioning of commercial banks. Prior to 1969, countryside was not considered the

problem of commercial banks.Multi-institutional approach to credit provision in

the countryside became policy.Commercial Banks, Regional Rural Banks and

cooperative institutions established wide geographical and functional reach.

Regional Rural Banks

• Created on the recommendations by a working group on commercial credit, called ‘Narsimham Committee’ in 1975.

• Intended to “combine the cooperatives’ local feel and familiarity with the business acumen of commercial banks”.

• Targets were set on expansion of rural branches.

Priority Sector Lending

• Social banking was also marked with setting up of guidelines for the sectoral allocation of credit.

• A target of 40 per cent of advances for the “priority sectors,” namely agriculture and allied activities, and small-scale and cottage industries was set for commercial banks.

• Advances to the countryside increased substantially, although biased in respect of regions and classes.

Second Phase: Late 1970s-1991

• Self employment generation by means of loans-cum-subsidy schemes were used as an employment strategy targeted at the rural poor.

• Period of ‘directed credit’, during which credit was directed towards ‘the weaker sections’.

• New Scheme: Integrated Rural Development Program (IRDP)

IRDP: Integrated Rural Development Program

• Started in 1978-79 as a pilot project.• Objective: Creation of productive income-bearing

assets among the poor through allocation of subsidized credit.

• Lead to significant transfer of funds to the rural poor, however, failed to create long-term income-bearing assets in the hands of rural poor.

• Reasons for failure include misidentification of beneficiaries, small loan size leading to purchase of low quality assets, etc.

Second Phase: Late 1970s-1991

• Expansion and consolidation of the institutional infrastructure of rural banking

• Unprecedented growth of commercial banking in terms of both geographical spread and functional reach.

Liberalization: Post-1991 Period

Policy objectives of this phase: Setting up a vibrant and competitive financial system to sustain

the ongoing reforms in the real economy’s structural aspects. Redistributive objectives to be fulfilled via fiscal instruments

rather than credit system instruments. Interest rates to be deregulated. Capital adequacy norms to be changed (to compete with banks

globally) Branch licensing policy to be revoked. Creation of new institutional structure that is “market driven

and based on profitability”.

Record of Progress of Rural Banking

• Contraction in rural banking in general and in priority sector lending and preferential lending in particular.

1967 1972 1990 19980

10203040506070

Growth of Scheduled Commercial Banks in Rural Areas

Share of rural bank offices in total bank of-fices

1972 1980 1990 Post 19910

2

4

6

8

10

12

14

16

18

Deposit Mobilisation in Rural Areas

Rural Deposits as a pro-portion of Total Deposits

Credit Starvation

• Shortage of credit for all purposes, including productive investment in agricultural and non-agricultural activity.

19691972

19801985

19901996

01020304050

Priority Sector Lending

Share of priority sector in total credit outstand-ing

Declining share of formal debt

Declining share of formal debt

Reversal of Policy Objectives

• Extending the reach of rural credit.• Providing cheap and timely credit to rural

households.• Overcoming historical problems of imperfect

and fragmented rural credit markets• Displacing the informal sector from its

powerful position in rural credit.

Miracle Cure: Micro Finance and Self Help Groups

• The Task Force on Supportive and Regulatory Framework for Micro-Finance in India defined micro-finance as:

“ The provision of thrift, credit and other financial services and products of very small amounts to the poor in rural, semi-urban and urban areas enabling them to raise their income levels and improve living standards.”

Miracle Cure: Micro Finance and Self Help Groups

Features of Micro-Credit: Very small loans No collateral Borrowers from among the rural and urban poor Loans for income generation through market-based self-

employment Formation of borrower groups (group lending), and Privatization over disbursement and the determination

of the terms and conditions attached to each loan. (through the mechanism of NGO control)

Miracle Cure: Micro Finance and Self Help Groups

Heralded as ONLY major policy instrument to fill the gap left by the formal sector.

Were viewed to rectify the two major weaknesses of the banking system:

Transaction Costs Better performance in respect of recovery of

loans.

Was there a miracle?

• Administrative costs of NGOs were high and relatively higher than those of commercial banks. (Ramachandran and Swaminathan,2002)

• NGOs cannot match the economies of scale of a comprehensive system of banking.

• Moreover, the costs of administration of controlled micro-credit have actually risen when NGO activity is scaled up. 8.6% of liabilities in 1988 to 18.1% in 1992.

Limitations: Micro Finance and Self Help Groups

• A system based on quick repayment of very small loans does not allow for funds to go into income-bearing activities that have a significant gestation period.

• High interest rates (24 to 36%)• High repayments dependent on high

transaction costs.• Exclusion of the poorest and perpetuation of

existing class hierarchies by groups.

Limitations: Micro Finance and Self Help Groups

• Though scale of bank finance through SHGs has expanded rapidly; from less than 10,000 in 1996-97 to 10 lakhs in 2004; not as widespread as it is in Bangladesh.

• ANDHRA PRADESH:o Had more than 50% of the SHGs in the country

by 2002.o Only 0.6% of total bank credit was chanelled to

SHGs.

What banks can offer?

• Advantages of scale• Reach• Specialized training to their employees in

development banking.• Better placed to coordinate with development

administrations, local governments and SHGs.• Wide range of financial services.

Way Ahead

• Revisiting the policy of Social and development banking ?

• Restoring geographical and functional reach of public sector banking.

• Reinstating differential interest rate policies• Reintroduction of special loans-cum-subsidy schemes.• Reinforcing priority sector norms and instead of

alternatives such as investment in RIDF bonds, penalties must be imposed on any failure of banks to meet these public interest targets.