Rural Credit Cooperatives in India

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This case was written by Bidhan Parmar (MBA/PhD ’09) under the supervision of Wei Li, Associate Professor of Business Administration. It was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation. Copyright © 2007 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to [email protected]. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation. Rev. 8/08.

RURAL CREDIT COOPERATIVES IN INDIA

One Sunday morning in July 2006, Mohan R. Narayan was keeping his eye on the weather. Lately the seasons were unpredictable. During the usual monsoon season the clouds had refused to rain, and now during peak harvesting time, temperatures were flaring. Like a child throwing a temper tantrum, sometimes the weather just refused to do what it was supposed to. Narayan knew that erratic weather was an ominous sign.

Narayan was a leading economist at a prestigious Indian university outside New Delhi.

Recognized for his work on banking-sector development, he had developed a reputation for being strong-willed through his staunch advocacy of financial discipline and free market competition. Recently, the Indian Congress had asked him to be a member of a distinguished committee whose goal was to analyze and make policy recommendations about India’s Cooperative Financial Institutions (CFIs), which included organizations such as credit unions and cooperative banks. On one hand, Narayan was enthusiastic about the job; it was an opportunity to help millions of rural poor and to have a positive effect on the country. On the other hand, he knew the system had a long history of overregulation, financial laxity, and corruption. Creating an actionable and clear strategy would be no easy task.

Narayan flipped past the weather report in the newspaper, and on page five saw a story

that shocked him. In villages in the western state of Gujarat, 100 farmers had committed suicide in the last week by drinking pesticides.1 The farmers reportedly had been heavily in debt to money-lenders. Because the recent drought had yielded little harvest, they had no money to get out of debt, and the poor farmers found themselves with no hope for the future or reason to continue living.

Six hundred miles away, Puja Mehta was in crisis mode. She was the director of the

credit cooperatives in the 15th district in the state of Gujarat. Seven farmers had committed suicide in the last week in her district alone and she did not know what to do. How could she

1 This fictitious example is based on real events reported in the New York Times on September 9, 2006, in an

article entitled “On India’s Farms, a Plague of Suicide.” http://www.nytimes.com/2006/09/19/world/asia/19india. html?ex=1316318400&en=5b14a09e800d407c&ei=5088&partner=rssnyt&emc=rss, (accessed 12 March 2007).

For exclusive use at BML Munjal University, 2015

This document is authorized for use only in MBA / Financial Institutions and Markets by Dr. Sangita Choudhary, BML Munjal University from August 2015 to February 2016.

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console their families? What would she tell the other members of the cooperative? When she was appointed to this job by her uncle, a local politician, she never thought it would be so gruesome. Over the past 15 years, Mehta had seen a lot of things. She saw firsthand that access to credit could empower the rural poor. Credit cooperatives were a way to get aid to those who needed it most without resorting to the usury of money-lenders. Since the country had liberalized its markets to international trade in agriculture in the early 1990s, she noticed that farmers were hit the hardest. They had seen the prices of their produce fall, and in order to compete, they had to use genetically modified seeds marketed by Monsanto that were substantially more expensive. With unpredictable weather, crop yield was also volatile. Every now and again, the government would try to encourage the cooperatives to be more profitable, but in time, they would reverse course. Mehta understood the cooperatives to be a social institution, which would crumble without government support. If the cooperative were able to get more money to the poor, it could make a bigger impact. She wondered if this latest round of suicides would spark the government to appropriate more funds to CFIs. She was certain that something had to be done. Cooperative Financial Institutions (CFIs)

CFIs comprised a broad category of institutions where members pooled their own resources to create a bank where they could deposit their savings and get credit. Governments around the world from Argentina to India had supported and encouraged the growth of various credit unions and credit cooperatives as a way for the poor to help themselves out of poverty. CFIs were distinct from microfinance institutions because they generally served clients with some savings or property and did not rely as much on donor support.2

Cooperatives were started simultaneously in Britain and Germany in 1844 during the

Industrial Revolution. The first cooperative in Britain was a group of 28 weavers, called the Rochdale Society of Equitable Pioneers, who pooled their resources to create a cooperative store that sold flour, oatmeal, sugar, butter, and candles. The members pledged to better their lives by pooling capital to acquire land for food production and provide housing and work for members. In Germany, the first credit union was created as a response to crop failures and the usury of money-lenders. These “people’s banks” mainly helped skilled workers borrow for business purposes. Both these movements laid the foundations for cooperatives in other countries.3

The cooperative institutions in India had a three-tiered structure (see Exhibit 1). At the

grass-roots level were village banks called Primary Agricultural Credit Societies (PACS). There were 112,000 PACS, roughly one for every six villages. They had the largest rural penetration with membership estimated at 120 million people, but only 50% of these members actually

2 Carlos E. Cuevas, Klaus P. Fischer, “Cooperative Financial Institutions Issues in Governance, Regulation,

and Supervision.” World Bank Working Paper No. 82, 2006. The International Bank for Reconstruction and Development, The World Bank.

3 “The Story of Credit Unions,” http://googolplex.cuna.org/20988/cnote/story.html?doc_id=460#1844 (accessed 12 March 07).



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borrowed from the PACS (see Exhibit 2).4 For the PACS to be regulated and properly funded, the government created two additional levels of cooperative banks. The second-tier banks were the 367 District Central Cooperative Banks (DCCB), and at the top tier, there were 30 State Cooperative Banks (SCB). The SCB did most of the regulation and monitoring of the CFI sector; therefore, rules, regulations, and norms varied from state to state. The Reserve Bank of India (RBI) and the National Bank for Agricultural and Rural Development (NABARD) made policy recommendations and kept records of government spending in the CFI sector.

By the early 1990s, CFI accounted for more than 60% of total agricultural credit in India; by 2007, that share had fallen to 34%, despite a 10% annual increase in the amount of absolute disbursement.5 The loss in market share had been made up by commercial banks that took the more financially secure clients out of the CFI system (see Exhibit 3). The farmers left in the system had fewer assets to serve as collateral for loans and less savings to deposit in the cooperative banks.

The Indian government had long appreciated the link between improving access to

financing and the reduction of poverty. Of the 26% of the population (260 million people) who were classified as living below the poverty line, 74% lived in rural areas. According to the World Bank’s National Council of Applied Economic Research, “rural banks serve primarily the needs of the richer rural borrowers: Some 66% of large farmers have a deposit account; 44% have access to credit.”6

Given the concentration of poverty in rural areas, the expansion and success of rural

banking had become a focal point in the fight against poverty. Since the early 1980s, the volume of credit flowing through CFI in India had increased, but the financial health of these organizations had also declined(see Exhibits 4 and 5).7 As of 2003, the accumulated losses of PACS were estimated at $10.4 billion. History of the Cooperative Movement in India8

The Indian government had been heavily involved in the development and regulation of CFI since their inception in the early 1900s. Witnessed cycles of regulation and laxity, Indian CFI evolved through four distinct phases.

In the 1900s, officers of the British Indian Empire recognized that high lending rates for

the poor increased poverty. They imported a European (German) model of credit cooperatives and were convinced that by breaking the cycle of indebtedness moneylenders create, the poor

4 A. Vaidyanathan, “Report of the Task Force on Revival of Rural Cooperative Credit Institutions,” Department for Cooperative Revival and Reforms (DCRR), 04 February 2005, Section 3.09 http://www.nabard.org/departments/ departmentforrivalsreforms_task_force.asp (accessed 12 March 2007).

5 Vaidyanathan, Section 3.17. 6 Priya Basu, Improving Access to Finance for India’s Rural Poor (World Bank, 2006), xv. 7 Vaidyanathan, Section 3.29. 8 Vaidyanathan, Chapter 2.



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would be freed from poverty. In 1904 and again in 1912, the British colonial government passed legislation encouraging and promoting cooperatives. The state began its protection of cooperatives in this period. In 1915, the Maclagan Committee advocated that “there should be one cooperative for every village and every village should be covered by a cooperative.” As interest and momentum began to build around the idea of CFIs, the activities of actual CFI diversified well beyond agricultural credit—which led to debates about whether there should be single (financial) or multipurpose cooperatives in a single village.

The second phase beginning in 1930 was marked by the increased role of the Reserve Bank of India (RBI). The RBI emphasized the creation and fortification of CFIs and encouraged them to be financially viable. The RBI also began lending credit to provincial cooperatives for seasonal agricultural operations and fluctuations. In this period, there was less promotion and growth of CFIs than in the first phase. A majority of CFIs were found to have frozen assets due to low repayment rates. The government liquidated these frozen assets and adjusted cooperatives’ claims to the payment abilities of their members. Having considered the CFIs too small to have the scale economies needed to withstand market competition and to fulfill their social obligations, the government offered CFIs protection from their main rivals—commercial banks—and simultaneously sought to increase their scales of operation by pooling resources among grassroots CFIs through bureaucratic intervention. For some, this was the beginning of state interference in the management of CFIs and “the consequent erosion in the credit discipline of the members.”

After Indian independence from Britain in 1947, CFIs received renewed attention as the

state sought rapid and equitable development for the poor. The state took on a larger partnership in not only equity but governance and management of CFIs. During this third period, state policy and institutional design was based on the premise that CFIs were vehicles for low-cost credit to be extended to rural areas. In 1981, the National Bank of Agricultural and Rural Development (NABARD) was created to further monitor and support the cooperatives. “The focus was on expanding and reorganizing the state-supported structures, without addressing the tasks of restoring and strengthening autonomy, mutual help and self-governance that are the cornerstones of genuine cooperatives.”9 Large amounts of state funds were injected into cooperatives, but it had little effect on repayment rates. As a potential solution, the state requested that commercial banks get involved in the management of CFIs. Although this greatly increased commercial bank penetration in rural areas, it brought with it rigid directives on the cost of credit, and the profile of acceptable borrowers.

When the state nationalized the commercial banks in 1969, it had even more control over

the sector. This time, state intervention meant a loosening of criteria and ultimately began to affect the quality of the lending portfolio. In response to the drop in repayment rates, the state infused more capital and required a “professional work force” to manage the activities of CFIs. Political expediency also became a problem in this period. The widespread practice of writing off loans to secure votes further aggravated the weak financial discipline of the sector. Cooperatives also became vehicles for distributing political patronage because the financial and

9 Vaidyanathan, 13.



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political power inherent in management positions at CFIs became ideal “gifts” for party supporters.

Beginning in the 1990s there was wider acknowledgement of the destructive potential of

too much state interference in CFIs. Several committees had made policy recommendations that sought to offer government support to viable and financially sound CFIs. States had been slow to concede regulatory powers to the RBI.

The history of CFIs illustrates the difficulties in striking a balance between self-

sufficiency and state support for CFIs. It left many questions open for debate. What were the goals of the CFI sector (financial self-sufficiency or social welfare)? How could both of these seemingly conflicting goals be brought together in a sustainable way? What set of metrics best captured the goals? Getting Credit in Rural India

India had a wide spectrum of financial service providers ranging from formal financial institutions (e.g., commercial banks and government-regulated cooperative banks) to informal arrangements (e.g., moneylenders and shopkeepers). Formal institutions were regulated by the Reserve Bank of India (RBI) and the National Bank for Agriculture and Rural Development (NABARD). Those two entities provided funding and administrative guidance to banks that interacted with the rural poor. India also had a growing semiformal financial sector that consisted mainly of microfinance institutions. These innovative lending practices typically reached 5% to 6% of the country’s poor rural households. Finally, survey data showed an active informal financial sector, where 44% of poor rural households reported borrowing from a moneylender or landlord in 2003, at an average annual borrowing interest rate of 48%.10 The informal financial sector represented a dominant source of funding for the poorest farmers and tradesmen.

The rural poor had borrowing needs that did not match well with the lending practices of

traditional banking institutions (see Exhibit 6). A majority of rural poor people were farmers, most of whose households relied on a mixture of agriculture and seasonal labor to earn a subsistent living. Most of the labor income (e.g., from harvesting and plowing) depended on agricultural cycles and rhythms, which in turn depended on the caprice of nature. For farmers with small plots of land, there was great uncertainty in crop yield, annual expenditures, and income. Typically a farming household had small regular expenses throughout the month. But a majority of households reported having to cope with at least one unforeseen expense each year, which they typically financed through savings or informal borrowing. The financial services most urgently needed in rural areas were those that enabled saving for the future, taking advances on future income, and building precautionary cash reserves for unexpected events.

Rural borrowers typically found formal institutions unattractive for a variety of reasons.

First, the typical product profile of formal institutions did not match their needs for flexible

10 Basu, xvi.



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products and services to meet their seasonal and volatile income and expense profiles. They tended to borrow frequently in amounts that were tiny compared with the typical credit offered by a commercial bank, and they tended to repay in small increments. They were also interested in insurance products as well as savings and lending products, which were not offered by commercial banks. Rural clients often had to walk several kilometers to get to a commercial bank branch, only to encounter cumbersome and lengthy procedures for opening an account or getting a loan (average loan approvals could take 33 weeks), as well as corruption (clients sometimes had to pay bank officials bribes of 10% to 20% of the loan).11 Finally, formal banking institutions required a form of collateral that the rural poor generally lacked. Typically that collateral is land, which most rural poor do not own.

Large commercial banks also were reluctant to lend to the rural poor for several reasons.

The rural population’s volatile income stream meant banks had to be concerned about repayment and default risk. This uncertainty was exacerbated by lack of a formal credit reporting system—without relevant credit history, the risk profile of a loan could not be easily ascertained. In the rural market, commercial banks incurred high transaction costs due to small loan sizes, more frequent transactions, travel expenses, linguistic differences and high illiteracy rates among borrowers, and more intense customer interactions (to educate customers about the system). India’s weak legal framework made it difficult to enforce contracts, which only added to the culture of distrusting poor farmers. Current Challenges in the CFI sector

The cooperative system was aimed at providing credit to those who could not meet their credit needs or could not afford to pay for credit in the commercial credit market. Due to information asymmetry, lack of sufficient collateral, high transaction costs, and small loan amounts, the net private-sector benefit of extending credit to the rural poor was much less than the net social benefit (see Exhibit 7). This gave rise to the argument for government intervention in this sector.

The government had competing and conflicting goals for the CFI sector. If the CFI sector

served those who could not be served by the market, how could market-based metrics be applied to CFIs in an equitable way? Should CFIs be required to be financially self-sufficient? Should they be protected from commercial banks? In addition, political patronage (trading credit for votes), inefficient allocation of funds, and corruption plagued the CFI system.

In a cooperative structure, the ratio of net lenders to net borrowers was important. The

more net lenders there were, the more money there was to lend. If net lenders started to leave the cooperative by depositing their savings in commercial banks, there would be less money to lend and fewer lower-risk borrowers in the pool, reducing the size of the cooperative’s loan portfolio and at the same time increasing the portfolio’s risk. The ratio of net lenders to net borrowers at the PACS level was tipping toward net borrowers as a result of increased competition from

11 Twenty-seven percent of patrons of commercial banks reported paying bribes; see Basu, 39.



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commercial banks (see Exhibit 8). There was an eroding stake in the cooperatives from the relatively well-off members who could afford to leave.

There were also significant issues related to governance. The two upper tiers of the credit

system (DCCBs and SCBs) were created to make sure that the PACS level received the necessary refinancing and support. The upper tiers managed the lower tiers in varying degrees across the country and within each state. The state government was responsible for conducting management elections as well as financial auditing, but in a few states, no elections at the PACS level had been held for 10 years. Although cooperatives were supposed to be run for the members and by the members, recommendations by member boards were typically overridden. Unnecessary intervention and political entrenchment of power could erode member confidence and responsibility.

In 2007, the state government played the role of dominant shareholder, manager,

regulator, and auditor—which created various conflicts of interests. The state intervened on the level of interest rates—setting a floor and a ceiling (which did not include the costs of bribes, typically paid by borrowers). It also set lower regulatory requirements for credit cooperatives than for commercial banks. For example, rural credit cooperatives faced a lower minimum capital requirement and a lower cash reserve ratio. Clarifying the role of government in funding and monitoring would be a key challenge for reformers.

Government intervention also affected the governance and functioning of grass-roots

cooperatives. PACS members felt they received insufficient financial mediation services from their cooperatives. They believed their voices and votes did not count as much as those of the directors and government officials. Most PACS managers were nonmembers appointed by local politicians whose compensation was not directly tied to any relevant performance metric. There was also concern about the level of training managers received. Some of these managers also used the cooperatives as vehicles to secure their political careers by promising loans to supporters. In these situations, what was best for the members fell by the wayside. Many PACS did not keep up-to-date records of their transactions, and because each state had its own reporting conventions, there was no central reporting system that made financial information easily comparable. In addition, the frequency and quality of audits needed improvement.

Given the wide variety of issues that the CFI sector faced, ranging from conceptual and

structural problems to individual motivation and responsibility, charting a path toward sustainable reforms of this sector would be no small challenge for the government, the CFI sector, and the rural communities. Finding a New Way Forward

Mohan Narayan knew something had to be done quickly to re-energize the cooperative sector. With a general election approaching in two years, there was not much time to study the situation, assemble recommendations, and get the necessary buy-in from commercial banks,



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CFIs, nongovernmental organizations, various levels of government, and the rural communities, to make effective and sustainable change. The next government might not make the CFI sector as high a priority as the current one did. Narayan finished his morning chai and began to think deeply about how he and his fellow committee members should tackle the major reform issues.

Across the country, Puja Mehta had heard the Indian government was assembling a

distinguished committee to make recommendations on the CFI sector. She hoped the committee would break the cycle of over-regulation and over-reliance on market mechanisms that the CFI sector had been caught in for the last 100 years. Would this next round of reforms further cut the sources of funds for the 15th district? She wondered how the credit cooperative would run without the necessary government aid. She had enough trouble keeping enough capital in the collective as it was. Due to recent competition with commercial banks, many of the net lenders and lower-risk borrowers in her cooperative were leaving. The cooperative was left with less capital to serve a higher-risk clientele. She was beginning to entertain the idea of extending credit to nonmembers, but she didn’t know if this was best for the cooperative or even at what rate to price those loans. Worse yet, she was being pressured by her uncle, who had hired her and was now running for political office, to extend loans to some high-risk clients.

In addition to all her troublesome financial concerns, Mehta wondered how she could

best help the poor out of poverty. What would another round of suicides do to the little remaining confidence the farmers had in the cooperative structure? What could she do differently on the ground to make their lives better and how could she do it in a way that was sustainable? Was there a way for the cooperative to put more power and responsibility in the hands of its members? As she walked to a village to speak with one of the families who had lost a family member in the recent suicides, she hoped the winds of change were in the air.



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Exhibit 1


Breakdown of Loans Outstanding (in billions of U.S. dollars)

Agricultural

Loans Nonagricultural

Loans Other Loans Total

% Agricultural

State Cooperative Banks $2.82 $3.70 $1.40 $7.93 36%

District Cooperative Banks $7.00 $4.96 $2.15 $14.11 50% Primary Agricultural

Credit Societies $5.24 $1.73 $2.62 $9.59 55%

Source: NABARD REPORT, http://www.nabard.org/pdf/rcci_task_report.pdf, (accessed 6 December 2007). Converted to U.S. dollars using March 2007 exchange rates.



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Exhibit 2


Flow of Ground-Level Credit to Agriculture through Various Agencies (in billions of U.S. dollars)

Agency 1992–93 1997–98 2000–01 2001–02 2002–03

Cooperative banks $2.12 $3.16 $4.68 $5.32 $5.34 % 62% 44% 39% 38% 34%

Regional rural banks $0.19 $0.46 $0.95 $1.10 $1.37 % 5% 6% 8% 8% 9%

Commercial banks $1.12 $3.58 $6.29 $7.59 $8.99 % 33% 50% 53% 54% 57%

Total $3.43 $7.20 $11.93 $14.01 $15.71




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Exhibit 3


Average Loan Size of Public-Sector Banks in Relation to PACS

# Accounts $ Outstanding Average Loan Size

Public-sector banks 164,000 $11.71 billion $714

PACS 639,000 $9.59 billion $150




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Exhibit 4


Financial Results of the Credit Cooperative System

2000–01 2001–02 2002–03 State Cooperative Bank Number 29 30 30

# Profitable 24 24 25 # in loss 5 6 5 # Eroded net worth 6 9 8 Total accum. loss $0.11 billion $0.13 billion $0.06 billion

District Cooperative Bank Number 367 368 367 # Profitable 247 243 237 # in loss 120 125 130 # Eroded net worth 139 139 144 Total accum. loss $0.72 billion $0.85 billion $1.00 billion

PACS Number N/A N/A N/A # Profitable 46,807 45,292 58,683 # in loss 41,991 43,511 53,626

# Eroded net worth Total accum. loss $0.48 billion N/A $1.04 billion




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Exhibit 5


Cooperative System Recovery and Non-Performing Asset (NPA) Percentages

2000–01 2001–02 2002–03

SCBs Recovery% 82 82 79 NPA% 13 13 18

DCCBs Recovery% 67 66 61 NPA% 28 22 20

PACS Recovery% 65 67 66 NPA% No NPA norms for PACS




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Exhibit 6


Outstanding Short-Term Loans to Individuals in the 15th District

2001 2002Advances against gold jewelry 36.92% 39.48%Loans against deposits 5.39% 4.88%Cash credit advances 57.69% 55.64%Total ST loans to individuals (U.S. dollars) $3,175,572 $3,314,886

Source: NABARD report on the Wayanad Experiment, http://www.nabard.org/departments/Ridge%20to%20Valley %20Wayanad%20Expt.pdf (accessed 15 March 07). Converted to U.S. dollars using March 2007 exchange rates.



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Exhibit 7


Costs and Margins of All SCBs and DCCBs (figures in percentages)

SCBs (all India) DCCBs (all India)

2000–01 2001–02 2002–03 2000–01 2001–02 2002–03

Yield on assets 9.38 8.88 8.67 10.13 9.86 9.16

Cost of funds 6.88 7.19 6.26 7.09 6.97 6.32

Financial margin 2.5 1.69 2.41 3.04 2.89 2.84

Transaction costs 1.36 1.38 1.46 2.04 1.92 1.72

Risk costs 1.25 1.9 1.42 1.89 1.65 1.73

Net margin 0.09 –0.52 0.04 0.15 0.27 –0.01




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Exhibit 8


Source of Deposits Outstanding as of 2003 (in billions of U.S. dollars)

Cooperatives Individuals Local Bodies Other Total

SCBs $6.65 $1.58 $0.28 $0.33 $8.84

% 75% 18% 3% 4%

DCCBs $6.12 $9.21 $0.68 $0.36 $16.37

% 37% 56% 4% 2%

PACS $4.32 $4.32




Rural Credit Cooperatives in India

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