December 2004

Document of the World BankR

eport No. 30740-IN

India Scaling-up A

ccess to Finance for India’s Rural Poor

Report No. 30740-IN

IndiaScaling-up Access to Financefor India’s Rural Poor

Finance and Private Sector Development UnitSouth Asia Region

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ACKNOWLEDGEMENTS

This repor t was prepared by a World B a n k team l e d by Pr iya Basu, under the overal l guidance of Joseph D e l M a r Pernia, M a n l o u Uy a n d Michael Carter. T h e peer reviewers were A n j a l i Icumar, Asli D e m i r g u c - K u n t and A b a y o m i Alawode.

M a j o r cont r ibutors to the repo r t were N i r a j Verma, U l r i c h Hess a n d Leora I d a p p e r o f the World Bank, a n d Pradeep Srivastava and Rajesh Shukla o f the N a t i o n a l Counc i l o f A p p l i e d E c o n o m i c Research (NCAER), India.

T h e repo r t draws on a Rura l Finance Access Survey (RFAS) for India, designed a n d under taken jointly by the World B a n k and NCAER, India. I t also draws on the following background papers: (i) “Microfinance: Analyt ical Issues for Ind ia” by Jonathan M o r d u c h and Stuart Rutherford; (ii) “Scalmg up Microf inance in India” by Priya Basu a n d Pradeep Srivastava; (iii) “Microfmance in India: Banyan T ree and Bonsai“ by V i j ay Mahajan a n d B h a r t i Ramo la Gupta; (iv) “Review of R u r a l Finance Institutions in India” by Ramesh Deshpande a n d N i r a j Verma; (v) “The Use of N e w Products, Processes and Technology in the De l i ve ry o f R u r a l Finance in Ind ia ” by U l r i c h Hess a n d L e o r a Idapper ; (vi) “ In fo rma l Finance in Rura l Ind ia” by Jock Anderson and N i r a j Verma; and (vii) Agr icu l tura l Commodity Markets in India: Po l i cy Issues for growth by Susan Thomas. Conn ie Bernard, D i n a Umal i -Dein inger a n d James H a n s o n p rov ided he lp fu l comments.

T h e repo r t incorporates suggestions from representatives o f the Governmen t of India, Reserve B a n k o f India, Na t iona l B a n k for Agr icu l ture a n d R u r a l Development , Small Industr ies Deve lopmen t B a n k o f I n d i a a n d commerc ia l banks, as w e l l as microf inance practi t ioners a n d other key stakeholders, who attended a workshop in N e w D e l h i in February, 2004 at w h c h a n earlier draf t of the repo r t was presented and discussed.

Admin is t ra t ive support was p r o v i d e d by A n i t a D’Souza, Hea the r Fernandes a n d Mar ia Mar jo r i e Espiritu.

TABLE OF CONTENTS

EXECUTIVE SUMMARY .......................................................................................................................................... I

I. INTRODUCTION ................................................................................................................................................. 1

INDIA’S RURAL FINANCE LANDSCAPE ........................................................................................................................ 3 What are the financial needs of the ruralpoor? 3 Rural finance service providers 4

11. ACCESS T O RURAL FINANCE IN I N D I A THE EVIDENCE .................................................................. 7

SUPPLY SIDE INDICATORS OF ACCESS TO FINANCE .................................................................................................... 7 ACCESS TO RURAL FINANCE: EVIDENCE FROM THE DEMAND SIDE .......................................................................... 11

Access to savingddeposit accounts 12 Payments Services -Limited use, high cash economy 14 Access to Credit 14 Access to Insurance 16 The Importance of Informal Finance 16

111. WHAT CONSTRAINS ACCESS TO FINANCE FOR INDIA’S RURAL POOR? ..................................... 18

WHY BANKS ARE RELUCTANT TO LEND TO RURAL CLIENTS .................................................................................. 18 Uncertainty and default risk 18 Lack of credit information. 19 The tyranny of collateral 19 Transactions costs 20 Weak legal framework and enforcement issues. 20 Government policy 20

WHY Do SMALL, RURAL BORROWERS FIND RURAL BANKS UNATTRACTIVE? ........................................................ 25 Absence offlexible products and services 25 Transactions costs 25 Collateral 26

IV. RECENT EFFORTS IN INDIA T O IMPROVE RUR4L ACCESS T O FINANCE: THE ROLE OF FORMAL-INFORMAL LINKAGES AND NEW PRODUCTS ....................................................................... 27

SHG-BANK LINKAGE APPROACH: LINKING COMMERCIAL BANKS TO GRASSROOTS BORROWERS .......................... 27 28 31 32 33

35 THE “SERVICE PROVIDER” MODEL OF MICROFINANCE PILOTED BY PRIVATE BANKS .............................................. 36

How Effective Has SHG Bank Linkage Been in Targeting the Poor? Impact on vulnerability ofpoor households Some Lessons from SHG Bank Linkage Key concerns: Limited outreach and scale of lending and issues in financial sustainability

What has constrained the outreach and scale of MFIs? MICROFINANCE INSTITUTIONS (MFIs) ..................................................................................................................... 34

THE KISAN CREDIT CARD (KCC) ............................................................................................................................. 37 RECENT INNOVATIONS IN MICRO- AND WEATHER INSURANCE ................................................................................ 38 COMPOSITE FINANCIAL SERVICE PROVIDERS ........................................................................................................... 39 PORTFOLIO SECURITIZATION .................................................................................................................................... 40 PRICE INSURANCE AND RISK MANAGEMENT PRODUCTS FOR FARMERS ................................................................... 40 THE STRATEGIC USE OF INFORMATION AND COMMUNICATION TECHNOLOGY (ICT) ................................................ 41

V. MEETING THE CHALLENGE OF SCALING-UP ACCESS T O FINANCE FOR INDIA’S RURAL POOR THE POLICY AGENDA ............................................................................................................................ 43

MAKING THE FORMAL FINANCIAL SECTOR BETTER AT BANKING THE RURAL POOR .............................................. 43 43 44

SCALING-UP MICROFINANCE ................................................................................................................................... 48

Low-cost ways of reaching the rural poor through the formal sector: Role of B a n k and Government Improving the incentive regime, and promoting competition: Role of Government policy

REFERENCES ......................................................................................................................................................... 52

ANNEX 1: STRUCTURE OF INDIA’S FINANCIAL SYSTEM ......................................................................... 55

ANNEX 2: WORLD BANK/NCAER RURAL FINANCE ACCESS SURVEY (2003) ....................................... 56

ANNEX 3: SUMMARY REVIEW OF THE PERFORMANCE OF RETAIL RURAL, FINANCE INSTITUTIONS (RFIS) ......................................................................................................................................... 58

ANNEX 4: APEX RURAL FINANCE INSTITUTIONS .................................................................................... 64

ANNEX 5: SUMMARY OF RECOMMENDATIONS OF RECENT GOVERNMENT ................................. 68

COMMITTEES ON FORMAL RFI REFORMS ................................................................................................... 68

ANNEX 6A REGULATION OF RURAL BANKING - SELECT INTERNATIONAL REFERENCES ...... 71

ANNEX 6B: SUPERVISION OF RURAL BANKING - SELECT INTERNATIONAL REFERENCES ..... 72

ANNEX 7: RURAL BANKING CRISES AND POLICY REFORM - RECENT INTERNATIONAL EXPERIENCES ........................................................................................................................................................ 73

ANNEX 8: ENABLING FRAMEWORK FOR MFIS . DEMANDS FROM THE SECTOR ............................ 74

EXECUTIVE SUMMARY

I Background

Since the ear4 nationalplans, successive governments in independent India have emphasixed the link between improving access tojnance and reducingpover& a stance that has had inflence global4.l T h e need to i m p r o v e financial access for India's poor, the overwhelming ma jo r i t y o f whom are concentrated in ru ra l areas, 2

mot i va ted the national izat ion o f commerc ia l banks in the late 1960s, and a n aggressive dr ive through the 1970s and 1980s to expand ru ra l banking, coupled with policies mandat ing banks to p rov ide subsidized credit to ru ra l households. T h e 1990s saw the par t ia l deregulation o f interest rates, a gradual reduct ion in Govemment 's stake in commerc ia l banks, a n d increased compe t i t i on in the bank ing sector. But pol i t ical compulsions have dictated the persistence of government in tervent ion in 'priority' sectors such as ru ra l finance. Governmen t s t i l l dominates the ru ra l f inance institutions, a n d duected credit and subsidies, albeit l ower than before, cont inue to distort r isk- retum signals in m r a l finance.

Access to jnance for the mral poor has improved somewhat over the past decades, with the public sector commercial banks being the dominant players in the fomal mral jnance market. Govemment 's policies o f b ranch expansion o f publ ic sector commerc ia l banks in ru ra l areas, part icularly in the 1970s a n d 1980s, certainly he lped bank ing outreach. Today, I n d i a has over 32,000 r u r a l branches of commerc ia l banks3 a n d Regional Rura l Banks (RRBs), some 14,000 cooperative b a n k branches, 98,000 Pr imary Agr icu l tura l Credit Societies (PACS), not to speak of the thousands of m u t u a l fund sellers, several N o n - B a n k Finance Companies (NBFCs) and a large post of f ice n e t w o r k with 154,000 outlets that are requi red to focus on deposit m o b h a t i o n a n d m o n e y transfers. No t surprisingly, I n d i a compares favorably with other developing countries in terms o f the average popu la t i on served p e r b a n k branch, a n d the average geographxal area served p e r branch.

But the vast major& of India's rural poor still do not have access t o fomaljnance. T h e World Bank-Nat ional Counc i l o f A p p l i e d E c o n o m i c Research (NCAER) Rura l Finance Access Survey (RFAS), 2003, prepared as a background to t h s report, indicates that ru ra l banks serve pr imar i ly the needs o f r icher ru ra l borrowers: some 66 p e r cent of large farmers have a deposit account; 44 p e r cent have access to credit. Meanwhile, the ru ra l poor face severe diff iculties in accessing savings and credit from the f o r m a l sector. Some 87 pe r cent o f the poorest households surveyed (marginal farmers) do not have access to credit, a n d 71 pe r cent do not have access to savings from a f o r m a l source. Access to fo rma l cred i t i s part icularly a p r o b l e m for mee t ing

Note: Marginal farming households=landholding<l acres; Small=l to 4 acres; Large farmers=>4acres; Commercial households= with or w/o land but wi th income from non-fann sources exceeding hal f o f total household income; Others=mixed households with land and non-farm commercial incomes but the latter being less than half o f their total household income. Source: RFAS. 2003

' The focus on poverty and finance was articulated most famously in the 1954 Reserve Bank of Ind ia (RBI) report on the All-India Rural Credit Survey of 1951-52 (RBI, 1954).

O f the estimated 260 million Indians (or 26% of the population) who live in poverty, some 193 million (or 74%) live in rural areas. Another 180 d o n rural people are "near poor". A majority of these households are marginal or small farmers, and the poorest households are landless.

The total number of bank branches (rural and urban) i s 66,500. The bulk of these branches are of public sector commercial banks.

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unforeseen expenditures and poor access to fo rma l f inance has resulted in a heavy reliance a m o n g poore r ru ra l households on i n f o r m a l finance, mostly moneylenders and shopkeepers. Around 44 per cent o f the households surveyed by RFAS, 2003 repor t hav ing b o r r o w e d in fo rma l l y a t least once in the preceding 12 months; the interest charged on i n f o r m a l loans averages 48 p e r cent pe r annum. Access to other financial services, such as insurance, also remains h t e d for the rural poor , a l though m a n y would k e to have access to insurance - over 82 pe r cent o f households surveyed in WAS, 2003, did not have any insurance, and practically n o n e of the poorest households surveyed h a d insurance.

Recent years have witnessed the growth o f n e w microf inance approaches designed to serve poore r households, a n d o f ten involving partnerships between Government , N o n - G o v e m m e n t a l Organizations (NGOs) and banks. But these approaches have not yet been able to make a dent. I n f o r m a l sector lenders thus retain a strong presence in rura l Ind ia.

I1 What Explains the Inadequate Access to Finance for India’s Rural Poor?

T h e lack o f access to adequate finance on reasonable terms for India’s ru ra l poor m a y b e attr ibuted to a combinat ion of factors affect ing both banks a n d their clients.

Why banks don’t want to serve the ruralpoor: Serving the ru ra l poor i s a high-risk, hgh -cos t proposition for banks: First) i s the p r o b l e m o f unce~ainty - abou t the repayment capacity o f poor ru ra l borrowers, a n d their irregular/volat.de i ncome streams a n d expenditure patterns - which, in the absence $credit information, drive up default risk. These problems are exacerbated by the borrower’s lack o f collateral, and /o r diff iculties in contract design and enforcement.

Second, the transactions costs of ru ra l lending in I n d i a are high, mainly due to m a l l l oan sizes, high frequency o f transactions, large geographical spread a n d heterogeneity o f borrowers, and widespread illiteracy. For private sector banks lack of a ru ra l b ranch n e t w o r k i s a n addit ional p rob lem.

Third, the Govemmentkpolicies have made thngs worse from the banks’ perspective, creating a “jkancial climate” that i s not conducive to lending in general, a n d ru ra l bank ing in particular:

High Jiscal d$cits and statutory preemptions imposed on banks c r o w d out credit to the private sector; another persist ing distortion that has failed to generate the desired results i s the ‘priority sector’ lending target; Persisting interest rate restrictions - “floors” on shor t - term deposit rates a n d lend ing rate, “caps”on small loans impose an “ implici t tax” on banks; Government’s domina t ion of/ interference in ru ra l banks, part icularly the R R B s a n d cooperative banks, fur ther distorts bankers’ incentives; inefficiencies arising from weak governance, poor management and weak regulatory standards a n d supervision, have meant that m a n y o f these banks are in deep financial distress, a n d no longer able to p e r f o r m their task of financial intermediat ion; Bankers’ risk aversion to lending i s exacerbated by a pervasive culture o f suspicion towards bankers, whose lend ing decisions are o f t e n subject to str ingent scrut iny by parliament, the Central Bureau of Investigation, etc.

Why smaU, rural borrowers find rural banks unattractive: First, ru ra l banks do not p rov ide flexible products a n d services to mee t the i ncome a n d expenditure patterns o f small ru ra l borrowers. Second, the transactions costs of d e a h g with f o r m a l banks are hgh. Procedures for opening an account or seeking a l o a n are cumbersome a n d costly (with high re ject ion rates) and, as indicated by the RFAS-2003, clients o f t e n have to pay he f t y bribes (ranging from 10-20 p e r cent o f the l oan amount)

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to access loans, so that the ult imate cost to borrowers i s very high (despite interest “caps”). I t takes, on average, 33 weeks for a l oan to b e approved by a commerc ia l bank.4 Third, banks demand collateral, w h i c h poor ru ra l borrowers lack. L a n d remains by far the most predominant form o f collateral. But, t h i s collateral i s seldom executed, so it i s j u s t another cost, with l i t t le benef i t in practice.

I11 N e w Approaches and Products to Improve Rural Access to Finance in Ind ia

In recent years, several n e w approaches and products have evolved to p rov ide finance to India’s ru ra l poor.

SHG-Dank linkzip program

Most notable among recent approaches to improve access tojnancefor the ruralpoor is the ‘Seghelp Groups (SHGs) Bank Lznkage’ model, the growth of which - j o m just 500 SHGs linked to banks in the ear& 1990s, to over 700,000 2003 - has been tmb remarkable. D a t a from the RFAS-2003 shows that SHG B a n k ltnkage appears to have targeted poore r segments of the ru ra l popu la t i on in an effective manner, reducing the vulnerabl l i ty of clients. But outreach, v o l u m e of lendmg a n d average loan size remain h t e d . With a n outreach o f about 12 d o n w o m e n a n d their households l tnked to banks through group savings accounts and a n estimated 2-4 d o n w o m e n hav ing outstandmg c r e d t from banks, SHG B a n k L inkage has a long way to go before i t can really make a dent. K e y challenges facing the init iat ive are: (1) Inadequate attention to group quali ty cou ld jeopardize longer t e r m c red ibh ty a n d sustainabllity. (2) Capacity constraints and the cost o f group formation5. (3) State-owned banks have been l e n d m g to SHGs at interest rates o f between 9 p e r cent to 12 p e r cent pe r annum., even though recent studies indicate that the a l l inclusive costs are, in fact, m u c h higher, and cou ld range anywhere from 15 p e r centb to 28 pe r cent pe r year. Unless banks charge interest rates to recover costs, the model’s f inancial viabdity and longer t e r m sustainability m a y b e jeopardrzed.

Microfinance I n s titi itions

I n recent years, other institutional structures for mimjnance have emerged, notabb, independent, specialized Mimjnance Institutions WFIs). T h e Small Industr ies D e v e l o p m e n t B a n k of I n d i a (SIDBI) has been the largest lender to the emerging MFIs, though Friends of Women’s World B a n k m g I n d i a (FWWB) as w e l l as the N a t i o n a l Women’s Fund (Rashtriya Mah i l a Kosh) have also played a n impor tan t role. T h e outreach of I n d i a n MFIs, however, i s modest in compar ison to SHG B a n k Linkage, and also in compar ison to MFIs elsewhere in the world. In M a r c h 2003, the I n d i a n MFIs sector as a who le h a d a to ta l outreach of less than one d o n borrowers. T h e h t e d outreach and scale o f I n d i a n M F I s , reflects, a t least in part, the absence o f an enabling policy, legal and regulatory f ramework w h i c h impac t the abdity o f MFIs to m o b d u e member deposits, equity a n d raise debt from external sources. MFIs are also constrained by the lack of adequate capacity a n d sk i l l s in financial con t ro l a n d management, M I S , n e w p roduc t design, etc. Further, since most M F I s in I n d i a l e n d to SHGs, this means that MFIs in I n d i a are constrained by m a n y of the same factors that have h e l d back the

High transactions costs of dealing with formal banks translate into a low frequency of transactions. According to the RFAS-2003, more than 60% of households with bank accounts report accessing their accounts at a frequency o f less than once a month (62.3% of households with accounts in banks access their accounts less than once a month, while the same percentage amongst households with accounts in R R B s i s 70.8).

The estimated cost of creating and sustaining new and high quality SHGs i s controversial, with National Bank of Agriculture and Rural Development (NABARD) claiming that it i s as low as Rs 1,000 (US022) per group and NGOs saying i t takes as much Rs 12,000 (US$267). The Ministry of Rural Development has established a norm of Rs 10,000 (USF222) per group, which experts claim i s realistic.

Which i s what private banks like ICICI Bank charge when they lend to SHGs.

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outreach a n d scale of SHG B a n k Linkage. In particular, capacity, t ime a n d cost issues related to group fo rma t ion have posed constraints.

Pmtiierships Between Private Bmtks, 2l.licrofinanciers and Senice Providers

Encouraged ear4 results, the new private sector banks, most notab4 ICICI Bank, but also UTI Bank, HDFC Bank and others, are active4 seeking exposure in the microjnance sector. These banks have been lendmg to MFIs. W h i l e their current exposure to microf inance i s too small to make a dif ference to their overal l portfolio, some o f these newer banks are pursuing innovat ive approaches to microf inance - as a potent ia l business and not mere ly as a social or priority sector l endmg obl igation. K e y innovat ions inc lude a pilot scheme by ICICI B a n k that uses NGOs or M F I s , traders, or loca l brokers (who are close to the farmer by the nature of their business), as intermediaries/ ‘service providers’ for origmating, managmg and col lect ing loans to groups o f small a n d marg ina l farmers. Banks are also experimenting with an approach now termed the “Integrated Agr icu l tura l Service Provider” (IASP) approach, where the b a n k identi f ies a n IASP that has a good relat ionshlp with farmers and provides genuine and t imely i n fo rma t ion through extension services, a n d enters into a tr ipart i te agreement with the IASP a n d the output buyer. This reduces transactions costs a n d the risk exposure of a l l parties and, therefore, presents a potential ly low-cost w a y o f serving the r u r a l poor engaged in margina l or smaller farming.

TIxe X s a n Credit Card

Another recent approach to providing agrikultural credit, including to small farmers, is the Kzsan Credit Card (KCC), launched in 1998-99. By M a r c h 31, 2003, some 31.6 d o n KCCs h a d been issued by commerc ia l banks, R R B s a n d cooperative banks. Though these are not credit cards, the I<CCs present a n u m b e r o f advantages for the borrowers and lenders by reducing both borrowers’ transactions costs and delays in accessing and renew ing c rop loans. But the success of the I<CC scheme has been uneven across. For instance, only 6 p e r cent o f households surveyed by the W A S - 2 0 0 3 repo r t hav ing a I<CC, a n d access to a I<CC appears to b e h igher for larger farmers (20 p e r cent o f surveyed large farmers compared to a figure of j u s t 2 p e r cent for marginal farmers).

Agricirlriirai Risk Management Prodircts for Fariners

A potential means of redua‘ng defalt risk in mraljnance, that has recent4 caught the attention ofthe Government of India (Gol), is the establishment Ofa “warehouse receipts p-tem’! T h i s involves farmers using thei r crops as collateral for post-harvest fmancing. For the warehouse receipt system to work effectively, receipts would need to b e recognized as legal instruments. Also, the grades a n d qual i ty standards o f the commodit ies would need to b e def ined centrally, warehouse operat ion standards would need to b e developed and effective supervision established.

Weather i ndex insurance can b e a good w a y for farmers to hedge businesses against imponderable weather risks and can b e a cheaper substitute for c rop insurance. T h e insurance i s index-based and, therefore transparent, a n d free of moral-hazard and adverse selection, w h i c h makes the p r o d u c t cheaper. In adbt ion, insurance payouts are t imely a n d immeda te . Although such products have not yet taken of f in I n d i a on a larger scale, BASIX, a n MFI, through i t s IG ishna B h a Samruddhi L o c a l A rea B a n k (ICBS LAB), recently p i l o ted a weather indexed c r o p insurance product, developed by ICICI Lombard . IC ICI L o m b a r d also o f fe red excess rain policies to a round 5,000 wheat farmers in U t t a r Pradesh (UP) (in conjunct ion with ICICI Bank) and 150 soya farmers in Madhya Pradesh (MT) in 2003/2004 (in conjunct ion with BASIX). M o r e recently the company has w o r k e d with the Governmen t of Rajasthan to pilot weather insurance for orange farmers in the state wh i l e also extendmg weather risk insurance for a ru ra l f inance portfolio of BASIX. T h e latter deal i s interesting

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from the point o f v i e w that i t captures, with one deal, a l l the farmers, big, small a n d marginal, who are p a r t of BASIX’s agriculture portfolio.

IV The policy agenda

Improving access t o jnance for India’s rzlralpoor, to meet their diversejnancial need (savings, credit, insurance against unexpected events, etc.) through flexible products at competitive prices, presents a formidable challenge in a count?y as vast and varied as India. But the opportunities, too, are plenti ful. In the near term, microf inance can, a t minimum, serve as a qu ick way to deliver finance. But the m e d l u m t e r m strategy to scale up access to finance for the poor should b e to ‘graduate’ microf inance clients to fo rma l f inance institutions where they can access standard ‘indlvidual’ loans, possibly on a fully commerc ia l basis. An immedlate p r o b l e m arises in that there are no obvious lenders for microf inance customers to graduate to - none, yet, are close to o f fe r i ng the reliabdity, convenience, continuity, a n d f lexibdity required by low- income customers. Nor i s the notion o f graduation built expl ici t ly into the design of microf inance in India. I f the idea o f graduation i s a serious one in India, efforts to p r o m o t e microf inance should go hand-in-hand with efforts to make the fo rma l sector bet ter a t “banking the POO~’’, and both government and private sector can play a cri t ical ro le in t h i s context.

An immediate challenge i s for fo rma l sector institutions to in t roduce products a n d services that are not only reliable a n d available on a continuous basis, but are also f lexible a n d convenient, a n d also to in t roduce measures that a l low for low-cost ways o f reaching the ru ra l poor. Here, microf inance can o f fe r some usefu l lessons to f o r m a l banks. O v e r the medium term, key re fo rms in government po l i cy are requi red to i m p r o v e the overal l incentive framework, a n d the regulatory a n d legal system within w h i c h ru ra l banks operate, so as to p r o m o t e greater efficiency a n d compe t i t i on in ru ra l finance.

Indla’s vast n e t w o r k of rural banks potential ly presents a tremendous advantage, and one on w h i c h the country cou ld capitalize in delivering finance for the poor. Currently, most banks operating in ru ra l areas, the major i ty of w h i c h are state-owned banks, do not seem to b e tai lored to mee t the needs o f the ru ra l poor in a n eff icient and effective manner. T h e responsibdity for in t roduc ing m o r e flexible products a n d services, that would better m a t c h the needs o f the ru ra l poor, rests with bankers. But Government , g iven i t s domina t ion o f rura l f inance institutions, also has an impor tan t ro le to play in spearheadlng change. In t h s context, microf inance offers a n u m b e r o f lessons for fo rma l banks.

Introducing flexible products: Smal l ru ra l clients prefer to borrow frequently, a n d repay in small instalments; banks cou ld useful ly explore the possibllity o f o f fe r i ng n e w a n d m o r e flexible l oan products, l ike those of fered by microfinance. Increased use by insurance companies, of the large and deep b ranch presence o f the posta l branch network7 (as w e l l as the commerc ia l bank network) for channeling insurance products, backed by adequate t ra in ing o f staff, c o u l d he lp l ower transaction costs and i m p r o v e access to insurance.

The needfor composite jnancial services: W h i l e small ru ra l bo r rowers seek savings a n d lendmg services, they also seek insurance (hfe, health, crop); b a n k branches in ru ra l areas would do we l l to explore opportunit ies to o f fe r composi te financial services, as they have begun to do in u r b a n areas, a n d as some microf inanciers have begun to of fer in ru ra l a n d u r b a n areas.

’ RFAS-2003 data showed that post office branches had the closest proximity (2 h s on average) t o rural clients compared t o branches o f commercial banks, R R B s and cooperatives (5 h s o n average).

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Simplzjcation ofprocedures to open a bank account, access credit, etc. c o u l d also go a long w a y in encouraging the poor to b a n k with the fo rma l sector, by reducing clients’ transactions costs. T h e I<CC experiment i s a m o v e in the right duection, but it needs to b e scaled-up a n d accompanied by other procedura l changes.

Better staj%zgpoLiaes and doorstep banking T h e high recovery rates o f microf inance are associated with staff ing policies that a l low recruit ing staff from the local area who understand clients’ needs, a n d a focus on doorstep banktng. State-owned banks operating in ru ra l areas currently do not have the f lexibihty to recru i t staff locally, but staff ing policies cou ld b e revisited. D o o r s t e p bank ing i s costly, but the gains from better recovery and cost savings from hiring local staff in ru ra l branches cou ld w e l l outweigh the higher transactions costs o f doorstep banlung.

Use oftechnology: Banks can use technology to dr ive down thei r transactions costs, for example, through the in t roduc t i on o f smart cards and biometrics. I

Interest rates. O n e obvious area cou ld b e for Governmen t to revisit i t s po l i cy o f sett ing interest rate “caps” on r u r a l lending rates and “ f l ~ ~ r ~ ” on the deposit rates. As n o t e d above, caps a n d floors have the opposite effect of w h a t i s in tended - poor borrowers are c u t off from access a n d e n d up p a p g h igher interest rates to i n f o r m a l lenders. Meanwhile, banks face an imp l i c i t tax (cost) that i s not i n s i p f i c a n t .

Revisiting the pokg on )tior@ sector’ Lending. G o v e r n m e n t should also consider revisit ing i t s po l i cy on priority sector lending requirements imposed on banks which, in any case, are not fully observed and o f t e n c i rcumvented through such means as subscript ion by banks to NABARD a n d SIDBI bonds. O n e option, that would al low the most compet i t ive lender to emerge in ru ra l areas a n d m i n i m i z e distortions, i s for government to make the priority lend ing obl igation “tradable”. T h e most compet i t ive lender would then b e p a i d by the less w e l l p laced banks to effectively take on their priority lend ing requirements for a price. Creating such a marke t for priority lend ing requirements would benef i t both banks and the ru ra l poor, who would b e able to access finance from the most eff icient a n d compet i t ive institution.

Entry of new private banks in mraljnance. Some pr ivate banks such as IC ICI B a n k have shown a growing interest in entering India’s ru ra l f inance sector-and have in t roduced innovat ive approaches a n d financial products to reach the ru ra l poor. G o v e r n m e n t needs to do w h a t i t takes to create a n env i ronment that would make i t possible and prof i tab le for interested private banks to enter the r u r a l f inance market. This would require l i b e r a h i n g interest rates (see above) so that lending to small, r u r a l clients can become a m o r e prof i tab le business for banks. I t would also require revisit ing b ranch l icensing policies (private banks m a y b e interested in buying up the b ranch networks o f the government-owned ru ra l banks). And it would require strengthening the supervision of ru ra l banks so as to he lp wean out the good from the b a d banks a n d create fur ther space for new, pr ivate sector entrants. T h e entry of private banks cou ld have a good demonstrat ion effect for the pub l i c sector banks on how to reduce transactions costs in ru ra l bank tng a n d how to m a k e ru ra l bank ing profi table.

Restmcturing the RRBs and mral cooperative banks. Restructur ing the R R B s a n d ru ra l cooperative banks poses a m a j o r challenge. Var ious Government-appointed task forces a n d committees have h igh l ighted w h a t needs to b e done to deal with the weaker R R B s a n d cooperative banks; the challenge really i s to b d d consensus for reforms a n d imp lemen t the changes. As a f i r s t step, the regulat ion a n d supervision o f these banks needs to b e urgent ly strengthened. Prudent ia l regulat ion

vi

standards related to capital adequacy, asset classification, i n c o m e recogni t ion a n d provisioning need to b e upgraded and in t roduced in a phased manner, and the supervisory enforcement improved. Weaknesses in regulatory standards, poor enforcement and regulatory forbearance, have underm ined marke t discipline and have contr ibuted to the deep financial distress that characterizes m a n y R R B s a n d cooperatives.

Better regulation and supemision wouldpave the w y for the restmcturing $these banks. I t would he lp wean out the adequately capitalized banks from the weaker banks (undercapitalized banks, a n d those that are insolvent). T h e p roper enforcement o f prudent ia l norms would m e a n tha t t he weaker banks are forced to address their problems through such means as mergers or closures. At the same time, t h i s would need to b e accompanied by operational restructuring, involving improvemen ts in governance to reduce state interference, better management, staff ing policies that a l l ow banks to emp loy loca l s ta f f who are f a d a r with the c o m m u n i t y a n d thereby better able to address the needs of their client, and the i n t roduc t i on of n e w products, such as loans with flexible repayment terms, a n d better services, such as door-step bank ing that can he lp better mee t the needs of ru ra l clients a n d m in im ize risk. In in t roduc ing n e w products and services for the ru ra l poor, lessons c o u l d b e d rawn from m i c r o finance.

Beyond these measures, Government can also plg an active role in other areas to facilitate increased eficieny $ mral finance markets. Better laws a n d regulations govern ing f inancial transactions, a judiciary that can enforce contracts, the demarcation o f p roper t y and improvements in l a n d titltng, better credit information, and an enhanced regulatory, supervisory a n d legal f ramework to support the development o f pr ice insurance products, pr ice derivatives instruments a n d c o m m o d t i e s futures markets can go a long way in he lp ing India’s ru ra l poor access finance on bet ter terms.

Efforts to make the f o r m a l sector better a t bank ing the poor should b e accompanied, in the near term, with measures to scale-up microf inance. This d require at tent ion to the following areas:

An enabling poliy, legal and regulato2y environment for microjnance. An enabling f ramework i s already in place for SHG B a n k Linkage, a n d scaling-up the m o d e l would require G o v e r n m e n t to ensure that the existing f ramework i s maintained. This would require ensuring that the m o d e l continues to have a champ ion with a clear leadership ro le - a task w h i c h NABARD has assumed with exemplary ddlgence by in t roduc ing policies a n d measures to encourage banks to l e n d to SHGs. And i t would require the authorit ies to ma in ta in a ‘hands-of f regulatory pol icy. For MFIs, G o v e r n m e n t c o u l d play an impor tan t ro le in establishing a n enabling policy, legal a n d regulatory f ramework for MFIs. W h i l e the success o f ind iv idual M F I s i s largely attr ibutable to their visionary leaders, t h s i s clearly not enough to mainstream the cause of MFIs. Advocates of MFIs argue tha t immediate measures needed include the following: (i) reducing minimum start-up capital requirements to facil i tate the transformation o f MFIs into NBFCs; (ii) encouraging mu l t i p le sources of equity for MFIs; (iii) facibtating MFIs to raise debt, i nc ludmg pe rm i t t i ng M F I s to mobdtze savings, with safeguards; (iv) developing a set of prudent ia l norms that are m o r e appropriate to institutions serving the poor, a n d set up supervision mechanisms a round those norms. Bet ter po l i cy coord inat ion among the various government ministr ies/ department/agencies that cover MFI issues would also he lp greatly.

Better group qua/$, and the importance $jnancial strstainabilig. Scaltng-up microf inance in I n d i a requires attention to the quali ty a n d sustainability o f groups, their promoters, and lenders (banks or MFIs). A strong focus on the quali ty o f SHGs by their NGO promoters was a key factor in the success o f the SHG B a n k L inkage m o d e l in i t s pilot phase. But in recent years, growing concerns have emerged abou t group quality as w e l l as the a b h t y o f par tner banks to p roper l y assess, monitor a n d manage risk on their S H G portfolios. Going forward, i f S H G B a n k L inkage i s to b e scaled-up, NABARD

vii

a n d i t s partners face an impor tan t challenge in ensuring that hgh quali ty groups are created a n d maintained. In particular, the success and sustainability o f S H G B a n k L inkage depends crucially upon a clear strategy on who d p r o m o t e n e w groups, and how they should b e funded. Equally, efforts need to focus on ensuring that banks pr ice their loans to SHGs at rates that would cover their costs and ensure financial sustainabdity of SHG B a n h g . Banks also need to focus m o r e on monitoring and managing SHG lending risk. Since most I n d i a n MFIs also l e n d to groups, issues related to group quali ty have a bearing on the success o f the MFI m o d e l as well.

Appropriate prodzrcts and services, and good stafing. How products are designed, how staf f are compensated, w h a t messages are delivered from headquarters, a n d who i s recruited onto staff, a l l have an i m p o r t a n t bearing on the success of microf inance. Technica l support to rura l f inance and m i c r o finance practit ioners in these areas i s required.

Incltlsiveness and competition in the microjnance sector can generate high pcyoffs. T h e inclusiveness of SHG B a n k Linkage, w h i c h has i nvo l ved a pa r tne rshp between government, NGOs, a n d a range o f ru ra l banks (commercial banks, R R B s , cooperative banks) has already generated a strong payof f . Fu r the r gains in terms o f outreach a n d financial sustainability m a y b e reaped through involving private sector banks and MFIs in S H G Banking. Recent experiments indicate good prospects for scaling-up models that are variations o f SHG B a n h g , and involve MFIs as intermediaries between SHGs and private sector banks (who w a n t to enter the market, but do not have the b ranch network). Equally, there i s space for independent, specialized M F I s in the I n d i a n microf inance marke t that cou ld p rov ide the necessary compet i t ion to SHG B a n k Linkage in the area of savings a n d credit provision, a n d also complement the services p rov ided by SHG B a n k Linkage. Ev idence from elsewhere in Asia, and particularly from Bangladesh a n d Indonesia, suggests that good, reliable, responsive, long- term MFIs for the poor can go a long way in improving access to finance. (Morduch a n d Rutherford, 2003).

Recent studies also indicate the key ro le that can b e played by MFIs that p rov ide composite services, given the w i d e array o f financial transactions (both borrowing a n d lending, o f t e n simultaneously, and at al l levels of income) that characterize the financial l i f e of the poor (Ruthven, 2001; Patole and Ruthven, 2001). T h e RFAS-2003 also supports t h i s conclusion. T h e poor are constantly borrowing, lending, saving, withdrawing, using and losing money, through contingencies, a n d calamities. T h e y need someone to help t h e m with al l these transactions. Composi te service prov iders are preferable from the v iewpo in t o f reducing the number of agencies with whom a poor household must deal, thus reducing transactions costs. Moreover , i f a composite agency has a good in te rna l M I S , i t can use the savings hstory of a household as a “collateral” for loans. S d a r l y , i f the same agency provides insurance for lives or l ive lhoods, i t will b e m o r e willing to give a loan. From the MFIs’ point of view, transaction costs come down as the same delivery system can b e used, with the addi t ion o f training, software and some staff. As discussed above, the growth o f the MFI sector i s closely related to a m o r e conducive policy, legal a n d regulatory framework.

Overcoming geographic concentration in mimojnance. A n o t h e r issue of concern i s that microf inance in I n d i a continues to b e skewed in i t s geographical distribution. T h e under ly ing causes for t h s inc lude the general malaise in the economy o f the central, eastem a n d north eastern states, with very l i t t le resultant demand for credit a m o n g the subsistence poor, a n d the absence (for h s t o r i c a l reasons) of good quali ty NGOs, that are d n g to init iate microf inance programs in these states (there are a large n u m b e r of small NGOs but al l o f t h e m with l i m i t e d experience a n d outreach). (Mahajan a n d Ramola, 2003). E x p a n d i n g the reach o f microf inance to these areas i s not a challenge that can b e m e t overnight. Investments are requi red in areas such as watershed development, small-scale irrigation, l ivestock up gradation and forest regeneration. Unfortunately, n o n e o f these are amenable to the “small, short a n d unsecured” nature o f microcredi t loans. These require long term, lumpy pub l i c investments. However , once made, they u n l o c k the potent ia l for enhancing the l i ve lhoods o f

... VI11

ndtons o f poor people, moving t h e m up from subsistence p roduc t i on to s u r p l u s p r o d u c t i o n and thereby increasing the demand for credit.

Attention to the demand-side. W h i l e the impor tance o f microf inance in consumpt ion-smoothening should not b e underestimated, i t s success in budding up poor peoples’ assets, over the m e d i u m term, would depend very m u c h on efforts duected at providmg assistance in sk i l l s development, technology a n d market ing - all o f w h i c h are crit ical to ensuring that investments made by poor households reap returns and contr ibute to a sustained increase in incomes a n d improvements in ru ra l l ivehhoods.

ix

I. INTRODUCTION

‘Xccess to jnancial markets is important for poor people. L k e al l economic agents, low - income households and mimenterprises can bent$ from credit, savings, and insurance services. Such services help to manage risk and t o smooth consumption. . ..and allow people t o take advantage ofpmjitable business oppo rtunities and increase their earningspotential.

But jinancial markets, because of their .penal features, often serve poor people badb.. .Since poor people often have insu@cient traditional forms of collateral (such as physical assets) t o ofer, thy are often excluded from traditional jinancial markets. . . transaction costs are often high relative to the small loans ppicab demanded by poor people. A n d in areas where population densip is low, physical access to banking services can be vey dz@cult. , . ”

WORLD BMK, WORLD DEVELOPMEICT REPORT2000-2001 ++

Finance i s a n extraordinarily effective tool in spreading economic opportunity a n d fighting poverty. To understand why access to finance i s so impor tan t for pove r t y reduction, w e begm with two examples. T h e f i r s t example illustrates how the poor m a y b e total ly incapacitated w h e n they do not have access to finance, wh i l e the second shows how a f e w dollars of f inanc ing can help poor people c l imb out of poverty, giving t h e m the f reedom to earn a n independent, f u l f h g l i v e h o o d .

‘l’hc St l j t ,I hla1;c.r of.Jolxi \ ~ & I , ~ @

There i s perhaps no greater authority on how to make finance available to the poor than Muhammad Yunus, the founder of the Grameen Bank. I n h i s autobiography, Yunus described how he came to understand the importance of finance for the poor when he was a professor of economics in a Bangladeshi university. Appalled by the consequences of a recent famine on the poor, he wandered out of the sheltered walls of his university to the neighboring village, Jobra, to find out how the poor made a living. H e started up a conversation with a young mother, Sufiya Begum, who was making bamboo stools. H e learned that Sufiya needed 22 cents to buy raw material for the stools. Because she did not have any money, she borrowed i t from middlemen and was forced to sell the stools back to them as repayment for the loan. That le f t her with a profit of only 2 cents. Yunus was appalled

“I watched as she se t to work again, her small brown hands plaiting the strands of bamboo as they had every day for months and years on end.. ..How would her children break the cycle of poverty she had started? How could they go to school when the income Sufiya earned was barely enough to feed her, l e t alone shelter her family and clothe them properly?’

Because Sufiya did not have 22 cents, she was forced into the clutches o f the middlemen. The middlemen made her accept a measly pittance of 2 cents for a hard day’s labor. Finance would liberate her from the middlemen and enable her to sell dkecdy to customers. But the middlemen would not let her have finance, for then they would lose their hold over her. For want of 22 cents, Sufiya’s labor was captive.

T h e paucity o f finance, w h i c h i s al l too o f t e n the n o r m a l state of affairs for the poor in m u c h of the world, i s rendered even m o r e stark w h e n one contrasts i t with the extraordinary impac t of j u s t a f e w dollars o f finance on the l ives o f the poor. To see this, w e m o v e to a n example in Sou them In&a where mimojnance-the provision o f tiny amounts of f inance to people with even t inier assets- he lped lift Puthbai a n d he r f a d y out o f poverty.

’l’hc I : isher\wmai i fri 1171 IL i ipa l l y

Puttibai came from a fishing community in Raipally, which l ies in an impoverished region of southern India. H e r family eked out a living through fishmg in the reservoir. H e r husband and two sons went out in the predawn darkness and cast their nets. They brought in their daily catch in the morning. Then Putlibai, along with her daughter and mother-in-law, cleaned and processed the fish in t ime for Putlibai to catch the morning bus to various local town

* See Rajan and Zinghales (2003).

1

markets each day. Putlibai sold the fish, and the family's net earnings were about $2/week, just enough to barely subsist.

Putlibai knew that a few extra fishing nets could go a long way in improving her livelihood - but she did not have the money to buy the nets. She could not borrow from the bank; she had heard that others from her community had been turned away by the bank, after several visits, and besides, she did not have any assets to pledge as collateral to the bank. The local moneylender charged exorbitant rates of interest (5 per cent per month), and Putlibai had friends who were never able to get out of the moneylender's clutches.

Then, in 1998, Swayam Krishi Sangam (SKS), a microfinancier, established a center (sungum) in Raipally. The center comprised of four joint liability groups who undertook to mutually guarantee each other's debt obligations; each group had five women as i t s members. All groups assembled together once a week for small financial transactions. This included savings o f 10 cents/week per member that was collected by the loan office of SKS. Collateral free loans were given to all members in the center within 3-6 weeks of initiating the savings activity subject to approval of a small application from the borrower explaining how the funds would be deployed in productive activities. The loans could be up to a maximum of $50 for the f u s t cycle and had to be repaid in 50 equal weekly installments, carrying an interest rate of 15 per cent flat per annum.

Like everyone else, Putlibai, who was one of the frrst to join, saved 10 cents/week. She took a loan of 535 after four weeks of the start of the center to buy more fishing nets. Wh i le she previously had only eight nets and was able to catch approximately 6 kilos of fish per day, she and her husband now tripled their daily catch and the family's weekly income increased to S6/week. Encouraged by t h i s success, Puthbai took a second year loan of 9100 for even more nets and further increased the family's earnings to SlO/week. By her third year, she had gained tremendous confidence and took a $150 loan and the daily catch i s now about 50 kilos per day. Putlibai can no longer sel l a l l the fish the same day and she uses a nearby cold storage plant to store unsold fish for the next day. H e r family's weekly net income averages around $15/week, a 750 per cent increase from three years ago. This year, Putlibai i s planning to take a loan for even more n e t s and i s considering employing people to help with both fishing and selling.

Putlibai's entrepreneurial succcss has inspired other families to take up fishing. Today, eight other SKS members in Raipally have taken loans for fishng nets and the ent i re community has benefited through increased economic activity. This i s a particularly inspiring story because Putlibai was one of the poorest members when SKS started and she was not very respected. Now she i s held in high esteem by the ent i re center and the ent i re village.

Broader access to finance helps an economy p roduce more, a n d distr ibute i t fairly.9 Both consumers a n d producers benefit, as their welfare a n d product iv i ty are raised.10 Without access to credit, one avenue o f opportunity, self employment, i s shut off. As a result, the poor are doubly damned-not only because they lose an option, but also because their bargaining p o w e r w h e n they work for those who have resources i s weakened. In the examples above, wh i l e both Sufiya a n d Puthbai h a d talents a n d ideas, the difference was that Puthbai was able to ob ta in the resources necessary to carry out he r ideas, a n d this gave he r ind iv idual choice a n d economic freedom, dignity, a n d the a b h t y to contr ibute to the weal th of he r communi ty . Indeed, access to credit allows a l l those with talent to obtain the resources necessary to carry out their ideas, a n d society i s r icher for it. Bet ter access to other financial services, such as savings, remittance services" a n d inszlrance, also means that individuals can insure themselves against periods of low income or unexpected fluctuations in income, a n d maintain their

For a producer, access to credit for futed or working capital enables an increase in production possibilities which can have far-reaching implications not only for the producer but for patterns of employment, occupational choice and even economy-wide productivity and growth. Financing constraints have been shown to feature prominently among the constraints of small and medium-size enterprises in some investigations. Hallberg (2001). Yet other studies indicate that frrms find the difficulty of access to financial markets to be the major obstacle to the expansion of their business activities, ahead o f factors such as macro instabhty, taxes, and street crime. Galindo (2001) lo For a good discussion on the microeconomic underpinnings of the welfare implications of improved access to financial intermediation, see Improving Access to Finance in Brazil, World Bank (2003). The study points out that intermediation enables inter-temporal choices in consumption and investment for the individual, allows the determination of the cost of capital and hence helps guide investment to i t s most productive use, and permits the social reallocation of savings from low to high productivity uses thus raising social welfare. I' Official estimates show that international remittances to India amounted to US$8.4 billion in 2003. The total volume of remittances would be much higher once credible estimates, as yet unavailable, for international remittances through unofficial channels and domestic remittances are added. Within the latter, domestic migrant labor income remittances play an important role for rural household income.

2

consumpt ion standards through the accumulation of f inancial savings.12 For example, for ru ra l farmers, savings constitute insurance, to protect themselves against per iods of drought or crop f d u r e . Savings also p rov ide a vehicle for future expenditure needs, whether expected (for example for special farmly occasions, or for the purchase of s i p f i c a n t assets such as a home) or unexpected. Access to finance cou ld also have longer t e r m welfare implications, pe rm i t t i ng people to borrow w h e n young, for example for education or for other physical or h u m a n capital, and then repay and save for ret i rement w h e n they are older.13

In India, since the early national plans, successive governments have emphasized the h k between improving access to finance and reducing poverty, a stance that has h a d in f luence globally.14 15 T h e need to i m p r o v e financial access for India’s poor mot i va ted the establishment of a vast n e t w o r k o f ru ra l cooperative credit banks in the 1950s’ fo l lowed by a dr ive to nationahze commerc ia l banks, launched in 1969. This l e d to thousands o f n e w bank branches in ru ra l areas across the country. T h e strategy during the 1970s and 1980s gave the lead ro le to the national ized (state-owned) commercial banks, who were charged with loosening the grip of tradit ional i n f o r m a l sector moneylenders through the use o f targeted low-pr iced loans. T h e 1990s saw the par t ia l deregulat ion o f interest rates, increased compet i t ion in the banking sector, and n e w microf inance approaches-that comb ine the safety a n d rel iabi l i ty offarmal finance with the convenience a n d f lexibi l i ty o f informal finance. Access to finance for the rura l poor has i m p r o v e d somewhat over the past decades. But the vast major i ty of India’s ru ra l poor s t d l do not have access to either fo rma l f inance or microf inance. I n f o r m a l sector lenders t h u s retain a strong presence in ru ra l India.

Wh_yfactts on the ruralpoor? T h e o v e n v h e h n g major i ty of poor people in I n d i a are concentrated in ru ra l areas. Of the estimated 260 d o n Indians (or 26 p e r cent o f the populat ion) who l ive in poverty, some 193 d o n (or 74 p e r cent) l ive in ru ra l areas. 16 Based on an international ly comparable pove r t y estimate of a dol lar a day, the n u m b e r of ru ra l poor in I n d i a i s estimated at a round 270 d o n . A n o t h e r 180 d o n ru ra l people are “near poor”.

India’s Rural Firtarice 1,andscape

India’s ru ra l poor are o v e r w h e h n g l y dependent on agriculture as the i r p r i m a r y source o f income; the major i ty are marg ina l or small farmers, a n d the poorest households are landless. T h e financial needs o f India’s ru ra l poor ref lect the volatde, uncertain and irregular i ncome streams and expenditure patterns o f these households. Our recently completed World B a n k - N C A E R Rura l Finance Access Survey P A S ) 200317, indicates that, wh i l e ru ra l f a d e s are predominant ly mul t ip le- i ncome households, their two main sources o f i ncome inc lude sale o f agricultural products a n d o f wage labor. Irregular employment i s the most impor tan t source o f i n c o m e from wage labor. For

’’ The role of savings and borrowing in protecting consumption against unexpected shocks, f i l s t discussed by Milton Friedman (1957) in the ‘permanent income hypothesis’ has since been extensively tested empirically, as discussed in Bond and Townsend (1996).

The ‘life cycle’ hypothesis as an explanation for savings and borrowing behavior, discussed in Ando, Modigliani and Brumberg in a series of articles in the 1950s and 1960s. See Mayer (1972), and Romer, (1996) for overviews. 14 The focus on poverty and finance was articulated most famously in the 1954 Reserve Bank of India (RBI) report on the All-India Rural Credit Survey of 1951-52 (RBI, 1954). l5 For a good discussion on the link between finance and poverty see Rajan and Zingales (2003). For a discussion on the microeconomic underpinnings of the welfare implications of improved access to financial intermediation, see World Bank (2003a). l6 This i s based on the Planning Commission of India’s definition of poverty, as the level of per capita consumer expenditure sufficient to provide an average daily intake o f 2,400 calories per person in rural areas and 2,100 calories per person in urban areas, plus a small allocation for basic non-food items. ” The findings of this survey are discussed in detail in the following chapter.

households with m o r e than one source o f income, agricultural i n c o m e i s the most impor tan t secondary source o f income, with sale o f f a r m produce a n d sale o f dairy products be ing the most prominent . Clearly, ru ra l households depend on one or both o f two types of incomes: seasonal (post harvest sale) or highly irregular due to irregular or par t - t ime wage labor, with the dependence on the latter be ing inversely p ropor t i ona l to the size o f l and holdlngs. T h e typical expenditure p ro f i l e of the households i s also o f small, dady or irregular expenses, i ncu r red throughout the month. Moreover , the overwhelming major i ty of rura l households repo r t hav ing to deal with at least one unusual expense each year, w h c h they are forced to finance either from cash at home, or through informal loans from famdy, friends, or moneylenders.

Research shows that poor people value financial services a n d w a n t these to b e reliable, convenient, continuous a n d flexible's. T h e y understand that f inancial services he lp t h e m spend, a t one time, i ncome earned at o ther times, and because those incomes t e n d to b e small, irregular a n d unreliable, they need the full armory of intermediat ing modes - saving up for future spending, tak ing advances against fu ture savings, a n d building cash reserves that can b e called on at any time. T h e poor need a wide range of financial services, from small advances to t ide over consumpt ion needs to loans for investment purposes a n d long t e r m saving that he lp t h e m manage l i f e cycle needs.19 G i v e n the vast popu la t i on of the poor in the country, w h a t has been the po l i cy f ramework a n d wha t exists in the financial landscape to cater to these needs?

I n d i a has a range of ru ra l f inancial service providers, i nc lud ing the f o r m a l sector f inancial institutions at one e n d o f the spectrum, i n f o r m a l providers (mostly moneylenders) a t the other e n d o f the spectrum, a n d between these two extremes, a number o f semi- formal lmicrof inance providers.

Formal providers. In terms of sheer size a n d spread o f operations, the f o r m a l sector f inancial institutions dominate the ru ra l f inance landscape:

o

o

Commerc ia l banks, mostly pub l i c sector banks (but also some pr ivate sector banks) a n d Regional Rura l Banks (RFU3s) together have m o r e than 32,000 ru ra l branches. I n d l a also has a vast ne twork o f ru ra l cooperative banks, with a three t iered structure at the state, distr ict a n d vdlage level. The re are some 14,000 branches o f ru ra l cooperative banks a n d m o r e that 98,000 grass roots level retad outlets of P r imary Agr icu l ture Credi t Societies (PACS), w h i c h are used by the cooperative system as channels for funds flow. T h e post of f ice system20 adds to the physical service point n e t w o r k o f the country with m o r e than 154,000 post of f ice branches handhng m o r e than 110 million m o n e y orders and admmistering 114 d o n savings accounts. Insurance companies have a moderate reach in ru ra l areas, though t h s i s gradually increasing.

o

o

These fo rma l ru ra l f inance institutions account for a lmost a l l ins t i tu t ional loans to r u r a l areas; the l oan exposure of commerc ia l banks i s Rs533,OOO d o n (2.6 p e r cent of GDP); the ru ra l deposit

See Morduch and Rutherford (2003). For a discussion of ways that low-income households cope with risk, see Morduch (1999a).

2o W h i l e the postal system i s heavily subsidized, i t nevertheless adds to the service branch outreach of the country and provides a valuable and trusted place for small investors to deposit their savings. The potential linkages with the postal network to deliver increased and more efficient financial services i s discussed in a World Bank study: The Reform o f India Post: Transforming a Postal Infrastructure to Deliver Modern Information and Financial Services, 2002.

4

base i s Rs 1,400,000 d o n (6.6 pe r cent o f GDP). T h e f o r m a l ru ra l f inance institutions are largely deposit f unded (65-80 pe r cent).

Formal Semi- formal/Micro finance Informal

Apex Development Micro finance Institutions (MFIs) Moneylenders Financial Institutions (DFIs) Self Help Group (SHG)-bank-linkage program Trade creditors Commercial banks Local shopkeepers Regional Rural Banks ( R R B s ) Cooperative Banks Insurance companies Post office network Reserve Bank o f I n d i a (RBI)

*

T h e f o r m a l f inancial institutions are regulated by the RBI, although i t has delegated to the Na t iona l B a n k for Agr icu l ture and Rura l Deve lopmen t (NABARD21) the task o f supervising ru ra l cooperative banks a n d R R B s . Deve lopmen t banks such as NABARD and the Small Industr ies Deve lopmen t B a n k o f I n d i a (SIDBI) p rov ide support to both the f o r m a l and semi f o r m a l segments through fundmg/ref inancing arrangements. NABARD prov ides ref inancing to banks l endmg in r u r a l areas, a n d S I D B I funds and supports MFIs.

Semi-j%mal/mimojnance sector. W e I n d i a i s h o m e to m a n y microf inance innovations, in terms o f people reached and the scale o f financing, microf inance in I n d i a i s s d a drop in the ocean. I t reaches less than 5 pe r cent o f the country’s ru ra l poor.

o D o m i n a n t a m o n g the microf inance models i s t he S H G b a n k l inkage model, whereby women’s S H G s are h k e d to the ru ra l branches of commercial banks, R R B s or cooperative banks. T h e SHG-bank h k a g e p r o g r a m has reached out to a round 12 d o n f a d e s in terms o f savings accounts. Credl t outstanding remains low; disbursements in FY 2002-03 accounted for only 2 p e r cent of the fo rma l sector credit outstandmg in ru ra l areas. T h e other m o d e l i s spec iahed MFIs, w h i c h reach around 1 d o n clients. T h e loans outstanding of MFIs i s a round 0.5 p e r cent o f the total ru ra l loans of the f o r m a l sector banks. T h e to ta l branches o f M F I s are estimated to b e in the range o f a f e w thousand compared to the vast numbers o f b a n k branches. Recent developments have l e d to other inter-l inkages between the formal, both pub l i c a n d private sector banks, a n d semi-formal sector initiatives, part icularly the S H G - b a n k h k a g e p r o g r a m (led by NABARD), as w e l l as l end ing by SIDBI ( w h c h has been a p ioneer a n d takes c r e d t for developing t h l s f inancial inst i tu t ional space) a n d commerc ia l banks to MFIs. Moreover , a f e w private sector commerc ia l banks such as IC ICI Bank, have t r i ed innovat ive ways to incorporate the lessons from microf inance into their operations a n d have made inroads in using microf inance methodologies to deliver ru ra l f inancial services. These innovat ions are detaded later in the report.

o

o

Injmalproviders: I n f o r m a l financiers inc lude a range of actors: landlords, loca l shopkeepers, traders, professional moneylenders, etc. W e there are no definite estimates o f the n u m b e r of i n f o r m a l sector providers, these are spread very widely across the country. Survey data indicate that poor ru ra l households re ly heavily on i n f o r m a l f inance to mee t a range o f f inancing needs: from consumpt ion and emergency f inancing to investment loans. Around 44 per cent o f the households surveyed by

’’ NABARD i s owned b y the RBI and the Go1 and was established b y an A c t of Parliament in 1982 as the apex bank for rural finance.

5

RFAS-2003 repor t hav ing b o r r o w e d in formal ly at least once in the preceding 12 months; the interest charged on i n f o r m a l loans averages 48 pe r cent per annum. N o t surprisingly, i n f o r m a l borrowing i s very impor tan t for the poorest (marginal a n d commercial categories), who are the most depr ived o f fo rma l finance.

With a f e w notable exceptions (such as Wes t Bengal, where l a n d reforms are the most advanced in the country), village moneylenders and other types o f i n f o r m a l financiers have been a round for as long as villages have existed. I n f o r m a l financiers have the advantage o f knowing their cl ient better t han most f o r m a l institutions such as banks, they have a better abi l i ty to enforce contracts, and p rov ide flexible products.

Scaling-up access to finance for India’s ru ra l poor, to mee t their diverse financial needs (savings, credit, insurance against unexpected events, etc.) through flexible products at compet i t ive prices, presents a formidable challenge in a country as vast a n d var ied as India. But the opportunities, too, are plentiful, a n d Governmen t has an impor tan t ro le to p lay in creating space a n d a flexible architecture for scale-up. 7311s repo r t i s organized as follows: D r a w i n g on WAS-2003, Chapter I1 reviews the current level a n d pat tern o f access to finance for India’s r u r a l households, with a focus on the poor. I t highlights inadequacies in rura l access to finance. Chapter I11 takes a closer look at w h a t explains the lack of financial access for India’s ru ra l poor. Chapter IV examines recent approaches in I n d i a to i m p r o v e access to finance for the r u r a l poor, focus ing part icularly on low-cost delivery models that have invo lved linkages between the f o r m a l and i n f o r m a l sector, based on the principles of microf inance. I t evaluates successes a n d failures, and identi f ies the m a i n challenges ahead in improving outreach a n d sustainability. T h e conclud ing section prov ides some suggestions on wha t needs to b e done to scale-up access to finance for India’s ru ra l poor.

6

11. ACCESS TO RUFUL FINANCE IN INDIA: THE EVIDENCE

Table 1: Depth of Financial Markets - India and Other Emerging Economies (1999/2000)

Total Public Private Total capita 1999 Domestic Domestic GDP per

Financial Equity Market Equities - Bonds on Bonds on Financial Atlas Assets* Capitalization / Value Traded Issue / Issue / Assets* / Method Private Credit (US$m) GDP (%) /GDP (YO) GDP (%) GDP C/O) GDP (%) (curr. US$) / GDP C/O)

Brazil 780,739 39.0 17.0 40.9 8.9 139.7 4,350 50.9

Supply Side Indicators o f Access to Finance

I n d i a has a deep financial system, attributable in large p a r t to the country’s vast ne twork of banks and other f inancial institutions, inc lud ing thousands of branches of ru ra l banks. Financial assets in I n d i a a m o u n t to abou t US$430 bdhon, in nomina l terms, compared to less than $250 billion in Argentina, US$330 bdhon in Malaysia, or US$386 bdlion in Mexico, despite India’s significantly l ower p e r capita income. T h e share o f financial assets in GDP in I n d a i s abou t 93 percent, compared to 81 percent in Argent ina a n d 68 percent in Mexico. F a b l e 1).

Financial dep th i s attributable in large pa r t to India’s vast n e t w o r k o f f inancial institutions, inc lud ing ru ra l f inance institutions. T h e 1970s and 1980s saw a r a p i d expansion o f India’s financial system into ru ra l areas. Following I n d u a Gandhi’s b a n k national izat ion drive, launched in 1969, commerc ia l banks were requi red to open ru ra l branches. Between 1973 a n d 1985, b a n k branches in ru ra l areas g rew at an average o f 15.2 p e r cent each year, about double the growth rate of branches in semi- u r b a n (6.4 p e r cent), u r b a n (7.8 p e r cent) a n d me t ropo l i t an (7.5 p e r cent) areas. Rural branches g rew from 1,833 in 1969 to 30,186 in 1985, an increase of 1,547 p e r cent (by comparison, the increase over the same p e r i o d for semi-urban, u rban and metropol i tan areas was only 194,315, an increase o f 220 p e r cent). R u r a l branches cont inued to expand in the 1980s, to 35,000 by 1991, d e c h n g slightly to 32,400 in 2001. Today, I n d i a has over 32,000 ru ra l branches o f commerc ia l banks22 a n d R R B s , some 14,000 cooperative b a n k branches, 98,000 PACS, not to speak o f the thousands o f m u t u a l fund sellers, several N o n - B a n k Finance Companies (NBFCs) a n d a large post of f ice n e t w o r k with 154,000 outlets that are requi red to focus on deposit m o b h z a t i o n a n d m o n e y transfers.

No t surprisingly, I n d i a compares favorably with o the r developing countries in terms o f the distribution o f f inancial services. T h e average popu la t i on served p e r commerc ia l b a n k b ranch in I n d i a was a round 15,000 in 2002, and inc lud ing the branches o f ru ra l cooperative banks, a t 12,800, close to levels in Indonesia a n d Mexico. Also in terms o f the average area seruedper branch, I n d i a compares favorably with other countries, ind icat ing a hgh degree of physical b ranch presence, w h i c h has been improving over time. (Figure 1).

22 T h e total number of bank branches (rural and urban) i s 66,500. T h e bulk o f these branches are o f public sector commercial banks.

7

India’s per formance with respect to insurance penetrat ion i s also better than countr ies l i ke B raz i l and China. Measured by insurance p r e m i u m as a percentage o f GDP, insurance penetrat ion in I n d i a in 2000 was close to 2.5 pe r cent, compared to a l i t t le over 1 per cent in Indonesia, under 2 p e r cent in China and Mexico, a n d a l i t t le over 2 pe r cent in Brazil. (Figure 2).

Year

1972 1981 1991 2001

2001*

Improvemen ts in ru ra l finance not withstanding, the supply o f fo rma l f inance appears to b e biased against the ru ra l populat ion. On average, a ru ra l b a n k b ranch in I n d i a serves almost three times the n u m b e r o f people served by a non- ru ra l branch. (Table 2). T h e vo lume of deposits a n d credit in ru ra l areas i s also m u c h l o w e r than in u rban areas. P e r capita deposits in ru ra l areas stood at Rs 2,150 (USD47) or around 10 pe r cent of nat ional p e r capita G D P in 2001, compared to Rs 33,780 (USD740) or a round 160 p e r cent o f pe r capita G D P in the same year for u rban areas. Credi t p e r person in ru ra l areas stood at Rs 900 (USD2O) or a round 4 pe r cent o f nat ional

Overall Rural Non-rural (Sq k m s )

40,241 91,151 12,389 232.4 19,137 29,685 8,820 88.7 14,054 17,858 8,700 52.6 15,515 22,841 8,461 47.8 12,806 N A NA 39.5

Figure 1: International Comparisons of Area Covered Per Branch

1 I I

I I

I

1

I

0 It* m ffl Ju suu iw StJ rms

Source, World Bank, Brazll, Access to Financial Services, 2003

Figure 2: Insurance Penetration IPremium/GDP\ across countries in 2000

d w$@ 8 Source. Insurance Regulato 2001-02 c i t i ng Swiss g e data.

p e r capiia G D P versus a figure of Rs 20,600 (USD450)-for u r b a n areas w h i c h i s a round 100 p e r cent o f nat ional p e r capita GDP. T h e ntrmber ofmedit accounts in mral areas relative to the total mralpopdation amounts to only 3.4 p e r cent against a ra t i o nearly three times higher for u r b a n areas.

Rural-urban differentials in insurance are even larger than the differentials for credit or savings. W h i l e general insurance agencies have a duective to source 5 p e r cent of their g ross p r e m i u m within three years o f operations from ru ra l areas (2 pe r cent in the f E s t year), the actual levels for most companies at present are m u c h lower. In terms of p r e m i u m from ru ra l areas, for FY2002-03 the share was 8.3 p e r cent reducing to only 1.4 p e r cent on excluding the share o f L i f e Insurance Corporat ion o f I n d i a &IC) t h u s

Table 2: Coverage of bank branches

Average population served per bank branch verage area per branch

ind icat ing that most insurance agencies are w e l l b e l o w requi red levels of ru ra l exposure.

T h e quali ty a n d choice o f products a n d services p r o v i d e d by ru ra l b a n k branches are generally l ower than their u rban counterparts. R u r a l branches are typically not computerized, do not o f fe r technology b a n h n g through ATMs or credlt a n d debi t card products. Moreover , w h d e u r b a n b a n k branches have increasingly started turning into one-stop-shops for a l l f inancial services (insurance, m u t u a l funds in addi t ion to b a n h n g products) a n d also p r o v i d e add-on services in terms o f payments

8

o f n e t a n d p h o n e banlung, payment o f uulity bills, cell phones, etc, r u r a l branches are unable to o f fe r a comparable services/product mix.

Region N o r t h e r n

Large regional differences exist in the distribution of financial services, both in terms o f the vo lume o f transactions and b ranch density, with clients in India’s economical ly weaker regions hav ing a disproport ionately l ower level of financial access. T h e spread of branches appears to b e closely associated with regional shares in populat ion: the eastern a n d central regions have larger shares in popu la t i on a n d therefore, despite their low share in income, occupy the second a n d third positions in terms o f share in branches. However , the presence o f branches alone does not ensure access to finance; as expected, i ncome i s a key determinant to financial access. Regional d f ferences in the vo lume o f financial services (volume of credit and deposits) are largely explained by regional i ncome differentials? Indla’s lesser developed and low- income eastern, central a n d north-eastern regions account for 54 pe r cent o f the populat ion and 40.5 p e r cent of to ta l branches, but only 20 p e r cent o f outstandmg credlt and 29 per cent o f deposits. (Table 3 a n d Figures 3-8)24.

Share in all Share in all Share in all Share in Regional per capita Share in all India India bank India GDP population GDP/national per capita GDP India credit deposits branches

18% 13.8% 1.28 21.5% 22.9% 16.1’1’0

T a b l e 3: Regional Differences in Financia l Services

North- Eastern Eas tern Central Western

3% 3.7% 14% 23.6% 17% 26.6% 22% 15.5%

1.6% :;:/ 12.9% 0.6 13.6% 1.39 32.20/ 26.4%

2.5% 17.7% 20.3% 15.6%

Southern

Source: RBI, Basic Statistical Retums, 2002; RBI, Handbook of Statistics, 2003; Census 2001

28%1 16.9Yd 1.631 26.6”/0( 22.6%1 27.4%

23 T h e only out l ier i s the western r e g i o n w h i c h has the highest v o l u m e o f f inancial services though only t h e second highest con t r ibu t ion to GDP a n d relatively low share in total branches. T h i s indicates m o r e a deve loped f inancial inst i tut ions n e t w o r k in this region, tha t has t radi t ional ly b e e n the hub of business a n d t r a d i n g act iv i ty in Ind ia . 24 T h e size of the circle in Figures 5-8 represents t h e share (or size) o f GDP of the r e g i o n whereas in F i g u r e 10 the size o f the circle represents the reg iona l share in the country’s populat ion.

Total

9

100%1 100% l . O d 100%1 100% 100%

Figure 3: Credit distribution by regional income e "

-1 ~~~~~

4% "

Source RBI, Basic Stausucal Returns, 2002 and Handbook o f Stausucs, 2003

Figure 5: Branch distribution by regional income

n

Source: RBI, Basic Statistical Returns, 2002 and H a n d b o o k of Statistics, 2003

Figure 7: Population per branch across regions, 2002

Source: RBI, B ranch Bank ing Statistics, 2002

Figure 4: Deposit distribution by regional income ~-

Source: RBI, Basic Statistical Returns, 2002 and Handbook of Statistics, 2003

Figure 6: Branch distribution by regional DoDulation --. r - . . r--'---

Source: RBI, Basic Statistical Returns, 2002 and Handbook of Statistics, 2003

Figure 8: Branch distribution by regional population

# * E .

Source: RBI, Basic Statistical Returns, 2002 a n d H a n d b o o k of Statistics, 2003

10

Access to Rural Finance: Evidence from the Demand SidcZj

Developments in India’s financial sector, particularly after the late 19bOs, resulted in substantial achievements in enhancing access to credit in ru ra l areas. T h e share o f rura l credit in tota l credit increased from 4.6 pe r cent in 1972 to 10.1 pe r cent in 2001; the share of rura l deposits in total deposits increased from 8.5 p e r cent in 1972 to almost 15 p e r cent by 2001. T h e growth of ru ra l b a n k m g in absolute terms a n d relative to GDP has also been significant F a b l e 4).

Shor t ly after independence in 1947, the f i r s t survey of ru ra l indebtedness (All I n d i a R u r a l Credi t Survey) prepared by the RBI documented that moneylenders a n d other i n f o r m a l lenders m e t m o r e than 9 0 percent o f ru ra l credit needs. T h e share o f banks in particular was only abou t 1 percent in tota l ru ra l household debt. Source: RBI data T h i s ra t i o remained low unul 1971 w h e n i t was 2.4 p e r cent, a l though the share of formal sources of credit in ru ra l areas increased s t e a d y to 29 pe r cent due to the rising share of cooperatives. Following b a n k nationalization, the share of banks in rural household deb t increased to abou t 2 9 p e r cent in 1981 and 1991 wh i l e the share of f o r m a l or inst i tu t ional sources in tota l debt reached 61.2 p e r cent before decl ining in 1991. Correspondingly, the share of moneylenders d e c h e d steadily over these four decades. F a b l e 5).

*“Others” includes non-institutional sources other than friends and relatives and moneylenders, cg., traders, agriculturist money lende landlord, etc. Source: All India Rural Credit Survey and All India Debt and Investment Surveys (AIDIS)

’’ See Annex 2 for details o n the factors guiding the choice o f states covered in the WAS-2003, and the survey methodology and sampling. The survey covers 6000 households in two states, Andhra Pradesh, AP (!mown t o be a leader in the provision o f rural finance) and Uttar Pradesh, UP (a laggard). Whi le the original intention was to contrast the findings of AP and with UP, in the event, with a few exceptions, such as access to microfinance, the findings f r o m the two states converged o n most indicators-possibly because access to finance in rural AP has been negatively affected b y increased poverty resulting f rom years o f consecutive drought. Therefore, the results were aggregated and presented as averages. A background paper on the Survey findings presents the separate results for AP and UP.

11

W e no of f ic ia l survey o f rura l access has been conducted since 1991, the World B a n k - N C A E R RFAS-2003 - t h i s covered 6,000 households in the two states o f AI? and UP) allows for some analysis o f trends between 1991 a n d 2003. Relative to the findings o f the AIDIS-1991, the incidence o f indebtedness (i.e. proportion o f households with debt outstanding to a fo rma l f inance institution) h a d fur ther increased by 2003, ind icat ing greater access a n d the a b h t y to borrow.26 U n d e r the assumption that households "prefer" f o rma l borrowing a n d were earlier ra t ioned

1 Tab le 6: Summary compar ison o f AIDIS (1991) a n d 1 RFAS (2003) I ~ l 1 1 n d i a I UP I A P

Source: RE31 (1989), National Sample Survey Organization (NSSO) R e p o r t No. 420, WAS-2003

due to inadequate supply of such debt, the increase in fo rma l indebtedness c o u l d b e v iewed as a n improvement . (Table 6).

India's poor households, who are concentrated in ru ra l areas'', have very l i t t le access to fo rma l finance. A recently completed World Bank- N C A E R - R F A S - 2003 '' indicates that 70 pe r cent o f marginal/landless farmers do not have a b a n k account; 87 p e r cent have no access to credit from a f o r m a l source (Figure 9). As a result, they are fo rced to re ly on i n f o r m a l finance, mainly from moneylenders who charge exorbitant rates of interest: the RFAS- 2003 finds that 48 p e r cent o f marginal/landless farmers have b o r r o w e d from an i n f o r m a l source at least once in the past 12 months, at rates pe r year.

48 per cent Note: Marginal farming households=landholding<l acres; Small=l to 4 acres; Large farmers=>4acres; Commercial households= with or wio land but wi th income k o m non-farm sources exceeding hal f o f total household income; Others=mixed households wi th land and non-farm commercial incomes but the latter being less than hal f o f their total household income.

Source : WAS-2003 , lCc:L"J:c to .1.111!117~s./ &po.rit ar1ntll:tf

O v e r one-half o f ru ra l households (59 pe r cent) do not have a n account with a f o r m a l f inancial institution. (Table 7). What's more, a m o n g those with no accounts, 97.5 p e r cent o f households repo r t never hav ing applied. Almost two-hds o f households without a n account do not perceive the need for deposit account services, whde another fifth repor t not be ing aware that they c o u l d open an account. T h e biggest reason for not hav ing an account appears to b e a perceived "lack of need".

26 Higher incidence of debt can be interpreted in different ways; i t could s i g n i f y greater access and ability to borrow but i t could also denote greater distress leading to higher demand for debt. 27 Of the estimated 260 million Indians (or 26% of the population) who live in poverty, some 193 million (or 74Yo) live in rural areas. Another 180 million rural people are "near poor". A majority of these households are marginal or small farmers, and the poorest households are landless. 28 The RFAS, 2003 covers 6000 rural households. The last such survey, the AIDIS, was undertaken by NSSO in 1991.

12

Marginal Small Large Commercial Others With Account 29.6 55.3 66.05 41.96 60.88

Without Account 70.4 44.7 33.95 58.04 39.12

households; with or w/o land but with income from non-farm sources exceeding half of total household income; Otherszmixed households with land and non-farm commercial incomes but the latter being less than half of their total household income. Source: RFA4S-2003

Total 41.16

58.84

W h i l e a round 41 pe r cent o f ru ra l households have a n account with a fo rma l f inancial institution, w i d e differences exist between the access of large a n d small farmers, and between those who h a d other sources o f income, and ‘pure’ farmers. By far the most depr ived segment in terms of access to a n account are the “marginal” f a rm ing households (with less than 2 hectares o f land), f o l l owed by the “commercial” category (households that rely on n o n - f a r m sources for m o r e that one-half of their income). O v e r 70 pe r cent o f marg ina l farmers have no b a n k account. (Table 7).

T h e bulk o f ru ra l accounts are in commercial banks, w h i c h have one a n d h a l f t imes the numbers o f ru ra l accounts

compared to the dedicated R R B s . (Figure 10). T h e cooperative sector only has a small fract ion of account holders (12 per cent). T h e post of f ice system, despite a ve ry w i d e n e t w o r k o f branches a n d close proximity to ru ra l clients (refer b e l o w to the discussion on transaction costs at the e n d of Section 119, surprisingly accounted for a n even smaller percentage of account holders (2 p e r cent), perhaps ind icat ing the latent potent ia l for tapping the large a n d widespread posta l n e t w o r k for provision of deposit serviceszg. W h i l e mul t ip le accounts with f o r m a l f inancial institutions are relatively rare, the survey indicates that ru ra l households do not expect to have a l l their f inancial service needs m e t by j u s t one provider, or by just one type o f provider, a n d that they are used to mu l t i p le i n f o r m a l providers.

Figure 10: Distribution of Accounts

Others 1% 1

Caoperative i3., 7 4%

Bank 51%

Source : WAS - 2003

Households’ preference for commerc ia l banks (over o ther types o f f o r m a l f inancial institutions) does not appear to b e related to physical distance (the m e a n distance to R R B s a n d cooperatives i s l ower than to commerc ia l banks). In general, frequency of v i s i t s to f o r m a l f inancial institutions i s low, with the m a i n reason for in f requent v i s i t s be ing the high costs related to travel t ime/transport. T h e most i m p o r t a n t reason for hav ing a n account i s for safekeeping of monetary assets: over 72 p e r cent o f with a n account repo r t safekeeping as the p r imary use of the account.

29 The low share of the post office system in WAS-2003, could however, be attributed partly to a lack of association amongst respondents of post offices as ‘fmancial service providers’, which i s the terminology that the survey used.

13

1 ’ ~ ! ~ ’ / / r e i ~ i c ,.SUY&W - Lipd/ rd LIJ.L)> h&h b i l ~ ’ h t ~ ~ ~ ~ t / ~ i t ~ j ’

E v e n those households who do repor t hav ing b a n k accounts appear to have l i t t le use for payments and checktng services. Moreover, there i s h t e d transactions demand as most transactions are cash- based. Some 48 pe r cent o f households in our survey repo r t receiving their incomes in the form of cash a n d 93 p e r cent repo r t cash at h o m e as the m a i n m o d e o f f inancing usual household expenses. And even in the case of payment services such as remittances, cash dominates: 82 pe r cent o f households repo r t cash as the m a i n m o d e o f remittance, as opposed to 15 p e r cent who repor t checks/drafts a n d 1.7 pe r cent repo r t i ng posta l m o n e y orders as modes of remittance.

With formal loan

Without formal loan

outstanding

I t follows that a substantial segment (over one-half) o f ru ra l households m a y have no use for the type of depository or payment services of fered by fo rma l f inancial institutions, w h i c h m a y b e explained by (1) their low levels of financial assets a n d flows, (2) an env i ronmen t characterized by the preponderance of cash transactions. Households with accounts tend to use t h e m in a h t e d way, accessing t h e m with low frequency and with l i t t le use o f checks (the p r imary use o f deposit accounts i s for safekeeping, with l i t t le ro le for payment services). Households without accounts are presumably too poor to have any excess savings to safeguard.

Marginal Small Large Commercial Others Total

12.97 30.79 44.36 16.78 29.47 21.01

87.03 69.21 55.64 83.22 70.53 78.99

There i s some ind icat ion o f a n increase in ‘indebtedness’ a m o n g ru ra l households over the past decade - however t h i s can also mean increased access to credit, a n d as such m a y b e a step forward. Acco rd ing to the AIDIS of 1991, j u s t 16 pe r cent o f rura l households h a d a f o r m a l l o a n outstandmg. Based on the World B a n k WAS-2003 , the correspondmg n u m b e r was 21 p e r cent.

Some 79 per cent o f ru ra l households do not have access to a f o r m a l loan, a n d once again, access i s part icularly a p r o b l e m for the marg ina l farmers a n d commerc ia l households. (Table 8). Furthermore, some 97 p e r cent of households without a f o r m a l l o a n repo r t not hav ing appl ied for a l oan in the past 3 years; the m a i n reason repo r ted for not applying i s a “lack of need”, a n d t h e second most i m p o r t a n t reason i s “complicated procedures--an indication, perhaps, of the fact that based on the experience o f others, they know they don’t stand a chance o f receiving a loan.

Table 8: Access to credit from financial institutions, by household category (YO)

Access to fo rma l credit i s part icularly a p r o b l e m for meet ing unforeseen expendtures - family sources and the loca l moneylender dominate. O v e r 90 p e r cent o f households r e p o r t f inanc ing unusual expenses from cash at home, whde the second most impor tan t source of f inanc ing such expenses was reportedly i n f o r m a l loans from family, friends, or moneylenders. N e w e r sources, such as the recently in t roduced IGsan Credi t Cards (ICC), are s t d l statistically insignif icant.

U s e o f bank credit for investments depends on the type of investment -bank loans are most frequently perhaps machinery a n d vehcles, whde the purchase o f l ivestock ( w h c h cannot b e collateralized easily) i s typically f inanced from

used for l a n d acquis i t ion/ improvement and

14

i n f o r m a l sources. About 4-6 p e r cent of loans from banks a n d R R B s respectively are used for purposes of working capital.30 Among households who have a f o r m a l l o a n outstandmg, commerc ia l banks are the m a i n source, a t interest rates of 12.5 p e r cent p.a. (Figure 11).

Collateral required (Yo of loans) Value o f collateral as O/o of l oan

Figure 11: Credit outstanding by source - - There i s h t e d evidence o f c r e l t ra t ion ing for fo rma l

received, with commerc ia l banks hav ing the best reco rd (loan a m o u n t received as a percentage of amoun t appl ied i s 92 p e r cent), fol lowed by R R B s (88 pe r cent) a n d government schemes (87 pe r cent). However, on the basis of applications rejected, ra t ion ing appears to b e hgh.

L o n g e r processing times for loans, together with bribes, cou ld result in higher effective costs to borrowers a n d consequent c r e l t rationing. I t takes, on average, 33 weeks for a l o a n to b e approved by a commercial bank. On average, some 27 p e r cent (and 48 pe r cent in UP) o f sample households who b o r r o w e d from an RRl3 repor t hav ing to pay a b r ibe to get the l oan (and t h t s f igure i s 48 p e r cent in the case o f UP), a l i t t le under 27 p e r cent of households who b o r r o w e d from a commerc ia l banks paid a bribe, a n d 10 pe r cent of households who b o r r o w e d f rom a credit cooperative paid a bribe. T h e b r ibe amounts vary from between 10 p e r cent of the l oan amoun t (in the case of banks) to 20 p e r cent (in the case o f cooperatives). In a l l cases the performance o f UP i s m u c h t h a n the average, ind icat ing deeper problems in the in tegr i ty and in ternal controls o f fo rma l f inancial institutions in UP. (Table 9).

c r e l t on the basis of amounts appl ied for, approved a n d Olhrrs

schams l%

Bank 51%

Source : WAS-2003

Source : WAS-2003

Bank RRB coops Schemes Others

87.0 89.3 72.9 58.3 83.1 9.1 9.5 11.0 26.8 24.3

T h e major i ty o f loans extended by commercial banks, R R B s a n d cooperatives are collateralued, with 89 per cent of households who b o r r o w e d from R R B s , and 87 p e r cent of households who b o r r o w e d from commercial banks, repo r t i ng that they h a d to p rov ide collateral. L a n d remains by far the most predominant form o f collateral. T h e value o f collateral requi red as a proportion of the loan, however, remains relatively low in the case o f banks and R R B s , at under 10 p e r cent, but high in the case of government schemes. (Table 10).

Source: RFAS-2003

30 Loans for w o r h g capital are relatively fewer since the sample consists primarily o f cultivating households with only a small fraction of small and microenterprises. Even within the latter, the majori ty are engaged in trading and other service activities.

15

Cre&t i s mostly used as stated; however, &version i s m o r e l ikely in the case of short t e r m (working capital) loans.

L i fe Insurance

I t m a y follow that the same households who repor t t he lack of need for depository/payment services, m a y also comprise a substantial proportion o f households without repayment capacity for any kind of cre&t from banks or other f o r m a l f inancial institutions. These households m a y comprehensively l ie outside the amb i t o f the f o r m a l f inancial sector.

13.21 n2.86

Access to insurance remains h t e d over 82 p e r cent o f households surveyed r e p o r t not hav ing any insurance, 3 pe r cent repo r t not knowing wha t insurance is, a n d 15 p e r cent repo r t hav ing insurance. L i f e insurance i s by far the most p redominan t insurance p r o d u c t available and the demand for h s p roduc t appears to far exceed i t s supply: whi le 13 p e r cent o f households have access to l i f e insurance, some 73 p e r cent repo r t that th j

Health Insurance

Table 11: Distribution of Insurance. bv % of households

0.371 5.48 Fire Insurance 0.031 0.26 Theft Insurance GopInsUrance OtherInsUrance

would b e their prefer red insurance product . D e m a n d for c r o p insurance i s also relatively high: w h i l e only 0.2 pe r cent of households repo r t hav ing c r o p insurance, some 18 p e r cent express a preference for t h i s p r o d u c t over o ther types of insurance. (Table 11).

1.01 0.74 0.2 18.98

0.13 1.68

Around 44 p e r cent of the households surveyed r e p o r t hav ing b o r r o w e d in fo rma l l y a t least once in the 12 months; the interest charged on i n f o r m a l loans averages 48 pe r cent pe r annum. N o t surprisingly, i n f o r m a l borrowing i s very i m p o r t a n t for the poorest (margmal a n d commerc ia l categories), who are the most depr ived of fo rma l finance, but it i s also i m p o r t a n t for small farmers. (Table 12).

T h e main source o f non- fo rma l borrowing i s

who repor t hav ing b o r r o w e d in fo rma l l y in the past 12 months used moneylenders);

modes t ro le at present. (Table 13). T h e strong

moneylenders (some 56 pe r cent o f households

microf inance (through SHGs or NGOs) plays a

growth of microf inance in AP in recent years i s

Table 12: Incidence and size of i n f d bomraing by household category (oh of households unless othenvise s t a d I

Table 33: Source of last non-formal loan,

S H G W 289 hdlord 7.76

b y % o f h o ~ l &

Mane$ gder 55.87 Friends/R$atives 31.36 ctkrs 212

I I Source: WAS-2003

16

households in AP are SHG members compared to 8 pe r cent for UP; in terms o f credit from sources other than the f o r m a l sector institutions, 11.5 pe r cent of AI? households b o r r o w e d from SHGs over the last year compared to 3 pe r cent for UP.

Puthe inpu ts

T h e largest uses of i n f o r m a l loans are for meet ing “famdy emergencies” and “social expenditures” arising from events such as births, marriages, deaths. Some 1 3 pe r cent o f borrowers r e p o r t using the i n f o r m a l l oan for investment-related purposes. (Table 14). 3.92

Flexible repayment o f i n f o r m a l loans, their shorter durat ion (as compared to fo rma l loans), a n d the frequency with w h i c h they can b e accessed, appear to b e significant features that make such loans m o r e attractive to the poor.

E u r d y € T ” q

Some perceived advantages o f i n f o r m a l loans over fo rma l loans are as follows: (1) contractual

28.76

Table 14 Uses of last i n f d loan, by O/o of households

I 11.61)

Sources: WAS-2003

tlexibdity, f lexibl l t ty in repayment terms/schedules; (2) l o w e r discrepancies between l o a n amounts sought and received; (3) less reliance on collateral: only 16.5 pe r cent of households r e p o r t providing collateral against the loan.

But a m o n g those who repor t providing collateral for i n f o r m a l loans, the overwhelming collateral c i ted i s “self labor” - evidence of in ter l inked credit contracts spanning credit a n d labor. Almost al l cases repo r t i ng self labor as collateral are landless/marginal farmers, who are too poor to o f fe r any assets as collateral, and hence most vulnerable to harsh contracts linking their l abo r to loans.

17

111. WHAT CONSTRAINS ACCESS T O FINANCE FOR INDIA'S RURAL POOR?

A comb ina t ion of factors - affect ing both banks a n d their clients - contr ibute to reducing the supply o f finance for the poor, driving up costs and hamper ing access.

\Yhy Banks Are Reluctant T o Lend to Rural Clients

From the perspective o f the ru ra l banks, serving the ru ra l poor i s a high-risk, h g h - c o s t proposition.

L e n d i n g to some segments, especially to the very poor, i s surrounded by uncertainty about repayment. T h e ru ra l poor tend to have irregular/volatde i n c o m e streams a n d expenditure patterns (Box l), a n d they also tend to b e highly exposed to systemic r i s k s such as c r o p failures or a fa l l in commod i t y prices, and therefore, m a y face real diff iculties servicing loans. So banks have legit imate concerns wh i l e d e a h g with the ru ra l poor, and tend to perceive such loans as risky.

Box 1: Income and Expenditure Patterns of India's Rural Poor

Rural households have highly irregular and volatile income streams. Irregular wage labor and the sale o f agricultural products are the two main sources o f income for rural households. The poorest rural households (landless and marginal farmers) are particularly dependent o n irregular wage employment: About two-thirds o f marginal farming households surveyed rely o n wage labor as their primary source o f income (in contrast, only 9% o f large farming households rely o n wage labor for primary income and none these households rely o n irregular wage labor.). while 29% r e h o n s e h e farm Droduce.

Rural households also have irregular expenditure patterns. Over one-half o f the households surveyed report the bulk o f their expenditures as being either daily or irregular. The typical expenditure profi le o f rural households surveyed i s that o f small, daily or irregular expenses, incurred all through the month. Furthermore, some 99% o f households report having incurred at least one unusual expenditure over the past s i x months, with the most frequent reasons for the latest unusual expenditure reported as medical or social purposes (related to births, marriaees. etc.).

Source.RFAS-2003

18

O n e o f the m a i n sources o f risk faced by ru ra l financiers in their dealings with prospective ru ra l clients i s a fa l l in c o m m o d ~ t y prices b e l o w p r o d u c t i o n cost levels, a n d t h i s risk becomes a l l the m o r e significant in the absence of eff icient price discovery a n d credible nat ional c o m m o d i t y prices. Market-based tools to insure against commod i t y pr ice volault ty (e.g. futures and options) already exist a n d are widely used in high-income countries, but they are not prevalent in India. Why? First, the minimum size o f contracts traded on organized exchanges far exceeds the annual value o f p roduc t i on o f ind iv idual small- a n d medium-sized producers. Second, small producers, as w e l l as m a n y marke t intermediaries, lack knowledge of such market-based pr ice insurance instruments a n d a n understanding of how to use them. Third, the sellers of such instruments, generally international t rad ing f i r m s , are o f t e n unwihg to engage with a n e w a n d u n f a d a r customer base o f small-scale producers, characterized by high transaction costs, credit issues, a n d per formance risk.

Problems caused by uncertainty are exacerbated by the lack o f reliable i n f o r m a t i o n on the past credit h is tory o f borrowers. There are a n u m b e r o f sources of credit i n f o r m a t i o n in India, but n o n e of these focuses on small, ru ra l borrowers. Credit i n f o r m a t i o n on such borrowers i s d i f f icu l t to obtain because the major i ty o f the ru ra l poor rely on moneylenders a n d other i n f o r m a l lenders, and i t i s not in the interest o f such lenders to pass on a borrower's good credit repayment reco rd to other prov iders o f finance. T h e unavai labhty o f credit i n f o r m a t i o n has reduced the v o l u m e o f lending in IndIa; because per formance risk measures are unavailable, the current risk management practice o f banks i s to con t ro l l oan amounts. Better credit i n f o r m a t i o n c o u l d dxect ly increase the amoun t o f f inancing available to ru ra l borrowers.

O n e way in w h i c h a financier can reduce the risk of losing his m o n e y to uncertainty i s by requi r ing collateral-valuable assets that the financier can keep in case the bo r rower defaults. Collateral reduces the p r o b l e m of uncertainty, since the lender can theoretically recover some, or all, o f h s l oan in the event of non-payment. I t also reduces i n f o r m a t i o n asymmetries-it i s o f t e n easier to value physical assets than to value character. Moreover , the b o r r o w e r will find it costly to put valuable collateral i f she intends to decamp with the proceeds of the loan, because she will lose the collateral. Thus, the collateral requirement can also he lp weed out the rogues from the potent ia l honest borrowers, leaving only those bonajde applicants who fully i n t e n d to repay the loan. T h e potent ia l loss of he r collateral also makes the b o r r o w e r think twice be fo re invest ing in r i s k y ventures. Collateral's twin effects, o f keeping rogues from applying for loans, and reducing the borrower's incent ive to take undue r isks, make i t a valuable device in encouraging lending. T h e potent ia l f inancier sees l ower risk in collateralized lending, wh i l e the b o r r o w e r benefits from the consequent l ower interest rate the financier charges.

O n e p r o b l e m in al l t h s , of course, i s that the r u r a l poor typically do not have collateral, so they lose out once again. Most of India's ru ra l poor, for instance, have no futed collateral or only small plots of l a n d that most o f t e n cannot b e mortgaged. Ident i f icat ion o f alternative collateral i s costly a n d cumbersome. So only those with assets can borrow! A n o t h e r p r o b l e m i s that collateral can only p rov ide security to lenders in an env i ronment where households have p roper titles to the i r assets, a n d where the legal system makes i t relatively s t ra ight forward for lenders to enforce contracts a n d repossess collateral; the legal system in I n d i a makes collateral registration, a n d i t s repossession by the financier, a long a n d arduous process.

19

T h e transactions costs of rura l lending in I n d i a are high, mainly due to the m a l l l oan size, high frequency o f transactions in ru ra l finance, large geographical spread a n d heterogeneity of borrowers, a n d widespread illiteracy. For private sector banks - their lack of a ru ra l b ranch n e t w o r k i s an addit ional p rob lem. G i v e n the extent o f rura l pove r t y in India, the value o f f inancial services required tends to b e small. T h e small size o f ru ra l loans in I n d i a result ing in a high due dhgence cost p e r loan, exacerbated by the heterogeneity of borrowers, m a k i n g i t d i f f icu l t for fo rma l f inanciers to cover such costs. T h e geographical spread of customers in ru ra l India, a n d widespread f i t e racy , fur ther drive- up the a h s t r a t i v e costs, after the l oan i s granted. B o r r o w e r supervision costs are high, as are compliance costs for customers. Financiers thus have to achieve a delicate t rade-of f between m i n i m i z i n g the l o a n default rate a n d m i n i m i z i n g a h s t r a t i v e / c o l l e c t i o n costs. For example, m ic ro - financiers are able to offset the high maintenance costs o f their loans with low default rates, whereas low supervision costs of ru ra l loans i s generally associated with high default rates. Furthermore, h t e d or no price discovery (only local pr ice benchmarks, no nat ional grades and prices for agricultural commodities, very l im i ted dissemination o f prices, brokers have i n f o r m a t i o n monopoly) makes credit risk assessment of ru ra l borrowers m o r e dif f icult , a n d credit i n f o r m a t i o n on such borrowers i s non-existent.

Governmen t has n o t been able to develop a n d enforce a legal a n d regulatory f ramework conducive to ru ra l finance, so that cont ract design, contract renegotiation, a n d contract enforcement remain weak, m a k i n g i t even m o r e d i f f i cu l t for financiers to p rov ide borrowers with the right incentives for repayment. W h i l e the recent enactment of the securit ization a n d asset reconst ruct ion l a w (2002) has helped i m p r o v e the legal f ramework for recover ing b a d loans, by facditating out -of -cour t settlements on non-pe r fo rm ing loans and instituting alternate methods of dispute resolut ion between creditors and debtors, the l a w does not cover small loans. L a n d tithng a n d registrat ion systems are weak, a n d the use and transfer of l a n d i s d i f f icu l t under the current framework. M a n y states do not p e r m i t leasing o f land, whi le in some states, the lease creates long- term irrevocable rights for the lessee to the disadvantage o f the lessor. All t h i s encourages unrecorded a n d uno f f i c i a l year-to-year o ra l leases, w h i c h prevent the lessor from get t ing a good lease value, a n d the lessee from putting the l a n d to best use.

Governmen t po l i cy has created a “financial clunate” that i s not conducive to l e n d m g in general, a n d to ru ra l banking, in particular. High fiscal deficits, the government’s domina t ion o f ru ra l f inance institutions, persisting weaknesses in the regulatory and legal framework, a n d a set o f policies towards the sector that have been designed to gain pol i t ica l patronage, have resulted in the distortion o f r i sk / re tum signals and inefficiencies in the delivery o f ru ra l f inance services. An ou tcome o f these realities has been a dilution o f the credit creating ro le of ru ra l banks.

First, higbjscal deJzcits haves l e d to Government’s appropr ia t ion o f a large share o f financial savings for itself, preempt ing credit to the pr ivate sector. At the same time, Government’s def ic i t f inanc ing policies have p rov ided bankers with opportunit ies to deploy b a n k resources in G o v e m m e n t securities, w h i c h are not only safe, but also, have yielded high profits for banks in a decl ining interest rate environment. 31 W e it i s t rue that statutory preemptions (Statutory Liquidity Ra t io (SLR) a n d

3’ Ind ian bank managers have found that they can in fact make large profits from the trading of Government securities in an environment o f declining interest rates (and bankers in Ind ia do not appear to have a full appreciation of the interest rate risk involved in such investment allocation decisions, v iewing G-Secs as risk-free assets). I ncome on sale o f investments has

20

Cash Reserve Ra t io (CRR) imposed on banks have been gradually reduced in recent years, they rema in high by international standards32 T h a t banks prefer to deploy resources in Governmen t securities ra ther than lendmg to the private sector i s evident from the data: At end-September 2003, investments in Governmen t securities accounted for some 45 p e r cent of n e t demand a n d t ime l iabht ies o f commerc ia l banks, m u c h higher than the mandated SLR of 25 pe r cent. B a n k credit to the private sector i s thus modest, at best, a n d the bulk of i t takes the form of relatively safe, mortgage-backed lendmg, other types of consumer loans to h igh- income individuals, a n d loans to top-end corporates.

Directed lending norms that require commercial banks to allocate 40 p e r cent o f their lending to the “priority sector” ( including agriculture) have not generated the in tended results, as most banks get a round t h i s requirement by subscribing to other eligible instruments i nc lud ing bonds issued by NABARD a n d SIDBI.

Second, interest rate policies reduce the attractiveness o f lending to small, r u ra l clients. Banks’ borrowing costs are k e p t high by “ f l o ~ r ~ ” on short-term deposit rates33, wh i l e G o v e r n m e n t policy dictates that lending rates on small loans (Rs 200,000 or below) in the ru ra l sector b e “cupped’ at the P r i m e L e n d i n g Rate (PLR), w h i c h banks are free to set. These restrictions impose a n “ implici t tax” on banks: Assuming a dif ferential o f 200 and 400 bps between PLR a n d marke t interest rates, the l o s s in the income of ru ra l banks from lower lending rates i s est imated at $550 million to $1.1 bilhon; t h s implies that t he n e t profit o f the banking sector cou ld b e as m u c h as 15-30 p e r cent l ower than w h a t i t cou ld have been. Naturally, t h s reduces the attractiveness of ru ra l lendmg, and part icularly to smaller clients, with the unintended consequence of “rationing” credit to the poor, ru ra l households. 34 Thus, the access of poor borrowers to fo rma l loans i s effectively c u t off, and they e n d up borrowing at m u c h higher rates from the i n f o r m a l sector.

Third, R B I ’ s creditplanning policy, whereby each ru ra l b ranch i s g iven a set of def ined villages (typically 15-20 vdlages) within w h c h i t can operate, (‘service area’ approach) restricts compet i t ion in ru ra l banhng . Fu r the r b a n k branches are unable to opt imize b ranch infrastructure a n d entry o f new, non- service area b a n k branches, i nc lud ing that of private sector b a n k branches, in the “service area” i s impeded since t h ~ s requires a ‘no-objection certificate’ from the service area b ranch w h c h i s o f ten not easily for thcoming.

been rising steadily over the past 5 years accounting for around 33% of operating profits in FY 2002-03. Simultaneously the share in total income of interest income on advances has fallen to levels be low 40%. RBI, T r e n d and Progress of Banking in India, 2003-03. ’’ SLR has declined from 38.5% in 1991 to 25% at present. Similarly the CRR has declined from 15% to 4.5% over the same period. However, the overall statutory pre-emption levels are higher than levels in other countries - South Afr ica (So/,), Malaysia (15%), Singapore (18Yo); Sri Lanka (20%), U S A (none). 33 A f loor/fmed rate o f 3.5% i s set for savings deposits. 34 Such difficulties can imp ly that sometimes, entire communities, and particularly the rural poor, may face l i m i t s on credit. Such theories of ‘credit rationing’ have been discussed for example b y Stiglitz and Weiss (1981), Wil l iamson (1986). Besley (1994) and Murdoch (1999) have discussed th i s specifically in the case o f communit ies such as small farmers and microfmance providers.

21

Fourth, Government’s dominat ion of/ interference in r u r a l banks (Box 2) has fur ther distorted bankers’ incentives and generated deep inefficiencies in the ru ra l f inance institutions. Of the 196 R R B s in the country, some 15 pe r cent were loss-making a n d 58 p e r cent were estimated to b e undercapitalized35 for the financial year endmg M a r c h 2002 (Figures 12-13). R R B s ’ operating costs relative to average assets are high at about 3 p e r cent, compared to less than 2 pe r cent for leading commerc ia l banks. And staff product iv i ty i s low - business/staff i s Rs9m w h i c h i s less than h a l f that of the larger pub l i c sector banks a n d between a sixth to a ten th that of the levels in leading private sector banks. Asset quality i s poor, with Non P e r f o r m i n g Loans (NPLs) at 16.5 pe r cent of to ta l loans (refer to A n n e x 3 a n d F igure 14). And wh i le the prof i tab i l t ty o f these banks, repo r ted at 1.2 pe r cent of average assets, appears good, the earnings forecast for these banks i s part icularly susceptible to marke t a n d interest rate r isks.

Box 2. Rural banking - government’s omni-presence

T h e pub l i c sector banks @e., major i ty government-owned) account for 80% of commerc ia l b a n k assets in India. Some 95% of commerc ia l b a n k branches in ru ra l areas are of pub l i c sector banks. And these account for 93% of to ta l ru ra l credit outstandmg. In terms o f governance, the boards of a l l pub l i c sector banks have major i ty representation from the government /RBI . However , with banlung re fo rms a n d increasing n u m b e r o f pub l i c sector banks be ing l isted in the capital markets (12 of the larger pub l i c sector banks are listed), governance standards have i m p r o v e d significantly in con fo rm i t y with the requirements o f the capital markets regulator, Securities a n d Exchange B o a r d of I n d i a (SEBI).

RRBs are also major i ty government-owned. T h e ownership structure of these banks i s as follows: Go1 owns 50% of the capital o f a n RRB, the ‘sponsoring’ pub l i c sector commerc ia l b a n k owns 35% (except for two R R B s that have a pr ivate sector b a n k ‘sponsoring’ the 35% commerc ia l bank stake), a n d the state g o v e m m e n t accounts for the rema in ing 15% of the capital. Four o f n ine b o a r d members are g o v e m m e n t appointees; in addi t ion RBI a n d NABARD have one nominee each a n d the sponsor b a n k (which are mostly pub l i c sector banks) have three representatives.

Rural cooperatives - For the State-Level Cooperative Banks (StCBs) the government ownership i s a round lo%, whde it i s a round 15% for the D i s t r i c t Centra l Cooperative Banks (DCCBs); nonetheless, through the powers assigned to the Regs t ra r o f Cooperatives, c o n t r o l of the state tends to b e pervasive. T h e state government, through the registrar of cooperatives has considerable powers a n d can supercede elected boards; As o f end-March 2001, the elected boards of 75 o f the 367 distr ict cooperative banks h a d been superceded. T h e state government also retains the rights to appoint senior management - the CEOs o f StCBs are o f t e n government officials (rather than professionals) a n d those for the DCCBs are either government or StCB officials.

35 By regulation, capital adequacy standards have not been extended to R R B s or cooperative banks. However, even by the lenient requirement of Rs 100,000 as minimum capital for cooperative banks, as the RBI Annual Policy Statement 2004 reports, at end-March 2004, as many as 143 out of 366 DCCBs and 7 out of 30 StCBs had not complied with even t h i s requirement. Similarly 61 out o f 196 R R B s had a networth lower than Rs 10 d o n (March 2002).

22

Figure 12: Status of Rural Banks in India

70.0% i I

4l 60.0%

E 50.0%

< 40.0% 0

30.0% 0 x 20.0%

10.0%

0.0%

P

s

I

UnprofRable Under-capitalized

Note : R R B s (196) StCBs: (29)

Figures m brackets represent total numbers of rural banks Source : RBI and NABARD

DCCBs (367)

Figure 14: NPLs in RFIs - Cause for concern.. .. ... -1 ... ... ." I"""" .". ""..""...... 35.00% 7 I

1.5% CI x -.OX

2 ,.5%

0.0%

-0.5%

-1.0%

Figure 13: RFIs - profitability (Return on Assets, RoA)

_ .

1 15 00%

10 00%

5 00% 1 .... . .

1337.38 1338'33 1333'00 2000.0i 2001.02

Source: RBI reports and NABARD statistics

Source : RRB/Coop., NABARD (RoAvg Assets) ; RBI : PSB data (RoTotal assets)

Figure 15: Deposits of RFIs - costs and significance

H 800% 80x 9 I :: 700% 70% ;

P 40A z

300% 30% :

H a 600% 60% '

500% 50% d -

- * 400% c

20 0% 20% 2 10 0% 10% u 0 0% 0 0%

PSBs-FYO2 RRBs-FY02 StCBsFYOl OCCBsFYO1

I DepositslTotdl assets +Cost of depositsrelative t0aVgaSSetS

Source: NABARD and RBI

T h e rura l cooperative b a n k m g sector i s in a n even deeper state o f distress.36 Some 32 p e r cent o f DCCBs and 22 pe r cent o f the StCBs are unprof i tab le a n d over two- th i rds of the DCCBs a n d j u s t under one-half of the StCBs are undercapitalized. (Annex 3 prov ides more details; Figures 12, 13 37

38). Asset qual i ty i s quite poor (Figure 1439) with the StCBs repor t i ng an NPL ra t i o of 13.4 p e r cent, a n d the DCCBs repor t i ng a n NPL rat io o f close to 20 per cent. W h i l e the DCCBs' have a reasonable operating cost ra t i o of a l i t t le over 2 p e r cent, staff product iv i ty at Rs 12m i s weak (the StCBs'

36 Commercial banks' rural operations are not analyzed separately as these are subsumed in their overall operations. However, as some indicators on asset quality indicate, their overall performance disaggregated for the rural operations, may not be too different from that of R R B s and cooperative banks. 37 Given the politically sensitive nature o f rural credit, with falling interest rates in recent years, announcements by successive governments, typically suggesting interest rate caps on agricultural credit, have not been uncommon. The last major announcement was made around a year ago and suggested a cap at 9% on farm loans less than Rs50,OOO (around $1,200). Whi le these announcements do not get mandated by RBI policy, such moral suasion provides the wrong signals for rural banks and increases the chances that could lead to rural banks being forced to adopt such pricing - i f they do so, the sugested rates would probably leave an inadequate, or even negative financial margin. 38 W h i l e many of the public sector commercial banks are now listed companies raising capital from the public and having independent and professional boards and are relatively free of the adverse impacts of government ownership, this i s not the case with the R R B s and rural cooperatives. 39 For commercial banks, a proxy for rural asset quality has been taken as the NPL ratio on the priority sector advances o f public sector banks; the public sector banks account for more than 90% of the outstanding advances in rural areas of commercial banks.

23

performance on these indicators i s better but i s really not comparable to retai l banks since the fo rmer are structured as apex institutions). Further, the weighted average cost of funds for the cooperative banks - 8.3 p e r cent and 8.6 pe r cent for StCBs a n d DCCBs respectively (Figure 15) - i s very hgh a n d leads to compressed financial margins. Overa l l the c o m b i n e d effects o f m o r a l suasion from the government to keep lending interest rates low, poor asset quality, low a b h t y to enforce recoveries and high cost of funds has l e d to the present tenuous position in the balance sheets of ru ra l cooperative banks.

Governmen t ownershp /con t ro l also means that R R B s a n d r u r a l cooperatives have to operate in l ine with government diktat and are not able to take decisions independently. Some examples o f this include: f o rced r e s c h e d u h g o f agmul tura l loans and ‘coerced’ l e n d m g to unviable government owned/contro l led commod i t y cooperatives (especially, t he sugar a n d texti le cooperative sectors), state governments’ use o f cooperative banks as channels for the delivery of various g o v e m m e n t schemes a n d debt or interest waiver schemesa, and elected boards be ing superceded. Rura l deb t or interest waiver schemes announced by state governments also create adverse incentives for farmers, who do not service the debt in a t imely manner on the expectat ion that, a t some point, a waiver will b e granted. All these factors h inder p roper management a n d operations of ru ra l banks and reduce the attractiveness o f ru ra l lending for these banks.

F$h, lax regulatory standards for R R B s and ru ra l cooperative banks, t he poor enforcement o f prudent ia l regulations, and regulatory forbearance, have underm ined marke t discipline a n d added to the financial f ragh ty of these banks, thereby imped ing the i r a b h t y to p e r f o r m the task of eff icient ru ra l f inancial intermediat ion. W e the RBI i s the overal l regulator of the ru ra l f inance sector, supervision of R R B s and ru ra l cooperatives i s delegated to NABARD. However , with regard to the regulat ion of cooperatives, there i s dual con t ro l - the state through the Registrar o f Cooperative Societies also plays a large role. T h e state government retains significant powers in ru ra l cooperative banks, cont ro l l ing al l matters relat ing to registration, membershp , election, f inancial assistance, loaning powers, business operations, l oan recovery a n d audlt. This leads to cross-directives, inadequate levels o f con t ro l o f the central b a n k with respect to bank ing funct ions and consequent weakening of the overal l qualtty o f regulat ion of the cooperative banks.

And whde regulatory standards have been progressively t ightened for commerc ia l banks a n d brought in l i ne with best practices, this has not been the case for the R R B s a n d ru ra l cooperative banks. Prudent ia l regulat ion standards related to capital adequacy have not been applied for R R B s and cooperative banks (there are no minimum capital adequacy rat ios prescribed) - given the large percentage o f ru ra l banks that are inadequately capitalized (Figure 12 above) t h i s means that a significant proportion of deposits o f ru ra l banks i s potent ia l ly at risk. Also, asset classification standards, a n d related to h s regulat ion on income recognl t ion a n d provisioning, need to b e upgraded to m a t c h up with that of the commercial b a n k m g system w h c h bases i tse l f on NPLs on a 90-day level. G i v e n these weak regulatory standards, i t i s perhaps not surprising that eligibll i ty norms from NABARD for a v a h g ref inance assistance remain qui te lenient -cooperative banks that have eroded deposits less than 50 p e r cent are eligible for refinance, as are R R B s w h i c h have a deposit erosion level o f less than 30 p e r cent.

NABARD, in i t s ro le as the apex development bank for ru ra l f inance has, in the past, p r o v i d e d subsidued ref inancing to commerc ia l banks, R R B s a n d cooperative banks. This cou ld have l e d to some c rowd ing out of marke t based credit to ru ra l areas a n d importantly, reduced the incentive a n d pressure on ru ra l banks to i m p r o v e financial per formance a n d m o v e towards increased reliance on market based funding. However , with decl ining interest rates in the economy, the incremental cost of

40 M o s t s igni f icant ly the Agr icu l tu re a n d Rural D e b t Re l ie f Scheme of 1989-90 but several o t h e r subsequent schemes, including, m o s t recently, the kharif interest waiver in 2002-03.

24

funds for ru ra l banks has declined faster t han for NABARD. T h e result of t h i s i s that NABARD’s typical re f inancing rates of between 6.25-6.75 p e r cent pea. are no longer subsidrzed a n d demand for ref inancing has d e c h e d , especially from the m o r e eff icient ru ra l banks.

W h y D o Small, Rural Borrowers Find Rural Banks Unattractive?

From the perspective of small, r u ra l borrowers (the users), ru ra l banks are unattract ive for the following reasons: Small, ru ra l borrowers find ru ra l banks unattract ive for the following reasons:

R u r a l banks do not prov ide flexible products and services to mee t the i ncome a n d expenditure patterns o f small rura l borrowers. As n o t e d above, small ru ra l borrowers have irregular/volatde i n c o m e streams and expenditure needs, a n d therefore, prefer to borrow frequently, a n d repay in small installments, but most banks do not o f fe r such products. Also, wh i l e small ru ra l borrowers seek savings a n d lending products, they also seek insurance (llfe, health, crop), w h c h banks do not generally o f fer .

‘I j i i ~ ? . i z r i ~ i ~ ~ i ~ . i ~ ~ . ~ / . ~

T h e transactions costs of dealing with f o r m a l banks are hgh. In part, high transactions costs stem from distance to the nearest f inancial institutions. Acco rd tng to the RFAS-2003, the med ian distance to the nearest f inancial institution ranges from 2 k m s @ost of f ice branches) to 5 k m s (commercial banks, cooperative banks); the median t ime taken to travel to the nearest commerc ia l bank, cooperative or RRB i s 3 0 minutes @ost off ices are available at closer proximity). Procedures for opening a n account or seeking a l oan are cumbersome a n d costly (with high re ject ion rates). Governmen t po l i cy dictates that ru ra l borrowers currently need to acquire a “no dues certificate” from every other lender in the village (as def ined by local lenders) that they do not have a l oan outs tanding.

Furthermore, clients have to pay he f t y bribes (ranging from 10 per cent-20 pe r cent of the l oan amount) to access loans, so that the u l t imate cost to bo r rowers i s very high (despite interest “caps”). On average, some 27 pe r cent (and 48 p e r cent in UP) of sample households in our survey who b o r r o w e d from a n RRB repor t hav ing to pay a b r ibe to get the loan, a l i t t le under 27 p e r cent of households who bor rowed from a commerc ia l banks p a i d a bribe, and 10 p e r cent of households who b o r r o w e d from a credit cooperative paid a bribe. T h e br ibe amounts appear to vary from anywhere between 10 pe r cent o f the l oan amoun t (in the case o f banks) to 20 p e r cent (in the case o f cooperatives). Moreover, longer processing times for loans, together with bribes, c o u l d result in higher effective costs to borrowers a n d consequent credit rat ioning. I t takes, on average, 33 weeks for a l oan to b e approved by a commerc ia l bank.4’ F a b l e 15).

4 1 High transactions costs of dealing with formal banks translate into a low frequency of transactions. According to the WAS, 2003, more than 60% of households with bank accounts report accessing their accounts at a frequency of less than once a month (62.3% of households with accounts in banks access their accounts less than once a month, while the same percentage amongst households with accounts in R R B s i s 70.8).

25

Bank RRB coops Interest rate (median) O/o p.a. 12.5 11 11

Loan amount received as Yo of amount 91.8 88.2 83.5

Schemes Others 14 14

86.6 93.9

Source : WAS-2003

applied Percentage households reporting bribes

Bribe as Y o of amount approved

Time taken to process a loan application

A third factor that makes f o r m a l banks unattractive for ru ra l borrowers i s that banks demand collateral, w h i c h poor ru ra l borrowers lack. Indeed, the ma jo r i t y o f loans extended by commercial banks, R R B s and cooperatives are collateralized, with 89 p e r cent o f households who b o r r o w e d from R R B s , and 87 p e r cent o f households who b o r r o w e d from commerc ia l banks, repo r t i ng that they h a d to p rov ide collateral (RFAS-2003). L a n d remains by far the most predominant form of collateral. But since t h i s collateral i s seldom executed, i t i s j u s t another cost, with li t t le benef i t in practice.

26.8 27.0 9.7 27.27 23.21 10.1 18.2 19.9 42.3 8.3

33 28.5 24 8.9 14.3

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IV. RECENT EFFORTS IN INDIA TO IMPROVE RURAL ACCESS TO FINANCE: THE ROLE OF FORMAL-INFORMAL LINKAGES AND NEW PRODUCTS $2

In light of the inefficiencies that characterize India’s ru ra l f inance markets a n d the relative lack of success of the formal ru ra l f inance institutions in delivering finance to the poor, NGOs, financial institutions, a n d government have made efforts, in partnership, to develop n e w fmancial delivery approaches to service the financial needs of the ru ra l poor. These approaches--or “micro finance” programs-have been designed to overcome some of the r i s k s and costs associated with fo rma l financing, a n d also to overcome the tyranny of collateral. T h e y i nvo l ve providing thrift, credit and other financial services and products o f very small amounts to the poor, with the aim to raise i ncome levels a n d i m p r o v e living standards.43 T h e y at tempt to comb ine the safety a n d rel iabi l i ty o f formal f inance with the convenience and flexibil l ty that are typically associated with informal finance. W e some of these programs have been m o r e successful than others, their h t e d outreach, scalabdity and financial sustainabihty rema in matters o f concern.

SHG-bank Linkage Approach: Linking Commercial Banks to Grassroots Borrowers

O n e approach to microf inance that has gained prominence in recent years i s the self he lp group (SHG)-bank l inkage program, pioneered by a f e w NGOs such as MYRADA in Karnataka and Professional Assistance for Deve lopmen t A c t i o n (PRADAN) in Rajasthan (and later in T a d N a d u and Jharkhand), with strong support from NABARD, which has been inst rumenta l in promoting t h i s groWth.4 S H G - b a n k h k a g e involves organizing the poor, usually 15-20 women, into self-help groups (SHGs), inculcating in the group the hab i t o f saving, linking the group to a b a n k (usually the ru ra l b ranch of a commercial bank, but also R R B s , cooperative banks, etc.), a n d ro ta t i ng the saved and b o r r o w e d funds through lendmg w i t h the group. T h e S H G s thus save, borrow and repay collectively. T h e lenders (banks) are o f t e n ref inanced by NABARD at slightly subsidized rates although, in recent years, high recovery rates have encouraged some banks to l e n d to S H G s without NABARD refinancing. T h e SHGs are not formal ly registered.

T h e funds m a y b e distr ibuted either to one or m o r e members o f the group - who are personally responsible for repayment (generally the group borrows at abou t 12 p e r cent p e r annum) - or spent collectively by the group. T h e group i s free to decide the interest rate charged to i t s members, but typically, a m e m b e r borrows from the group at about 24 p e r cent p e r annum.45 T h e groups make their in ternal credit decisions, decide on the repayment period, etc. M o n e y i s used for both consumpt ion (health, marriages, etc.) and, over time, for ind i v idua l and group investment products. A f t e r a l o a n i s fully repaid, t he group m a y borrow again, o f t e n a larger amount . Banks typically p rov ide a l o a n equivalent to four times the group’s savings but, as the group matures, a n d based on the group’s track record, banks are ready to l e n d more; some o f the R R B s visi ted repo r ted m a k m g loans amoun t ing to 10 times the SHG’s savings.

42 This section draws largely on the background papers by Morduch and Rutherford (2003), Mahajan and Ramola (2003) and H e s s and Mapper (2003). 43 Whi le microfinance typically covers the poor in rural, semi-urban and urban areas, the focus here i s on the rural poor. 44 Guidelines from the RBI were issued in 1992, to experiment with a pilot of 500 SHGs to link with banks. This pilot program as well the work of a number of NGOs was reviewed by a Working Group on Bank Lending to the Poor through NGOs and SHGs (1995) and detailed guidelines were drawn to encourage banks to use this method. NABARD was given the task of leading this effort and it took to task with exemplary diligence. I t involved NGOs, commercial banks, regional rural banks and even cooperative banks in forming SHGs and then linking those up with nearby bank branches. 45 I n contrast, money lenders would charge annual interest rates ranging from 36 -120% p.a. The average interest rate charged by money lenders i s 48%.

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T h e success of the SHG-bank linkage m o d e l depends crit ically on the tasks o f promoting, nurturing, strengthening a n d monitoring SHGs - tasks that are p e r f o r m e d by the Self H e l p Promoting Institutions (SHPIs). Traditionally, grass-roots level NGOs have pe r fo rmed the tasks of promoting and monitoring SHGs. M o r e recently, ru ra l branches of commerc ia l banks, cooperative banks, RRFh, NBFCs, etc. have a l l begun to play the ro le o f SHPIs. But, recent evaluation studies reveal the comparatively better performance o f SHGs p r o m o t e d by NGOs (as opposed to the other SHPIs).

n y iviar JI cumulative nos.

SHGs require a large amoun t o f pre- and post- lending monitoring. Most lenders use “facihtators” (who m a y or m a y not earn a commiss ion and/or bonus for group repayment and recru i t ing n e w groups). Facil itators m a y b e local business people, heal th workers, government employees, teachers, etc. Be fo re a l oan i s granted, the group must p r o v e their abdity to save over time, learn bookkeeping ski l ls, a n d show their commi tmen t to cont inue as a cohesive group. I t o f t e n takes over a year before a n established group can borrow. T h e facil i tator i s responsible for in t roduc ing the group to the bank, imp lemen t ing savings patterns a n d teaching basic accounting practices. (Although the facditator m a y not accept m o n e y on beha l f o f the lender). A f t e r the l o a n i s made, the facil i tator attends monthly meetings (attendance i s a good ind icator of the cont inued success o f the group) and enforces repayment.

million)

O v e r the last 10 years, the S H G - h k a g e m o d e l has become the dominan t m o d e of m i c r o finance in India, a n d the m o d e l has been successful in encouraging sigmficant savings a n d high repayment rates. T h e n u m b e r of SHGs h k e d to banks has increased from just 500 in the early 199Os, to over 700,000 by 2003. T h e SHG-bank linkage p r o g r a m today reaches some 12 d o n w o m e n a n d their households in terms o f deposit services, cumulatively providing over Rs 2,049 Cro re (US$ 445 d o n ) as c r e d t between 1992 to M a r c h 2003. (Table 16).

1999

Table 16 : Growth in volumes of SHG-bank linkage

~ 1 1 1 ~ ~~ I Number of SHGs linked to banks, I Cumulative bank loans (Rs.

32.995 571 2000 2001 2002 2003

114,775 1,930 263,825 4,809 461,478 10,263 717,306 20,487

There appears to b e widespread enthusiasm in I n d i a abou t the benefi ts of the S H G - h k a g e approach, notably because: (1) I t helps reduce transactions costs for the banks (their costs related to credit evaluation, l oan monitoring a n d decisions are reduced, since banks can re ly on the SHPI to identi fy a n d p r o m o t e groups a n d pass-on the l o a n appropr ia t ion decisions to the group) as w e l l as the borrowers (as the group i tse l f prov ides constant w a t c h and follow-up); (2) By using “peer- pressure”, the approach increases the l i ke l i hood that ind iv idual group members d repay as w e l l as that the group as a who le d not default (other group members effectively proxy for collateral); (3) L o a n default rates are very low, on average less than 1 p e r cent; (4) I t empowers rural w o m e n .

Although data available to u s cannot answer t h i s question du-ectly, w e can look at some ind i rect indicators on the re la t ionshp between SHGs a n d the poor using results of the WAS-2003 for the states o f AP a n d UP. 4 First, the ma jo r i t y of the beneficiaries o f SHG B a n k L inkage are from a m o n g

46 T h e RFAS-2003 targeted roughly 60 villages in each state, though the actual number o f villages sampled was higher in UP. Da ta from WAS-2003, wh ich was a household survey, include responses from those who were members of SHGs, as

28

the poore r groups. WAS-2003 indicates that nearly 54 p e r cent o f SHG members are from the poorest groups-the landless and marg ina l farmers. However , signif icant differences exist across states. W h i l e 73 percent o f SHG members in UP are from the poorest households - the landless and marg ina l farmers, the c o r r e s p o n h g proportion in AP i s l ower (43 percent). In AP, though, almost a quarter of the poorest households be long to SHGs, but the proportion o f households from richer categories tha t be long to SHGs i s m u c h h g h e r . F a b l e 17).

Table 17. SHG membership b y type of households Marginal

Andhra Pradesh

SHG member (Yo households)

YO of SHG members

Uttar Pradesh

SHG member (Yo households) 10.3

O/O of SHG members 72.8

Marginal = landholding less than 1 acre, Small = 1-2 acres, b with o r w i thou t l and but involved in commercial activities. Source: RFAS-2003

M e d i u m

8.8 7.4 I

Large

29

11.4

4.1

4.4

:&m = 2-4 acres, Large = more than 4 acres.

Others Total

29.6

5.7 100

l the rs includes household

To explore further the success with w h c h SHGs are targeting the poorest, w e used the WAS-2003 data to examine the attributes o f households that are SHG members. Our results indicate that that SHG B a n k L inkage i s certainly quite effective in targeting poore r households (in the part icularly the two quintdes above the poorest households). T h e re la t i onshp between the poorest households and SHG membership i s posit ive too, though not significant statistically. This only fur ther u n d e r h e s the challenges ahead in expanding the outreach o f microfmance to the poorest. (Box 3).

well as vdlage-level data. Based on the latter, a total of 736 SHGs were in operation in the villages covered by RFAS-2003, with the overwhelming majority in AP as would be expected. Not only does AP have the preponderance of SHGs, these groups are overwhelmingly comprised o f women only. Women’s groups accounted for 95 percent of all SHGs in the state. By contrast, in UP groups comprising only men and mixed groups were also well represented.

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Box 3. How successfully has SHG bank Linkage targeted the poor?

T h e estimated coefficients are reported in terms o f the incremental impact on the

S H G member due to a small change in

increase in the number o f SHGs in the d a g e by 1 increases the probabil ity o f a household being in an S H G by 0.2 percent. Similarly, households in the second quinti le have a 7.8 percent higher hkel ihood o f being in SHGs compared t o households in the richest quintile.

probabil ity o f the household being an

the explanatory variable. Thus, an

A l though the overall fit o f the regression

Table 18. Probit estimates of likelihood of a household being a member of an SHG

Shgnum 0.002 0.001 2.27

Poorest 0.039 0.030 1.32 Quint2 0.072 0.028 2.67 Quint3 0.102 0.034 3.13

0.039 0.028 1.41 Quint4 Bankac

-0.007 0.002 -3.46 N= 2910 PseudoR2= 0.011

dF/dx s.e. 2

Coastal -0.045 0.017 -2.58

-0.042 0.019 -2.23

W e can also use the WAS-2003 data to answer a related question using villages and SHGs in AP, where SHGs were found in al l villages: Arepoorer villages more Like4 to have a lager number ofSHGs? What explains inter-village variations in SHGs? O n e approach i s to use the standard Poisson mode l for count data to analyze the number o f SHGs in a given village. Specifically, le t y, denote the number o f SHGs in village i and le t yl b e distributed as a Poisson with mean y,where

PI = exp @l P) and X, i s a vector o f explanatory variables. However, a preluninary l o o k at the data shows an over dispersion in number o f SHGs relative to the Poisson, with the variance substantially higher than the mean. To account for the over dispersion, we use a negative b inomia l d istr ibut ion that can b e viewed as modifylng the equation above to

pl = exp (X, P + u,) where u1 denotes some omi t ted variable(s) such that eu, follows a Gamma distribution with mean 1 and variance a. Larger values o f a imply greater dispersion in the data.

47 Friends and family are a major source o f informal borrowings.

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Results o f the negative b inomia l regression are provided be low using a number o f explanatory variables related t o poverty in the village - village average per capita income (avpcy), inequality in land holdings (giniland), and connectivity o f the

station and nearest metal road (rail & road village measured by distance to nearest railway

respectively). Poorer villages will have lower per capita incomes, whi le greater inequality f o r any g v e n per capita income would indicate more poor people in the village. Villages farther away from access to rail and road, and hence markets, may be relatively poorer. T h e percentage o f ill iterate households in the village i s also likely to be

In

attainment fo r villagers w h o are not illiterate in the

Other are village size in terms o f number of households (size) and whether

correlated with village poverty and i s included. addition, w e also include an index o f educational

form Of percentage having primary education'

T h e results suggest absence o f a strong relationship between village-levelindicators o f poverty and the number o f SHGs. T h e size o f the village i s significant indicat ing the larger the village, greater the number of SHGs found. K g h e r rates o f illiteracy, presumed correlated to poorer villages, are associated with fewer SHGs in the village.48 Similarly, the negative s i g n f o r (distance to) metal road implies villages in the interior, away from good roads, have fewer SHGs. Noticeably, neither village per capita income nor inequality within the d a g e i s significant, again underlining the weak link between poverty and presence o f SHGs. T h e coefficient f o r NGOs i s negative but insignificant, implying n o significant relationship between presence o f NGOs and number o f SHGs in the village.

Table 19. Negative Binomial Regression Estimates for SHGs in a village, AP Coef. z P>Z

Constant 5.96 3.98 0 Size 0.002 6.15 0 Illiterate -0.04 -2.25 0.024 p -ary . -0.07 -3.88 0 A T Y 0.00 0.07 0.943 Giniland -1.47 -0.94 0.348

Ngo Rail 0.01 1.43 0.154 Road -0.06 -1.95 0.052

-0.03 -2.01 0.045

-0.33 -1.60 0.11

COOP 0.02 2.29 0.022 Alpha 0.22 0.06 3.49 N 59 Pseudo R* 0.12

0.0000. Robusl estimates usedjir standard errors. fikelihood ratio test ofa@a=O: &2(1) = 50.79 Prob > chi2 =

Recent analyses indicate that access to loans under SHG b a n k L inkage has con t r i bu ted to the reduc t i on in vulnerabi l i ty o f poor households.49 This reduc t i on in vulnerabdity takes the form of: (1) Improvement in asset position: the p r o g r a m sigmficantly i m p r o v e d the asset position (comprising l ivestock a n d consumer durables) of sample households. T h e average increase in assets was about 72 percent, from Rs 6,843 to Rs 11,793 in real terms (in one to three years). About 59 percent of households saw assets increase after groups were formed. Be fo re the groups were formed, one in three households h a d no assets; after t he groups were f o r m e d that changed to one in s i x ; (2) Increase in savings: the average savings p e r m e m b e r m o r e than tripled, from Rs 460 be fo re the group to Rs 1,444 after; (3) Cbanges in borrowing patterns and activities jnanced average borrowing p e r household increased from Rs 4,282 to Rs 8,341. A shift was observed in the activities of the self-help groups, with a lower share o f consumpt ion a n d cu l t ivat ion loans after the groups f o r m e d a n d a larger share

48 However, this would also be consistent with the notion that greater illiteracy makes more difficult the formation o f

49 See, for example, Puhazhendhi and Satyasai (2000) and World Bank (2003). SHGs.

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of all ied agricultural activities a n d small businesses; (4) Increase in employment employment pe r household w e n t from a n average of 318 days a year to 375 days. T h e proportion of employment generated through n o n f a r m and o f f - f a rm activities increased; (5) Increase i n conszrmption expenditwe: consumpt ion expenditure pe r household pe r month increased from Rs 799 to Rs 993. Pe r capita consumpt ion increased from Rs 197 pe r month to Rs 249; (6) Impact on income: the average n e t i ncome p e r household increased from Rs 20,177 to Rs 26,889. About 43 percent of the incremental i ncome generated was from n o n f a r m activities; (7) Impact onpove3: abou t 234 households were b e l o w the pove r t y l ine before groups were formed, compared with 122 after; (8) Social impact 89 percent o f members repor ted that, as a result of the group’s activities, they c o u l d mee t officials from the government or from banks, whde about 77 percent h a d never h a d that opportunity before. Changes were also repor ted regarding attitudes toward women.

Fur ther work should b e conducted on the performance o f the p r o g r a m from the point o f v i e w o f the financial institutions that p rov ide the h k a g e . This would p rov ide lessons on the costs a n d benefits associated with the self-help group model, inc lud ing w h i c h enti ty in the lmkage covers w h a t costs, wha t financial benefits banks get from the self-help group program, potent ia l adjustments and innovations banks have made to the self-help group model, and incentives tha t mot ivate t h e m to b e invo lved in the p r o g r a m and in microf inance in general. I t will b e part icularly i m p o r t a n t to analyze private banks to d raw on their experiences and assess their potent ia l to p lay a larger ro le in microf inance in India.

In large part, the success of SHG B a n k L inkage m a y b e attr ibutable to the fact that i t i s w e l l aligned with I n d i a n history a n d circumstances, a n d capi takes on the country’s vast n e t w o r k of rura l bank branches. T h e idea of local savings-and-loan clubs enjoying access to f o r m a l f inancial services by becoming corporate customers o f banks i s a good one a n d i s practiced in a small w a y in many countries. A wel l - run c lub can keep i t s reserves at the b a n k a n d take bulk loans w h c h it can on- lend to i t s members at a premium, cover ing i t s costs and reward ing i t s savers in the process. In India, t h l s practice seems part icularly appropriate on two counts: First, the country has active NGOs that have been zealous in their efforts towards group formation; NGOs v i e w SHGs as hav ing m a n y benefits (such as women’s empowerment) beyond microf inance. Second, and perhaps even m o r e important, SHG B a n k L inkage seems particularly suited to I n d i a because the m o d e l capitalizes on the country’s vast (and unique) n e t w o r k o f ru ra l banks that are otherwise unable to reach out to the poor. However , as the analysis above indicates, the S H G B a n k L inkage p r o g r a m faces i m p o r t a n t challenges in expanding outreach a n d reaching the poorest qu indes of ru ra l households.

Equal ly important, the success of S H G B a n k L inkage underscores j u s t how i m p o r t a n t a r o l e s l u l l f u l leadership, good policy, a n d a conducive legal a n d regulatory f ramework can play. Indeed, the ro le o f government in establishing the necessary po l icy a n d legal framework, a n d the leadershp ro le assumed by NABARD in championing the movement, cannot b e underestimated. Governmen t recognized the potent ia l o f SHG bank ing very early on in the movement’s history; NABARD was given the task o f leading t h i s e f fo r t a n d i t took to task with exemplary diligence. I t i n v o l v e d NGOs, commercial banks, R R B s a n d even cooperative banks in forming SHGs a n d then hktng those up with nearby b a n k branches. Lega l obstacles were removed and the RBI issued Guidel ines in 1992, to experiment with a pilot of 500 SHGs to link with banks. This pilot p r o g r a m as w e l l t he work o f a number o f NGOs was rev iewed by a Working Group on B a n k L e n d m g to the Poor through NGOs and S H G s (1995) a n d detaded guidelines were d rawn to encourage banks to use t h i s me thod .

To encourage banks to l e n d to SHGs, NABARD made available subsidized ref inancing to banks for their l endmg to SHGs, so that the groups cou ld take bulk loans from banks tha t c o u l d b e on-lent to g roup members who c o u l d use t h e m to take up or expand microbusinesses. (More recently, such

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subsidrzed ref inancing to banks has been phased out, as banks have begun to see SHG lendtng as a prof i tab le a n d commercial ly viable business). Fur ther inducements for banks came in the form of a l lowing banks to coun t SHG lending towards their legal ob l igat ion to direct a fract ion of their loans to the poor (‘priority sector lending’ obligations). I t seemed an ideal w a y to realize a n old I n d i a n dream - to make the vast ne twork o f ru ra l banks key suppliers o f loans to the poor.

However , outreach remains l im i ted in terms of the n u m b e r o f households served, and the scale has been modest, in terms of the vo lume o f credit outstandtng a n d average size o f loans. T h e p r o g r a m has reached only abou t 12 d o n w o m e n and their households (in a coun t ry where 460 d o n people l i ve on less than $/day) in terms of savings accounts and an estimated 2 - 4 million w o m e n in terms of outstanding credit accounts. T h e outstandmgs of the SHG p r o g r a m in M a r c h 2003 were a round Rs 10 billion ($ 217 d o n ) , thus catering to 2.2 p e r cent to 6.6 p e r cent of the estimated demand a n d amoun t ing to around 1.9 pe r cent o f ru ra l outs tandmg b a n k credit. L o a n amounts remain small. In 2003, the SHG member households got a n average of R s 1,766 as credit, after be ing in a group a n d meet ing monthly for anywhere between 9 to 24 months. In 2002-03 only 22 p e r cent of SHGs exist ing at the beginning o f the year, received loans during the course o f the year - even assuming a two year l o a n period, t h i s means that m o r e than h a l f of the exist ing S H G s did not receive a l oan during the year. And the p r o g r a m remains concentrated in the South o f India, with nearly 75 p e r cent of funds flowing to S H G s in the four sou them states. T h e following factors cou ld explain the constraints to scaling up the SHG-Bank linkage program:

A key constraint i s the lack ~ c a p a i t y topromote and maintaingroups to enszire quality. In the early phase o f the SHG movement, the tasks of promoting, nurturing a n d strengthening groups50, were p e r f o r m e d by grass roots NGOs. However , in NABARD’s zeal to link a cumulative to ta l of one d o n SHGs to banks by 2008, a n d as SHG B a n k L inkage has caught the at tent ion of polit icians who v i e w the p r o g r a m as a n easy v o t e winner, quantitative targets on the n u m b e r of groups to b e p r o m o t e d each year are overr id ing concerns about the quali ty o f the groups promoted . M a n y o f the recent groups have been p r o m o t e d by institutions that either lack the requi red s k i l l s a n d local knowledge or ones that are d r i ven by short t e r m monetary incentives. M a n y groups have c o m e together on an a d h o c basis, only because they w a n t a loan. Inadequate at tent ion to group quali ty cou ld threaten the longer t e r m credibihty and viabihty of the entire program. Indeed, recent evidence suggests that t he quali ty o f groups i s already b e p n i n g to suffer. A recent M a h l l a Abhviniddh Society, A n d h r a Pradesh Survey (APMAS) in 2002 indicated that only 17 percent o f a l l groups were o f adequate quali ty for bank l inkage a n d this was in a state w h i c h i s considered the leader in the movement . Thus, lack o f good quali ty SHG promote rs - with increasing use of non- t rad i t ional p romote rs of SHGs, affects the quality of group fo rma t ion by such entities. Thus, wh i le scale objectives m a y b e attained in the short t e r m through using non-tradit ional SHPIs, long t e r m sustainabdity a n d quali ty rema in as issues to b e tackled.

A second p r o b l e m relates to the cost Ofgroupformation, a n d the h e taken. Promotion o f good quali ty groups requires a n investment of both t ime a n d money. Someone has to i n c u r the cost of promoting groups (organizing meetings, t ra in ing the members). T h e estimate o f this cost i s controversial, with NABARD claiming i t to b e as low as Rs 1000 p e r group a n d NGOs saying i t takes as m u c h Rs 12,000. T h e M u u s t r y of Rura l Deve lopmen t has established a norm o f Rs 10,000 p e r group, w h c h experts c la im i s realistic. T h u s , reaching NABARD’s internal target o f forming a n addit ional one

50 These tasks include inculcating in the groups a culture o f savings and repayment, teaching them bookkeeping ski l ls, strengthening their internal capacity to undertake administrative tasks (accounting, meeting minutes, correspondence, and negotiations with bankers) and commercial activities (business start-ups, marketing, and reinvestment), ensuring the groups remain financially sustainable and have the ability to weather personal losses (accidents, sickness, death), and natural disasters, etc.

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million groups by 2008, would require an estimated Rs 10 billion. W h e r e these funds will b e sourced from remains unclear. Moreover, even after a group has been promoted, cont inuous efforts are needed to monitor these groups a n d strengthen their in ternal capacity to undertake adrmnistrative tasks (accounting, meet ing minutes, correspondence, a n d negotiations with bankers) a n d commercial activities (business start-ups, marketing, and re-investment). E f f o r t s are also needed to ensure the groups remain financially sustainable a n d have the abi l i ty to weather personal losses (accidents, sickness, death), and natural disasters. Lead lng NGOs that have been engaged in t h i s act ivi ty indicate that i t takes a minimum o f three years o f nurturing be fo re a group i s ready to b e l t nked to a bank.

Third, issues concerning the model'sJl;nuncials~stu~nubil~~ in the face o f pressures on banks to l e n d to SHGs at subsidized interest rates cou ld constrain the fur ther growth of SHG B a n k Linkage. Banks have been lendmg to SHGs at interest rates of between 12 per cent a n d 12.5 p e r cent. Recently, two state-owned banks, the State B a n k of I n d i a a n d A n d h r a Bank, have announced the i r i n t e n t i o n to l e n d at 9 p e r cent per annum, v iew ing SHG lending as a highly prof i tab le business. Recent studies, however, indlcate that the a l l inclusive costs of l endmg to SHGs are in fact m u c h h igher than w h a t state-owned banks seem to think, a n d cou ld range anywhere between 15 p e r cent (which i s w h a t pr ivate banks l ike IC ICI B a n k charge w h e n they l e n d to SHGs) to 28 p e r cent. In a study o f f ive RRB branches, Sinha (2003) shows that the a l l inclusive costs o f l e n d m g to SHGs ( t a h g into account the relatively high transactions costs o f dealtng with SHGs as w e l l t he costs o f group formation, w h i c h b a n k are increasing beginning to bear) would translate into interest rates of anywhere between 22 p e r cent and 28 p e r cent pe r year, a n d in one case, where the RRB was located in a low density, forested district, the costs translated into interest rates as high as 48 p e r cent p e r annum. T h e SHG portfolio i s a small part of the to ta l b a n k lending, portfolio quali ty i s good, a n d i t m a y b e possible to cross subsidize t h i s , but unless banks charge interest rates to recover costs, the model's f inancial viabdtty and longer t e r m sustainabdtty m a y b e jeopardized.

Microf inance Jtistitutions (MFls)

A second approach to microf inance involves delivery o f finance to the poor through the creation of specialized MFIs. This e f fo r t has been l e d by the SIDBI Founda t ion for M ic ro -Cred i t (SFMC) and other apex lending institutions, i nc lud ing the RMI< a n d FWWB. M u c h o f the credit o f the growth of the sector has been pioneered by these institutions. SFMC, as the largest player, l e d a n u m b e r o f innovat ions i nc ludmg mainstreaming the microf inance sector, facdttating ltnks to commerc ia l banks a n d lenders, promoting better practices amongst MFIs through i t s capacity bddlng program, p ioneer ing support to rat ing init iatives a n d n e w instruments i n c l u d m g the recently launched t ransformat ion loadquasi -equi ty product . As a result of such init iatives the MFI sector has grown at a fast rate over the last s i x years or so. Some o f these M F I s are based on the Grameen model . Others p r o m o t e a n d establish financial hks with SHGs. T h e M F I s o f fe r some o f the features o f the i n f o r m a l sector such as flexible products, customer fr iendly practices but at a h igher interest rate51 than f o r m a l sector, wh i l e bringing in some features o f the fo rma l institutions - such as documented l o a n contracts, detailed books of accounts, MIS, staff, and some degree of supervision by a regulatory authority.

5 1 M-CRIL's 2003 M i c r o Finance Review presents the Annual Percentage Ratio (APR) of rated Ind ian MFIs as 24.3%. There are s igns that with competit ion and growing efficiency in operations, interest rates o f MFIs can reduce over time; Spandana, a leading MFI in AP, amongst the largest in the country, reduced i t s lending rate from 18-20% p a flat to 12-15% p a flat and has plans to reduce i t further on account of operational efficiency g a i n s with growing scale o f operations; ASA, a leading MFI in Tami l N a d u also reduced i t s interest rate from a high 24% pa flat to 15-16% p a flat that i s close to the rates that SHGs themselves charge each other for internal lending. O the r examples can be found particularly from these two states, where the degree o f competit ion between MFIs i s strongest.

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O v e r the past decade, the number o f MFIs in I n d i a has grown. However , with a f e w exceptions, most M F I s in I n d i a are very reg ion specific, small in size-the largest be ing S H A R E M i c r o f i n Ltd with loans outstanding o f about Rs 50 crore and BASIX of Rs 35 crore in March, 2003-and their collective outreach has been h t e d . In M a r c h 2003, the M F I s sector as a who le h a d outstandmgs o f Rs 240 crore ($52 d o n ) reaching less than one d o n borrowers.

O n e estimate indicates that the average loans disbursed by the top 10 M F I s amoun ted to just Rs 16 crore p e r MFI. A n o t h e r estimate, based on 69 rated MFIs (which are a m o n g India’s top 100 MFIs), shows that these M F I s h a d about 6,500 borrowers and Rs. 2.3 crore l oan outstanding, pe r MFI. (Sinha, 2003). In comparison, MFIs in Bangladesh are estimated to reach m o r e than 60 pe r cent o f the poor in the country with the larger programs such as Grameen Bank, BRAC, P r o s M a and ASA all reaching w e l l over one d o n clients each. Grameen Bank‘s l o a n portfolio alone exceeds that o f the entire microf inance sector in I n d i a by a factor of f ive whereas BRAC’s portfolio i s m o r e than three times that of a l l MFIs in India; both ASA’s a n d Proshlka’s portfolio i s also greater t han that o f the entire microf inance sector in India.

In addi t ion to the relatively small scale of their operations, I n d i a n MFIs also t e n d to have a h t e d scope. D u e to regulatory reasons, only a hand fu l of MFIs, such as Vivekananda Seva K e n d r a 0 Sishu Uddyan, VSSU y e s t Bengal) A p a r t from promoting mutua l savings among groups (SHG or Grameen type), a f e w NGO M F I s o f fe r savings services by tak ing deposits from their members. Others have h a d to use M u t u a l Bene f i t T r u s t s or Mutua l l y A i d e d Cooperative Societies (MACS). Only the SEWA Bank, Ahmedabad a n d the BASIX L o c a l A rea B a n k ICBSLAB (in three districts of AP a n d Karnataka) o f fe r savings as RBI regulated entities.

o f fe r savings as a service.

T h e h t e d outreach a n d scale of I n d i a n M F I s , relative to the MFI giants in Indonesia and Bangladesh, reflects, a t least in part, the absence o f an enabling policy, legal a n d regulatory framework. M F I s suffer from the fact that their regulatory oversight i s fragmented across m a n y government agencies. MFIs are not al lowed to mob i l i ze deposits (even from their own members) unless they conver t themselves into a n NBFC. And even as NBFCs, a n ‘investment grade’ ra t ing from corporate ra t i ng agencies i s requi red for mobilizing deposits. T h ~ s i s d i f f i cu l t for most MFI- NBFCs; based on past examples, on account of the typically geographically concentrated and non- col la terahed portfolios that MFIs have, ra t ing agencies, in almost a l l cases, have not assigned the requi red credit rating. T h e minimum start-up capital requirement for registering as a n NBFC (Rs 20 d o n or US$450,000) i s typically b e y o n d the reach of most MFIs. Similarly, the minimum capital requirements for insurance companies (Rs 1 billion, or US$23 million) are high. MFIs have problems raising equity: NGOs are not a l lowed to invest in MFI equity, because o f the charitable status of NGOs under the Section 11 a n d 12 o f the I n c o m e T a x Ac t . Regulat ion on fore ign dtrect investment (FDI) in M F I s dictates rather high minimum levels; fore ign equity must b e a minimum of $500,000 for FDI upto 51%, $5 million for FDI between 51-75’/0, a n d $50 million for F D I 75-100%. What’s more, since 2002, MFIs are no longer al lowed to raise deb t from fore ign donors a n d development finance institutions through the ‘External Commerc ia l Borrowing’ (ECB) route.

Second, the cost o f funds for I n d i a n MFIs i s relatively high, and un l i ke in Bangladesh a n d a n u m b e r of o t h e r countries, the I n d i a n MFI sector has not benef i ted from grants/subsi&ed fundmg. U n h k e in, say, Bangladesh, where Pal l i Karma-Sahayak Founda t ion (PICSF) lends to M F I s a t 4-6 p e r cent p.a. (less than h a l f the market interest rate), I nd ian M F I s , right from inception, t e n d raise debt (from SIDBI, FWWB or commerc ia l banks) a t market rates (between 11-13.5 p e r cent p.a.). W e , in m a n y ways, t h i s i s a m o r e sustainable w a y to grow, in practice, the hgh cost o f funds comb ined with

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problems in accessing equity, has meant that achieving p r o f i t a b h t y a n d growth has been m o r e d i f f icu l t for I n d i a n MFIs than their counterparts in countr ies l ike Bangladesh.

Third, the I n d i a n MFI sector suffers from capacity a n d s k d s constraints, a n d inadequate support systems. As microf inance i s a specialized activi ty a n d g iven tha t m a n y MFIs have evolved from NGOs that have otherwise been focusing on grant based activities, s ta f f t e n d to have stronger inc l inat ion towards social development issues a n d t e n d to possess l i m i t e d s k d s in finance, accounting and business management. Thus, sensitization to issues hke in ternal controls, impor tance o f credit dtscipline amongst groups/members, MIS, financial c o n t r o l a n d management, f inancial analysis, business planning, systems development, n e w p r o d u c t design, etc t e n d to b e of relatively low quality. MFIs need considerable technical assistance to scale up s k i l l s in these aspects.

Fourth, most M F I s in I n d i a l end to SHGs. T h i s means tha t MFIs in I n d i a are constrained by m a n y o f the same factors that have h e l d back the outreach a n d scale of SHG B a n k Linkage. In particular, capacity, t ime a n d cost issues related to group fo rma t ion have posed constraints.

The “Service Provider” Model o f MicroWnance Piloted by Privatc Banks

In January 2000, the RBI al lowed banks to lend to MFIs a n d treat t h i s as pa r t o f their priority sector lending. Since then, a n u m b e r o f banks have used t h i s opportunity to l e n d to MFIs, main ly NGOs, a n d a l l banks now o f fe r lines ofcredit to MFh in addi t ion to t e r m loans. This enables MFIs to d r a w n down the loan at the pace they build their portfolio, thereby reducing the effective interest payment. Banks appear to have h a d a pos i t ive experience of lend ing to MFIs, where transaction costs for banks are l ower as compared to lending to SHGs, a n d the repayment rates are 98 percent and above. Encouraged by early results, the n e w private sector banks, most no tab ly IC ICI Bank, but also UTI B a n k a n d HDFC Bank, are actively seeking exposure in the microfmance sector. W h i l e their current exposure to microf inance i s too small to make a dif ference to their overal l portfolio, even the i r priority sector l endmg portfolio, these n e w banks are pursuing n e w a n d innovat ive approaches to microf inance - as a potent ia l business and not mere ly as a social or priority sector lending obligation.

T h e various approaches to microf inance launched in recent years by ICICI B a n k to reach ru ra l borrowers are notewor thy. O n e approach involves linking IC IC I Bank‘s n e t w o r k o f about 100 ru ra l branches to SHGs; through this approach, IC IC I B a n k funds abou t 6,000 groups. To overcome the constraints faced by the lack o f I C I C I Bank‘s r u r a l b ranch network, IC ICI B a n k uses loca l “promoters” to he lp organize the groups. T h e interest rate on loans under t h i s approach are abou t 18 p e r cent and promoters are paid a salary that depends on recovery rates, size o f loans, etc.

A n o t h e r approach p i l o ted in areas where IC ICI B a n k does not have a physical presence involves the use of NGOs or MFIs52 , traders, or local brokers (who are close to the farmer by the nature o f the i r business), as intermediaries/“service providers” for loans to small a n d marg ina l farmers. T h e tasks of l o a n appraisal, processing, management, collection, etc. are delegated to the NGO/MFI but the loans are always on the books of the b a n k (ICICI B a n k funds the bo r rower direct ly and the l o a n does not pass through the NGO/MFIs). ICICI B a n k prov ides a n in i t ia l l oan to the NGO/MFI to develop SHGs, but then requires that the NGO/MFI repay the l o a n in a f e w years a n d become a “viable unit” through charging service fees to the groups directly. In general, IC ICI B a n k charges the group 12 per cent plus the service p rov ide r charges 6 p e r cent, equal to 18 p e r cent. A n o t h e r recent ini t iat ive taken by some private sector banks a n d insurance agencies to overcome the lack of ru ra l b ranch presence has been the use, for a fee, of the vast posta l b ranch of f ice n e t w o r k as a means to

52 T h e I C I C I Bank has launched a pilot ef for t for this joint ly with Cashpor M i c r o Credit, a section 25 company specially set up for t h i s purpose by Cashpor Financial and Technical Services Ltd, in the Chandauli distr ict of U t t a r Pradesh.

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p r o v i d e financial services. T h i s includes channeling o f insurance products a n d m u t u a l funds a n d use of posta l branch of f ice space for sett ing up Au tomated Tel ler Machines (ATMs).

IC ICI Bank, as w e l l as other banks such as Or ien ta l B a n k of Commerce, are also experimenting with a n approach now termed as the “integrated agricultural service prov ider” approach. O n e vers ion of t h s approach that cou ld perhaps b e repl icated on a wider basis, i s the ICICI Bank Farmer Seruice Center operating model (Mahindra Shubhlabh model). U n d e r t h i s model, IC ICI has ident i f ied an integrated agricultural services provider, or LASP (Shubhlabh), that has a good relat ionship with the farmer a n d prov ides genuine and t imely i n f o r m a t i o n through extension services. IC ICI B a n k enters into a tr ipart i te agreement with the IASP a n d the output buyer. IC ICI B a n k prov ides credit to the farmers on the recommendat ion o f the IASP, the farmer pledges his p roduce to the output buyer at a market- based price, the LASP provides inputs to the farmer. L o a n processing, disbursement a n d col lect ion are effectively done by the IASP, wh i le the credit decision remains nomina l l y with ICICI Bank. At the e n d o f the season, the farmer supplies the c r o p to the output buyer a n d the output buyer deducts the l oan amoun t from the sale proceeds and remi ts the l oan to IC ICI B a n k in full settlement of the l o a n amount. T h e IASP receives a service fee for the l oan processing a n d supervision services (1.5 p e r cent on recovered loans). T h e m o d e l creates a symbiotic relat ionship between the input supplier, f inancier and trader. This reduces transactions costs a n d the risk exposure o f a l l parties and, therefore, presents a relatively low-cost way o f serving farmers. I t helps i m p r o v e i n f o r m a t i o n collection, reduces credit risk, a n d increases access to ru ra l f inancing. However , deepening these relationships to the marginal farmers, s c a h g up the pilots, a n d repl icat ing them, rema in m a j o r challenges.

O t h e r variations on t h i s m o d e l inc lude ICICI? trader famerjnancing model (Rallis - HLL) in Haryana’s Basmat i growing area, where Rallis, as an IASP, provides comprehensive f ie ld support with fortnightly checks a n d ensures pest control; a n d ICICI? farmer finanakg coupled with insurance model, be ing p i l o ted in T a m i l Nadu’s c o t t o n growing area (Appach), offers tailor-made insurance packages a n d bulk storage capacity to farmers in order to avo id contamination.

Whenever possible, the lender would &e to avo id pay ing the farmer directly. A m o d e l be ing used by ICICI B a n k i s to pay the input supplier direct ly a n d pre-arrange with the trader to prepay the lender be fo re pay ing the borrower . T h e bo r rower contracts to sell his crops at a market-based pr ice - since i f a contract pr ice was used and the marke t pr ice was higher, the farmer would not deliver a n d default (and sell a t the h igher rate).

The Kisan Crcdit Card (KCC)

A recent approach to providing credit to the agriculture sector, i nc lud ing small farmers, i s the I<CC, o f fe red by commerc ia l banks, R R B s a n d cooperative banks. Since their i n t roduc t i on in 1998-99, some 3 1 . 6 d o n KCCs h a d been issued by M a r c h 31,2003. Though these are not truly credit cards, the I C C s present a n u m b e r o f advantages for the borrowers a n d lenders. Bo r rowers appear to have found t h i s scheme quite usefu l because o f the ease with w h i c h they can access credi t a n d renew loans on a yearly basis, once the i n i t i a l screening has been done, the reduc t i on in n u m b e r of v i s i t s requi red to branches, the cho ice l f reedom of purchase o f inputs a n d operat ion o f accounts at the designated branches. I<CCs have substantially reduced the paperwork and delays associated with renewal o f c r o p loans. B ranch s taf f also appear to have found the scheme helpful, as i t has reduced transactions costs. On the lines o f KCC, banks have launched the L a g h u U d h a m i Credi t Cards for small entrepreneurs.

However , one concern i s the uneven growth in the distribution of the I<CC scheme. For instance, in our sample o f households from AP a n d UP, only 6 pe r cent o f households r e p o r t hav ing a I<CC (RFAS-2003), a n d access to a I<CC appears to b e higher for the larger farmers: wh l l e some 20 p e r cent o f large farmers repo r t hav ing a I<CC, the correspondmg f igure for marg ina l farmers I i s j u s t 2

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p e r cent. T h e reasons for t h i s appear to include the following: (i) instructions from c o n t r o h g off ices sometimes reduce the f l ex ibh ty o f branch staff; (ii) some farmers have been unable to avail of the f a c h t y due to lack of t i t le to the l and that they td; (iii) m a n y farmers possess l a n d under o ra l lease arrangements, w h i c h are not recognized; (iv) some farmers have not yet availed o f the scheme because they are unaware o f i t s benefits.

Box 4. Kisan Credit Cards: Making some in-roads

In Teek village near Kurukshetra town in the agriculturally prosperous state o f Haryana, more than 70 per cent o f the villagers had a KCC. Relative to all other avenues o f institutional finance - primary agricultural cooperatives, banks including R R B s , land development banks - discussions revealed the K C C to be the most preferred channel o f short-term finance (more so than informal finance f rom commission agentsladhtim and shopkeepers, which were ranked second and third, respectively, and credit f rom cooperatives, ranked last) since it provided easy access to cash credit l ines o f fixed amounts based on land ownership ( R s 10,000 per acre subject t o an upper limit o f Rs 100,000) and was free o f the demands o f rent-seeking officials who otherwise can get as much as 10 per cent o f the loan as pre-sanction bribes. Bankers too reported good repayment performance and l o w transaction costs in processing these loans.

The situation in Barabanki district o f Uttar Pradesh, however, was quite different where, in Ghadhiya, a village o f 230 households, only two persons had managed to acquire KCCs, despite many other applications being made. The relatively l o w level o f physical connectivity and location on the fringes o f two administrative blocks which made the location a bureaucratic no-man’s zone, partly explain the reason for the l o w access to services by formal institutions here.

T h e illustrations serve to highlight that while nationwide growth figures have been impressive, there i s a long way to go before the full potential o f th i s product i s utilized.

T h e success of the KCC, a n d other s d a r facilities that cou ld b e i n t roduced in the future, would depend crit ically on the following factors: (i) extending the f a c h t y to ru ra l n o n - f a r m activities; (ii) efforts to update l a n d records in a t imely manner; (iii) a relaxation by the RBI in the rules so as to accommodate for ora l lessees a n d sharecroppers; (iv) greater f lexibi l i ty to b ranch managers to b e innovat ive in the use o f the I<CC fach ty to mee t the total i ty o f the credit requirements of f a r m households;(v) greater f lexibl l t ty to cardholders to make deposits a n d withdrawals; (vi) uniformity in service charges interest rates a m o n g various banks; (vii) a reduc t i on in documentat ion charges; a n d (viii) efforts to better publ icize the scheme.53

Recent Innovations in Micro - and Weather Insurance

Micro- fife and accident insurance. In a short p e r i o d o f three years since Inda ’s insurance sector was opened up to private investment, there have been a n u m b e r of interesting innovat ions to p rov ide insurance services to the ru ra l poor. T h e poor most o f t e n cannot a f f o r d t rad t i ona l insurance products that are h k e d with earnings. Some M F I s and banks are considering new, m i c r o insurance products designed specifically for ru ra l a n d poor borrowers that they c o u l d cross-sell to small borrowers. SEWA Ahmedabad i s by far the leader in developing a n d o f fe r i ng insurance products to i t s customers. SEWA prov ides insurance services managed through i t s Vim0 SEWA affiliate, w h i c h works as a noda l agency for the L I C and a n u m b e r of general insurance companies. Vim0 S E W A i s perhaps the nation’s largest MFI insurer, cover ing over 100,000 women, for l i f e as w e l l r i sks related to houses and assets used in earning their l ivel ihoods. I t also offers heal th insurance cover ing

53 This report does not examine, in detail, the effectiveness o f various Government-sponsored rural finance schemes such as Swarnajayanti G r a m Swarozgai Yojana (SGSY), but these are being examined in a companion volume.

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matern i ty as well. ICICI B a n k has also fachtated a l i fe insurance t r u s t that i s self-funded by SHGs a n d pays out in the case o f death o f the part icipant or he r spouse.

Weather insurance. Ano the r i nnova t ion has been in the area o f weather insurance. In 2003, IC ICI Lombard , a private sector general insurance company, started o f fe r i ng drought cover policies v ia BASIX a n d excess rain covers through ICICI Bank. Such contracts of fer the dist inct advantage o f solving the delayed payment p r o b l e m that i s c o m m o n with the government area-yield based c r o p insurance programme. BASIX launched i t s f E s t weather insurance p r o g r a m in July 2003 through i t s I (BS LAB in Mahbubnagar. Since loca l area banks are h t e d to operations in three adjacent districts a n d therefore face h t e d natural portfolio diversif ication, t h i s he lped convince I (BS that weather insurance contracts for i t s borrowers cou ld mit igate the natura l default risk inherent in l e n d m g in drought p r o n e areas such as Mahbubnagar, a distr ict that has experienced three consecutive droughts since 2000. ICBS bought a bulk insurance po l i cy from ICICI L o m b a r d seeking to sell i nd i v idua l farmer policies for three categories of groundnut and castor farmers: small, m e d i u m a n d large. I n f o r m a l interviews with the farmers who bought the policies revealed that farmers are very we l l aware of the rainfall-based index nature o f the contracts a n d value the qu ick payout o f the weather policy, w h i c h d i s t i n p s h e s it from the experience with the government c r o p insurance scheme in India. IC ICI Lombard also of fered excess rain policies to a round 5,000 wheat farmers in U t t a r Pradesh (in conjunct ion with ICICI Bank) a n d 150 soya farmers in Madhya Pradesh in 2003/2004 (in conjunct ion with BASIX). M o r e recently the company has w o r k e d with the G o v e r n m e n t of Rajasthan to pilot weather insurance for orange farmers in the state whi le also extending weather risk insurance for a ru ra l f inance portfolio o f BASIX. T h e latter deal i s interesting from the point o f v i e w that i t captures, with one deal, a l l the farmers, big, small a n d marginal, who are p a r t o f BASIXs agriculture portfolio. This approach i s therefore, potential ly scalable even wh i l e hav ing the a b h t y to reach small a n d marginal farmers on account of i t s use o f a financial intermediary/microfinancier. However , cost (around 10 p e r cent o f sum insured) remains an issue even though relative to the t rue costs o f the government c rop insurance p r o g r a m (around 15 p e r cent), the cost i s lower. I f the same or lower cost enabled with greater risk diversif icat ion can b e v iab ly sustained over time, the argument for moving towards such a p r o d u c t becomes stronger. Perhaps as in tradit ional c r o p insurance, t h i s cou ld b e backed by government subsidies part icularly since early evidence seems to suggest that the subsidy requi red maybe lower than for tradit ional c r o p insurance. Further, the other benefi ts o f the use o f an objective indicator (rainfall) to determine payouts a n d reduced t ime lag between c la im a n d payment (relative to tradit ional c rop insurance) associated with t h i s p roduc t strengthen the case for pursuing the development and scaling up of t h i s innovat ion.

Composite Financial Scrvicc Providers

A variat ion of microf inance that has emerged in recent years i s composite service provision, in other words, a single microf inance institution prov ides a n array o f services, i nc lud ing credit, savings, insurance, etc. A recent set of studies sponsored by the Inst i tu te for Deve lopmen t Po l i cy a n d Management, UIC, (Ruthven, 2001; Patole a n d Ruthven, 2001), found that a w i d e array of f inancial transactions 00th borrowing a n d lending, o f t e n simultaneously, and at a l l levels o f income) characterized the financial l i f e of the poor. T h e aggregate financial transactions were between 113 p e r cent to 167 p e r cent o f the i n c o m e levels o f the ve ry poor and the poor respectively, in r u r a l Allahabad, a n d 149 p e r cent to 135 pe r cent in u r b a n D e l h i slums. T h e World B a n k WAS Survey (2003) also supports t h i s conclusion. T h e poor are constantly borrowing, lending, saving, withdrawing, using a n d losing money, through contingencies, a n d calamities. T h e y need someone to he lp t h e m with al l these transactions.

Composi te service providers are preferable from the v iewpo in t o f reducing the n u m b e r of agencies with whom a poor household must deal, thus reducing’transactions costs. Moreover , i f a composi te agency has a good in tema l MIS, it can use the savings history of a household as a “collateral” for

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loans. S d a r l y , if the same agency provides insurance for lives or livelihoods, i t will b e m o r e d n g to give a loan. From the MFIs’ point of view, transaction costs come down as the same delivery system can b e used, with the addi t ion o f training, software and some staff.

T h e r e are now some examples, albeit few, of composite financial service prov iders in Indla, mostly to b e found a m o n g MFIs. T h e three top M F I s in I n d i a are a l l trying to o f f e r a composi te set of services to their customers, in spite of a fragmented and unsuppor t ive regulatory f ramework. For example:

S E W A Ahmedabad provides a combinat ion of savings a n d credit through i t s S r i Mah i l a S E W A U r b a n Cooperative B a n k and insurance services managed through i t s Vim0 S E W A affdiate, w h i c h front ends for the L IC and a n u m b e r of general insurance companies.

T h e BASIX group’s I (BS LAB, i s able to p rov ide a l l the services - savings, i nc lud ing daily deposits collected from the doorstep o f i t s borrowers, credit for a range o f purposes from c r o p loans to non- f a r m activities and to SHGs; a n d c rop insurance to farmers under the ICCC / Rashtr iya I ( r i s h i B i m a Yojana as we l l as a weather indexed c rop p r o d u c t developed by ICICI Lombard , a n d p i l o t e d last year. B A S I X retails l i f e insurance on behal f of AVIVA L i f e Insurance C o m p a n y a n d provides l ivestock insurance to i t s borrowers through Roya l Sundaram Genera l Insurance Company.

Portfolio Secrrritixation

Portfolio securit ization of the m i c r o l oan portfolios o f M F I s i s a n innovat ive approach, recently p i l o ted in I n d i a by ICICI B a n k a n d S H A R E , a microf inancier. ICICI B a n k has j u s t completed two such deals in AP. In the larger one, i t has paid $4.3 d o n for a portfolio o f 42,500 small loans from S H A R E , a microf inancier. S H A R E will b e responsible for col lect ing the loans. T h e securit ization i s not asset-backed; rather, ICICI B a n k will have as collateral instead a “ f i r s t loss’ guarantee o f an 8 p e r cent deposit from the to ta l from Grameen Foundat ion.

T h e approach has m a n y advantages: IC ICI B a n k manages to reach bo r rowers i t cou ld never otherwise have approached, a n d p a l m off most of the adrmnistrat ion to S H A R E . This also helps it mee t i t s government-set target o f direct ing 40 p e r cent o f i t s loans to the “priority sectors”, i nc lud ing 18 p e r cent to farmers. S H A R E secures a n e w source o f funds, of f SHARE’S balance sheet, a t a cost that i s 3 to 4 percentage points cheaper than i t pays for a b a n k loan. T h i s will h e l p S H A R E mee t i t s a i m of increasing the n u m b e r of borrowers from under 300,000 now to 1 d o n . T h e deal also helps create a n e w asset class for w h i c h there i s demand a m o n g the m o r e liquid investors.

W h i l e such securitizations can b e done for the better MFIs, for w h i c h credit ratings are available, scaling up would pose a serious challenge, g iven the paucity o f reliable, independent i n f o r m a t i o n on the bulk o f the MFIs a n d their l o a n portfolios. Also, at present, there i s no secondary marke t for the securities, but ICICI B a n k i s t a h g to CRIS IL , a credit ra t i ng agency, abou t the prospects for i t s ra t ing the paper, a n d i s hoping that over time, o ther banks will enter the marke t too.

Price lrisuraricc and Risk hlanagement Products for Farmers

Commodityprice insurance. Fluctuations in c o m m o d i t y prices are a m a j o r source o f risk in ru ra l finance. Market-based tools to insure against c o m m o d i t y pr ice volatt l i ty (e.g. futures a n d options) can he lp reduce the risk o f default by margma l a n d small farmers, a n d hence i m p r o v e the terms on w h c h they can access finance. Such tools already exist a n d are widely used in hgh i n c o m e countries. Risk management service providers, such as grain elevators a n d oilseed crushing plants, p r o v i d e farmers with access to risk management tools using purchasing contracts. As a result, t he demands of ind iv idual farmers for insurance are aggregated into a contract o f a commercial ly viable size, thereby

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enabling even farmers who produce a relatively small quanti ty of a c o m m o d i t y to indirect ly purchase insurance. In developing countries k e India, small farmers a n d marke t intermediaries tend to lack knowledge o f such market-based pr ice insurance instruments a n d a n understanding of how to use them. Also, the sellers o f such instruments, generally international t radmg firms, are o f t e n unwdhg to engage with a n e w and unfamil iar customer base o f small-scale farmers, characterized by high transaction costs, credit issues, a n d performance risk. O n e i l lus t ra t ion o f a n i nnova t ion that was t r ied recently relates to the I n d i a n Cof fee B o a r d and three commerc ia l banks that designed a comprehensive pilot for retading N e w York traded coffee “put options” to p ro tec t farmers against adverse pr ice movements ( t h i s was designed with significant cont r ibut ions from the Commodity Risk Management Group o f the World Bank54). However, fewer than expected coffee farmers pre- registered for t h i s scheme and therefore i t has not been launched in 2004. T h e set up o f t h i s pilot was dr iven by regulatory constraints, as banks are not al lowed to deal with derivatives. T h i s continues to constrain the growth o f such pr ice risk management products.

T h e development o f commodit ies futures markets can help eff iciency pr ice discovery and go a long way in reducing r i s k s related to a fal l in commod i t y prices b e l o w p r o d u c t i o n cost levels. In particular, micro-futures can he lp marginal and small farmers hedge against c o m m o d i t y p r i ce fluctuations.

Establishing warehouse receipt systems. A n o t h e r means o f reducing the default risk in ru ra l f inance m a y b e through establishmg “warehouse receipt systems”. Ths involves farmers using their crops as collateral for post-harvest financing. T h e basic idea i s as follows: T h e warehouses store the produce for a fee a n d deliver a receipt to the farmer, a n d the receipt becomes immediately enforceable (sunilar to checks). For the warehouse receipt system to work effectively, receipts would need to b e recognned as legal instruments. Also, the grades a n d quali ty standards o f the commodit ies would need to b e def ined centrally, warehouse operat ion standards would need to b e developed a n d effective supervision established. T h e G o v e r n m e n t of I n d i a (Goo has been examining this issue; a recent task force set up by the M i n i s t r y o f Finance h igh l ighted the following measures requi red to develop a warehouse receipt system: (i) creation of a central warehouse registry a n d a central regulatory authority; (ii) malung warehouse receipts a negotiable instrument; (iii) al lowing for the full transferabihty o f warehouse receipts; a n d (iv) the i n t roduc t i on o f national ly recognized grades a n d qualities for commodit ies.

The strategic use of Information and Communication Technology (ICT)

A leading agr i -commodi ty marke t player in India, ITC, has p ioneered the use o f e-choupal: a desktop computer, with a n in ternet connect ion and revolut ionary impl icat ions for m o r e than 4,000 villages. T h e e-choupal i s operated as a commercial venture by a loca l farmer who earns a commiss ion from the sales that take place through the e-choupal internet connection. Farmers use the e-choupal to check prices for agricultural p roduce at the nearest mandi, or in internat ional c o m m o d i t y markets, as w e l l as to trade commodit ies. Bet ter market i n fo rma t ion enables farmers to obtain better prices. T h e e-choupal i s also a m o d e to seek technical advice, obtain weather forecasts, a n d order agricultural inputs or indeed a range of other commodit ies. These e-choupals also p rov ide potent ia l avenues for lenders, agricultural c o m m o d i t y traders a n d farmers to interact in a relatively seamless manner, with low transaction costs and i m p r o v e d (credit a n d market) i n fo rma t ion . With r a p i d expansion plans to cover a fifth of India’s vdlages in the future, ITC’s e-choupals are a great i l lus t ra t ion o f the powers of i n fo rma t ion technology.

See H e s s and K l a p p e r (2003). 54

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T h e strategic use o f i n fo rma t ion and communicat ion technology i s cr i t ical to addressing the transaction cost p r o b l e m in ru ra l fmance. Some experiments in t h i s direct ion have been made, notably by B A S I X to use to give out very small loans (below Rs 1,000) and col lect repayments, using smart cards readable at devices placed in Subscriber Trunk D i a l i n g (STD) Pub l i c Cal l O f f i c e (PCOs). Though the in i t ia l experiment has not been successful, due to a combinat ion of technical and financial reasons, i t certainly established that there i s a marke t for “nano-credit” (loans b e l o w Rs 5000 or $100) w h i c h can b e prof i tab ly and eff iciently served using sophisticated ICT.

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V. M E E T I N G THE CHALLENGE OF SCALING-UP ACCESS TO FINANCE FOR INDIA’S RURAL POOR: THE POLICY AGENDA

Improving access to finance for India’s ru ra l poor, to mee t the i r diverse f inancial needs (savings, credit, insurance against unexpected events, etc.) presents a formidable challenge in a coun t ry as vast a n d varied as Ind ia. But the opportunities, too, are plenti ful. In the near term, microf inance can, at a minimum, serve as a qu ick w a y to deliver finance. But the m e d i u m t e r m strategy to scale up access to finance for the poor should b e to ‘graduate’ microf inance clients to fo rma l f inance institutions where they can access standard ‘individual’ loans, possibly on a fully commerc ia l basis. An immediate p r o b l e m arises in that there are no obvious lenders for microf inance customers to graduate to - none yet are close to o f fe r i ng the rel iabhty, convenience, continuity, a n d f lexibi l i ty requi red by low- income customers. Nor i s the notion of graduation built explicit ly into the design o f microf inance in India. In Indonesia, in contrast, B a n k Rakyat Indonesia (SRI) has w o r k e d closely with (and in fact supervises) the Badan I G e d i t Desa (BISD) network, w h i c h has for some been a feeder to BRI. E v e n so, there i s relatively l i t t le graduation overal l from the BICDs to BRI, par t ly because BRI is only now developing products that work w e l l for the smallest-scale clients. In Bangladesh, the pretext of graduation has been universally abandoned for lack o f an a p p e a h g nex t step-and for the desire of NGOs to continue workmg with clients with whom they have developed relationships over m a n y years. I f the idea of graduation i s a serious one in India, efforts to p r o m o t e microf inance should go hand-in-hand with efforts to make the f o r m a l sector bet ter at “bankmg the poor”, a n d both government and private sector can play a cri t ical ro le in h s context.

Making the Formal Financial Sector Better At Banking The Rural Poor

An immediate challenge i s for f o r m a l sector institutions to in t roduce products a n d services that are not only reliable a n d avadable on a continuous basis, but are also f lexible a n d convenient, and also to in t roduce measures that a l low for low-cost ways o f reaching the ru ra l poor. Here, microf inance can o f fe r some usefu l lessons to f o r m a l banks. O v e r the meditim t e r m , key re fo rms in government po l icy are required to i m p r o v e the overal l incentive framework, a n d the regulatory a n d legal system within w h c h ru ra l banks operate, so as to p r o m o t e greater efficiency a n d compe t i t i on in ru ra l finance.

India’s vast n e t w o r k o f ru ra l banks potential ly presents a tremendous advantage, and one on w h i c h the country cou ld capitalize in delivering finance for the poor. Currently, most banks operating in ru ra l areas, the major i ty of w h c h are state-owned banks, do not seem to b e tai lored to mee t the needs of the ru ra l poor in a n eff icient a n d effective manner. T h e responsibi l i ty for in t roduc ing m o r e flexible products and services, that would better m a t c h the needs of the r u r a l poor, rests with bankers. But Government , g v e n i t s domina t ion o f ru ra l fulance institutions, also has a n impor tan t ro le to play in spearheading change. In t h s context, microf inance offers a n u m b e r o f lessons for fo rma l banks.

Introducing ffexible and easily accessible products Smal l ru ra l clients prefer to borrow frequently, and repay in small installments; banks cou ld useful ly explore the possibility of o f fe r i ng n e w and m o r e flexible l oan products, l i ke those of fered by microfinance. Increased use by insurance companies, o f the large a n d deep b ranch presence o f the posta l b ranch network55 (as w e l l as the

55 RFAS-2003 data showed that post off ice branches had the closest proximity (2 h s on average) to rural clients compared to branches o f commercial banks, R R B s and cooperatives (5 h s on average).

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commerc ia l b a n k network) for channeling insurance products, backed by adequate t ra in ing of staff, c o u l d he lp l o w e r transaction costs and improve access to insurance.

The need for composite financial services W e small ru ra l borrowers seek savings a n d lending services, they also seek insurance (life, health, crop); bank branches in ru ra l areas would do w e l l to explore opportunit ies to o f fe r composite financial services, as they have begun to do in u r b a n areas, a n d as some microfmanciers have begun to o f fe r in ru ra l a n d u r b a n areas. T h e need for remittance services i s also gaining increasing impor tance particularly on account of the large v o l u m e o f international remittances (US$8.4 bLUion through of f ic ia l channels in 2003) corn ing to India. L o w e r i n g transactions costs and increasing the avai labhty of such services through increased b a n k a n d posta l b ranch coverage d help generate n e w business wh i l e also wean away customers from using i n f o r m a l channels for remittances.

Simplification ofprocedures to open a b a n k account, access credit, etc. c o u l d also go a long way in encouraging the poor to b a n k with the fo rma l sector, by reducing clients' transactions costs. T h e KCC experiment i s a m o v e in the right direction, but i t needs to b e scaled-up a n d accompanied by other procedura l changes.

Better staffing policies and doorstep banlcing: T h e high recovery rates o f microf inance are associated with staff ing policies that a l low recru i t ing staff from the local area who understand clients' needs, a n d a focus on doorstep b a n h g . State-owned banks operating in r u r a l areas currently do not have the f l e x i b h t y to recru i t s ta f f locally, but staff ing policies cou ld b e revisited. D o o r s t e p banlung i s costly, but the gains from better recovery and cost savings from hiring loca l s ta f f in ru ra l branches cou ld w e l l outweigh the h g h e r transactions costs o f doorstep b a n h g .

Use oftechnology: Banks can use technology to dr ive down their transactions costs, for example, through the i n t roduc t i on of smart cards and biometrics.

/??IPT(J?!i!?j i / i c ih('filii/Ji? rCii@?, :7ildpi.W?lit~I~~ I'l/??@tifioi!: h i $ ? ~ ' ( ~ ; N ~ ' L ' i ~ ~ 7 . ~ ~ b i i f fki&!J'

Interest rates. O n e obvious area cou ld b e for Governmen t to revisit i t s po l i cy of setting interest rate "caps" on ru ra l lending rates a n d "floors" on the deposit rates. As n o t e d above, t h i s has the opposite effect of w h a t i s in tended - poor borrowers are c u t of f from access a n d e n d up paying h g h e r interest rates to i n f o r m a l lenders. Meanwhile, banks face a n imp l i c i t tax (cost) that i s not insignificant. Also, as indicated by the WAS-2003, the 'store o f value' reason for holdmg accounts dominates the transactions needs o f ru ra l households; most transactions are cash-based. This suggests that deposit m o b h a t i o n m a y b e relatively inelastic to interest rates (however fur ther study i s needed) w h i c h cou ld m e a n that there i s scope for m o r e attractive spreads for commerc ia l banks - if interest rates were fur ther deregulated. T h e success o f countries such as Indonesia a n d Phil ippines that have no interest rate controls but have succeeded in m a k i n g deep in-roads in ru ra l areas, i s noteworthy.

M o r a l suasion by governments on interest rates on f a r m loans a n d announcements of interest (and principle) waivers by state governments from t ime to time, must b e avoided. With regard to the former, announcements by government's on interest rate c e h g s even i f with compensatory subsidies to banks, dis-incentivize ru ra l bankers, hamper the credit culture tha t cou ld otherwise have been established and lead to the expectation amongst farmers that low interest rates d cont inue in perpetuity. T h e ro le of the state thus, harms the f inancial system rather than p e r f o r m a n enabling role. Simdarly interest waivers announced by governments, create a n adverse incentive amongst farmers not to service the debt, riding on the expectation tha t waivers m a y eventually b e announced. Clearly such measures have a n adverse impac t on the f inancial system a n d altematives such as direct f a r m p ro tec t i on measures, i nc lud ing increasing the outreach of agricultural risk mi t igat ion need to b e given serious consideration by governments at both the central a n d state levels. Moreover , to the

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extent that such announcements are generally l i nked to disaster situations, disaster re l ie f and r e h a b h a t i o n measures56 need to form the government response - these can b e pol i t ical ly viable a n d financially m o r e prudent and effective than s e e h g to waive interest.

Revisiting the policy on fpriority sector’ lending. Governmen t should also consider revisit ing i t s po l i cy on priority sector lending requirements imposed on banks. Priority lend ing quotas are not fully observed a n d o f t e n circumvented through such means as subscript ion by banks to NABARD and SIDBI bonds. O n e option, that would al low the most competit ive lender to emerge in ru ra l areas a n d m i n i m i z e distortions, i s for government to make the priority lending obl igat ion “tradable”. T h e most compet i t ive lender would then b e paid by the less w e l l placed banks to effectively take on their priority lend ing requirements for a price. Creating such a marke t for priority lend ing requirements would bene f i t both banks and the ru ra l poor, who would b e able to access finance from the most efficient a n d competit ive institution.

Entry of newprivate banks in rural finance. Some pr ivate banks such as IC ICI B a n k have shown a growing interest in entering India’s ru ra l f inance sector-and have in t roduced innovat ive approaches a n d financial products to reach the ru ra l poor. Governmen t needs to do w h a t i t takes to create a n env i ronment that would make i t possible a n d prof i tab le for interested pr ivate banks to enter the r u r a l f inance market. This would require l iberal izing interest rates (see above) so that lending to small, r u ra l clients can become a m o r e prof i tab le business for banks. I t would also require revisit ing b ranch licensing policies (private banks m a y b e interested in buying up the branch networks of the government-owned ru ra l banks). And i t would require strengthening the supervision of ru ra l banks so as to ensure financial discipl inelreduce m o r a l hazard problems wh i l e also fostering an e n a b h g env i ronment for financial intermediaries (see below). T h e ent ry of pr ivate banks cou ld have a good demonstrat ion effect for the pub l i c sector banks on how to reduce transactions costs in ru ra l bank ing a n d how to make ru ra l bank ing profi table. I t would also create m o r e competit ion, that would he lp wean out the good from the b a d banks a n d create further space for new, pr ivate sector entrants. To t h i s extent, measures to support innovat ions by the private sector banks a n d consolidate and disseminate lessons from such pilots, would help in leveraging adequately on their init iatives.

Restructuring the RRBs and rural cooperative banks. Restructuring the R R B s a n d ru ra l cooperative banks poses a m a j o r challenge. Var ious Government-appointed task forces a n d committees57 have highl ighted in detail w h a t needs to b e done to deal with the weaker R R B s and cooperative banks; the challenge really i s to build consensus for reforms a n d imp lemen t the changes. (Annex 5). As a f i r s t step, the regulat ion a n d supervision o f these banks needs to b e urgently strengthened. Prudential regulat ion standards related to capital adequacy a n d asset classification (and related to the latter, regulat ion on i n c o m e recogni t ion a n d provisioning) need to b e upgraded and in t roduced in a phased manner, a n d the supervisory enforcement improved . Weaknesses in regulatory standards, poor enforcement a n d regulatory forbearance, have underm ined marke t discipline a n d have contr ibuted to the deep f inancial &stress that characterizes m a n y R R B s a n d ru ra l cooperative banks. I m p r o v e d prudent ia l standards needs to go along with clearer demarcat ion a n d pr ior i t izat ion of functions to address the c o n f i c t of interest in apex institutions’ (RBI and NABARD) regulatory, supervisory, re f inancing a n d development functions. W h i l e perhaps the decreasing impor tance o f refinance from apex institutions cou ld b e the w a y tha t some of these issues will b e resolved, nonetheless, there i s a need to deliberate actively on t h i s issue. And w h i l e there m a y

56 In this context, the following report could be a useful reference: Financing Rapid Onset Natural Disaster Losses in India: A Risk Management Approach; World Bank, 2003. 571ncluding the Capoor Committee and the Pad Committee reports on the rural cooperative banks and the Rao Committee on R R B s .

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b e no one right and no short t e r m solution, reviewing international experience would b e useful58 in terms of studying prudent ia l regulat ion a n d supervisory mechanisms (central b a n k versus a u d a r y supervision versus delegated supervision (Annex 6) a n d determin ing ways to m in im ize potent ia l c o n f i c t of interests between these roles.

Better regulation and supervision wouldpave the way for the restructuring of these banks. I t would he lp wean out the adequately capitahzed banks from the weaker banks (undercapitalized banks, a n d those that are insolvent). T h e p roper enforcement of prudent ia l norms would mean that the weaker banks are fo rced to address their problems through such means as mergers or closures.59 Studying the experiences o f countries such as Korea, Mexico, Peru, Tha i l and a n d Chmese Taipei, where recent ru ra l bank ing crises h a d emerged and been dealt with, would b e usefu l to assess the kinds o f po l i cy response that was adopted (Annex 7).

Bet ter regulat ion and supervision need to b e accompanied by operational restructuring, involving improvements in governance to reduce state interference (especially for r u r a l cooperative banks, the duality of c o n t r o l issue needs to b e addressed - al l banlung functions need to vest clearly with the central b a n k rather than b e shared with the state government; these funct ions inc lude policies on interest rate and loans, reserve and appropriation, remission o f debts, b ranch licensing, powers to appoint auditors and supercede the Board, powers to appo in t CEOs, etc), bet ter management, strong policies on l o a n sanctions (without any inf luence o f the government) i nc lud ing measures to check related pa r t y lending, clear portfolio risk management strategies, s ta f f ing pol icies that a l l ow banks to employ loca l s ta f f who are farmliar with the commun i t y a n d thereby bet ter able to address the needs o f their client, a n d the i n t roduc t i on o f n e w products, such as loans with flexible repayment terms, a n d bet ter services, such as door-step bank ing that can he lp better mee t the needs of ru ra l clients and m in im ize risk. In in t roduc ing n e w products a n d services for the ru ra l poor, lessons c o u l d b e d rawn from microfinance.

Bet ter regulat ion a n d supervision also needs to b e go h a n d in h a n d with strengthening the ref inancing eligibil i ty norms for ru ra l banks used by NABARD a n d the due dhgence under ly ing lending to ru ra l finance. With regard to the former, relatively len ient condi t ions used at present p rov ide wrong signals to ru ra l banks a n d thereby, reduce the incent ive to i m p r o v e financial performance sufficiently, whde also potential ly c rowd tng out pr ivate sector f inancial i ns t i t u t i onsbo . T h e point on the quali ty o f due ddigence i s particularly relevant to the practice of l e n d m g against state government guarantees - t h i s includes NABARD refinance to state level cooperative banks a n d state governments but also lendtng by state level cooperative banks to other c o m m o d i t y cooperative sectors against a state guarantee. Of ten, g iven the c o m f o r t of a state guarantee, such l e n d m g m a y not b e backed by adequate due dil igence on the pa r t of the lender, a n d therefore, wh i l e re ta in ing a standard asset on i t s books on account of the government guarantee, u l t imate ly t h i s c o u l d create a fiscal l i a b h t y for the state i f the under ly ing asset f inanced by the in termediary i s not a viable project. Such lending cou ld inc lude NABARD’s exposures under the R u r a l In f rast ructure Deve lopmen t Fund, i t s l endmg to long t e r m cooperative banks (many o f w h i c h have eroded their capital base) a n d

58 T h e experience of countries such as Canada, Mexico, Peru, Germany and Braz i l would b e a good start ing point as we l l as studying the cases of countries where weak regulat ion and supervision l e d to collapse of the cooperative system (Nicaragua, Venezuela) - the following website provides m o r e information: Lv\v~v.worldbank.orp./rccif~coons 59 This is indeed in l ine with the recommendations made b y various Government-sponsored committees on the future of the R R B s and cooperatives, w h i c h suggest measures to reduce government ownership, undertake structural consolidation, improve governance and management, strengthen regulation and supervision and so forth. 6o T h e flow of funds to the rural finance sector from financially weak entities, not mere ly creates weak assets for the rural banks, but also p o t e n t i d y crowds out private sector prov is ion of f inancial services. W h i l e it can b e argued that the private sector does not have a significant presence in rural areas at present, recent init iatives by these banks discussed in this report, could indicate a turning point in their degree o f focus on rural finance.

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the l end ing (often ‘directed’ by state govemments61) by state cooperative banks to unviable a n d bankrupt, government o w n e d sugar (and other commodi ty) cooperatives backed by state guarantees.

B e y o n d these measures, Governmen t can also play a n active ro le in m a n y other areas to fachtate increased efficiency o f ru ra l finance markets and increased compe t i t i on that would he lp financiers make credit available m o r e efficiently to ru ra l borrowers, both large a n d small. Bet ter laws a n d regulations govern ing financial transactions, a judiciary that can enforce contracts, the demarcation o f property, bet ter credit information, i m p r o v e d price discovery in ru ra l markets, cou ld go a long way in addressing marke t constraints. Specifically, these measures would include:

Improving contract enforcement, the legal framework and land titling. To encourage banks a n d other pr ivate creditors to l e n d in rura l areas, t he government needs to strengthen the legal f ramework for recover ing smaller NPLs. W e the recent enactment of the securit ization a n d asset reconst ruct ion l a w (2002) has helped improve the legal f ramework for recovering b a d loans, by fachtat ing out -of -cour t settlements on NPLs and instituting alternate methods of dispute resolut ion between creditors a n d debtors, the l a w does not cover small loans. E x t e n d i n g the l a w to small loans would greatly fachtate l oan recovery on ru ra l loans, thereby, reducing the default risk faced by R u r a l Finance Institutions (RFIs). L a n d t i h g and registrat ion systems should also b e strengthened, restrictions on the use a n d transfer o f l a n d removed, a n d enforcement mechanism improved, so as to fachtate the use of l a n d as collateral. At present, some 90 p e r cent of l and parcels in I n d i a are repor ted ly subject to disputes over ownership, w h c h take decades to settle in court. W h i l e these are complex issues, a start cou ld b e made by efforts to i m p r o v e the t i h g a n d registrat ion process through the automat ion o f l and records. L a n d laws need to b e m o d i f i e d to facilitate the development of a free-and-fair land-lease market. Indeed, m a n y states do not p e r m i t leasing o f land, whi le in some other states, the lease creates l ong - te rm irrevocable rights for the lessee to the disadvantage o f the lessor. All t h s encourages unrecorded and uno f f i c i a l year-to-year ora l leases, w h i c h prevent the lessor from gett ing a good lease value, a n d the lessee from putting the l a n d to best use.

Better credit information would directly increase the amount of financing for ruraf borrowers, by reducing transactions costs and costs related to default risk. A c r e d t bureau that focuses on small, ru ra l clients cou ld e h a t e the need for these certificates a n d decrease the t ime necessary for loan approval and disbursement. A w a y f o r w a r d m a y b e for NABARD to consider collecting credit i n fo rma t ion on m i c r o borrowers, both groups a n d individuals. A f u s t step cou ld b e to require the 2,500 N A B A R D - a f f h a t e d financial institutions to p r o v i d e default i n f o r m a t i o n to a central registry. For example, in m a n y r u r a l areas, NABARD arranges for farmers to mee t informally, a n d share default i n fo rma t ion a m o n g themselves. I t would b e he lp fu l i f t h i s i n f o r m a t i o n - historical ly a n d across regions - were k e p t electronically a n d made easily accessible. O n e constraint i s the un ique ident i f icat ion of borrowers. However , the current system - of inc lud ing name, father’s name a n d address - i s considered accurate in over 95 p e r cent o f cases. In addition, as Na t iona l IDS become m o r e common, NABARD c o u l d require that every bo r rower have a n ID (as i s the case in Sr i Lanka). A s d a r init iat ive cou ld b e under taken with SIDBI a n d other apex m i c r o finance lenders. A usefu l reference would b e the South A f r i c a n credit bureau that also covers the m i c r o finance sector, using the apex m i c r o finance counc i l as a channel to collate i n f o r m a t i o n on micro-borrowers.

Better price discoveT, crop insurance and commodity price insurance to reduce default nkk. O n e o f the m a i n sources of default risk faced by r u r a l f inanciers i s a fa l l in c o m m o d i t y prices b e l o w p roduc t i on cost levels. T h e development of commodi t ies futures markets cou ld b e way o f improving pr ice discovery and hence, reducing risk. This would require changes to the regulatory a n d

61 M o s t recently the case of the Maharashtra State Cooperative Bank‘s exposures to the state’s sugar cooperative sector.

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legal framework, specifically, government and RBI need to re-examine the entire set of fo rward markets regulations and Section 8 of the bankmg law. At present, the regulatory f ramework for forward markets seems to c o n f i c t with the rap id ly l i b e r a h i n g futures marke t regulations. O n e aspect o f t h i s conf l ic t i s the interpretat ion of section 8 of the b a n k m g law. Currently, the l a w does not a l l ow a b a n k to buy commod i t y pr ice derivatives, even if the b a n k does not take any exposure by r e t a h g the derivative as price insurance to commod l t y producers. Banks should b e a l lowed to trade derivatives as long as speculation and exposure to pr ice movements are l i m i t e d a n d w e l l supervised. A variant p roduc t i s “micro futures”, w h i c h are smaller denominated fu ture products marketed to smaller businesses or independent farms. Contract sizes on future contracts are o f t e n too large to accommodate small holders needs. Smaller m i c r o futures on pr inc ipa l crops a n d weather measures in m a j o r cities cou ld b e retaded through brokers a n d bank and marketed to retad buyers. T h i s i ns t rumen t cou ld he lp margmal and small farmers hedge against c o m m o d l t y pr ice fluctuations.

Access to pr ice insurance and pr ice derivative instruments would also he lp c o m m o d i t y producers and traders access finance on better terms. But this would require the I n d i a n authorit ies to redefine the regulatory f ramework govern ing the use of c o m m o d l t y pr ice derivatives. Approp r ia te supervision would need to b e put in place to curtai l the speculative use o f these inst ruments a n d h t exposure to m o r e sophisticated structures with marg in requirements. T h e supervisor would need to d i s t i n g u i s h between simple straightforward hedging instruments, such as “put” options a n d futures, a n d m o r e compl icated and h a r d to track swaps, “collars”, “swaptions”. etc.

An i m p o r t a n t tool in agricultural risk mi t igat ion c o u l d b e weather based insurance products. T h e m a i n pre-condi t ion for the scaling-up of weather insurance i s the t imely a n d full avai labhty of weather data, preferably online. Currently, weather stations in I n d i a are o f t e n not automated a n d data i s not available online. In addition, the use of weather derivatives i s subject to tight restrictions, essentially they are not pa r t o f the recognized financial instruments w h c h leaves only the inst rument o f weather insurance. Thus, government would have to: (i) ensure that those who would m e to pilot t h s inst rument are p rov ided full access to h s t o r i c a l a n d current weather data ( w h c h does seem to exist, but i s not readily available at present); (ii) m a k e avadable t h i s data on l ine (on the basis o f specific agreements); (iii) introduce weather derivatives as a tradable inst rument .

Recent innovat ions in agricultural risk mi t igat ion have opened the doors for innovat ions to reduce default risk in rura l f inance wh i l e also providing pro tec t i on to the borrower . For il lustration, the basic p r o d u c t o f fered and be ing developed by the Agr icu l ture Insurance C o m p a n y of I n d l a (AICI), the main prov ide r o f c rop insurance at present, i s based on a n area-yield fo rmu la t i on - the G o v e r n m e n t cou ld a l l ow providers o f risk management services the right to a l l ow the farmer to assign the area- y ie ld indemnit ies payment to the risk p rov ide r in exchange for n e w ta i lored r i s k management products better suited to the ind lv idual farmer’s risk management needs. Ths innova t ion cou ld p r o v e p i vo ta l in addressing main p r o b l e m with the current program, namely of delayed i n d e m n i t y payment.

Y e t another means o f reducing the default risk in ru ra l f inance m a y b e through establishing “warehouse receipt systems”. T h e immediate priori t ies in t h i s area, as h igh l ighted by a recent task force set up by the M i n i s t r y o f Finance, are as follows: (i) creation o f a central warehouse registry and a central regulatory authority; (ii) m a h n g warehouse receipts a negotiable instrument; (iii) al lowing for the full transferabll ity o f warehouse receipts; and (iv) the i n t r o d u c t i o n of national ly recognized grades a n d qualities for commodit ies.

Scaling-lTp Microfinance

As efforts are made to i m p r o v e the f o r m a l sectors’ abi l i ty to serve the poor, microf inance can p lay a n i m p o r t a n t ro le in the in ter im. S c a h g - u p access to finance for India’s r u r a l poor through microf inance d require attention to the following areas:

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An enabkg policy, legal and regulatory environment for microfinance. An e n a b h g framework i s already in place for SHG B a n k Linkage, a n d s c a h g - u p the m o d e l would require Governmen t to ensure that the existing f ramework i s maintained. This would require ensuring that the m o d e l continues to have a champ ion with a clear leadership ro le - a task w h i c h NABARD has assumed with exemplary diligence by in t roducing policies a n d measures to encourage banks to l e n d to SHGs. And it would require the authorit ies to mainta in a ‘hands-of f regulatory pol icy. For M F I s , Governmen t cou ld p lay a n impor tan t ro le in establishing an enabling policy, legal a n d regulatory f ramework for MFIs. W h i l e the success of ind iv idual MFIs i s largely attr ibutable to the i r visionary leaders, t h i s i s clearly not enough to mainstream the cause of MFIs. Advocates of MFIs argue that immediate measures needed inc lude the following: (i) Reduc ing minimum start-up capital requirements to facihtate the transformation o f MFIs into NBFCs; (i i )Encouraging mu l t i p le sources o f equity for MFIs; (iii)Facllitating M F I s to raise debt, i nc ludmg pe rm i t t i ng MFIs to m o b h e savings, with safeguards; (iv) Deve lop ing a set of prudential norms that are m o r e appropriate to institutions serving the poor, a n d set up supervision mechanisms a round those norms. Bet ter po l i cy coord inat ion a m o n g the various government ministr ies/ department/agencies tha t cover MFI issues would also help greatly.

Attention to group quality, and the importance of financial SustainabZty S c a h g - u p microf inance in I n d i a requires attention to the quality a n d sustainabil ity of groups, their promoters, and lenders (banks or M F I s ) . A strong focus on the quali ty of SHGs by thei r NGO promoters was a key factor in the success of the SHG B a n k L inkage m o d e l in i t s pilot phase. But in recent years, growing concerns have emerged abou t group quali ty as w e l l as the abihty o f par tner banks to proper ly assess, monitor and manage risk on their SHG portfolios. Going forward, if SHG B a n k L inkage i s to b e scaled-up, NABARD a n d i t s partners face an i m p o r t a n t challenge in ensuring that high quali ty groups are created and maintained. In particular, the success a n d sustainabllity of SHG B a n k L inkage depends crucially upon a clear strategy on who will p r o m o t e n e w groups, a n d how they should b e funded. Equally, efforts need to focus on ensuring that banks p r i ce the i r loans to SHGs at rates that would cover their costs a n d ensure financial sustainabll ity o f SHG banking. Banks also need to focus m o r e on monitoring a n d managing SHG lend ing risk. Since most I n d i a n MFIs also l e n d to groups, issues related to group quali ty have a bear ing on the success of the MFI m o d e l as well.

Clear targeting of clients. Equal ly i m p o r t a n t i s the need to ensure p r o p e r targeting of clients. T h e dual pursuit of social ends a n d financial profits i s a n ongoing tension for a l l in microfinance. W h i l e our analysis of SHG B a n k L inkage indicates that the m o d e l has so far successfully targeted the poore r segments, mission drift i s a c o m m o n fear as pressures mount to serve r icher clients with larger loans (and thereby to earn h g h e r profits pe r l o a n since transactions costs p e r rupee tend to fa l l with loan size?. K e e p i n g focused on i t s target popu la t i on i s thus crit ical to the success o f microf inance in India, as elsewhere.

T h e experiences o f Bangladesh, Indonesia a n d elsewhere offers some usefu l po inters for Ind ia. There has been m u c h debate abou t how str ingently to target, a n d how best to do i t in practice. A f i r s t priority i s to clearly determine who is be ing targeted a n d define el igibl l i ty rules. In Bangladesh, Grameen and BRAC emp loy eligibll i ty rules to restr ict a t tent ion to households holding under a h a l f acre o f land. Grameen expands the def in i t ion to also exclude households with m o r e than the equivalent o f an acre’s worth o f assets. BRAC excludes households without a manua l laborer. Others, l ike Safesave, re ly on geographic targeting, restr ict ing at tent ion to specific s l u m s in Dhaka. Microf inance in Bangladesh has earned a reputat ion for maintaining a focus on w o m e n from functional ly landless households (although this has softened in practice). In Indonesia, BRI has also focused on serving the under-served, but, in contrast, it has focused on low- income households (and not jus t those b e l o w the pove r t y line) a n d most clients are men.’

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Appropriate products and services, and good statling i s critical to ensuring effectiveness. How products are designed, how staff are compensated, w h a t messages are delivered from headquarters, and who i s recruited onto staff, al l have a n i m p o r t a n t bearing on the success of microfmance. Group promoters from local communit ies are generally better able to target poo re r households. P roduc t design i s another means of targeting. L e n d i n g in groups a n d sending staff to vdlages has been credited with m u c h o f microfinance’s appeal in Bangladesh, as in India. A cri t ical but less-heralded breakthrough for Grameen was to create a l oan p r o d u c t that a l lowed borrowers to repay in small, weekly installments. This suited poor households well, since they c o u l d repay out o f the regular bits of income coming in daily or near-daily. Charg ing appropriate interest rates has also helped s tem leakage o f resources from target populat ions to those r icher or polit ically-favored. On the savings side, BRI has t r ied to encourage b r o a d access by maintaining very low minimum balances ($0.57) a n d low minimum deposits for opening accounts. N e w depositors can start a n account with 10,000 rup iah ( jus t over $l), and the n e w savings products have g iven BRI i t s most notable success in serving the poor. On the borrowing side, BRI requires borrowers to put up collateral to secure loans, but the b a n k has chosen to b e very flexible in w h a t it wdl accept, so that collateral i s not a m a j o r constraint w h e n seekmg poor clients. A survey completed in 2000, for example, shows that 88 p e r cent of non-customers h a d acceptable collateral of some sort. In order to push s t i l l further, BRI has inst i tu ted products that require no collateral a t a l l for loans up to r u p i a h 2 d o n ($225), o f fe red at the dlscret ion of the unit manager.

Inclusiveness and competition in the microfinance sector can generate high payoffs. T h e inclusiveness of SHG b a n k Linkage, w h i c h has i n v o l v e d a partnership between government, NGOs, a n d arrange o f ru ra l banks (commercial banks, R R B s , cooperative banks) has already generated a strong payoff. Fu r the r gains in terms o f outreach a n d financial sustainabil ity m a y b e reaped through involving pr ivate sector banks and MFIs in SHG Bankmg. Recent experiments indlcate good prospects for scalmg-up models that are variations of S H G Bankmg, a n d invo lve M F I s as intermediaries between S H G s and private sector banks (who w a n t to enter the market, but don’t have the b ranch network). Equally, there i s space for independent, specialtzed MFIs in the I n d i a n microf inance market that cou ld p rov ide the necessary compe t i t i on to SHG B a n k L inkage in the area of savings a n d credit provision, and also complement the services p r o v i d e d by SHG b a n k Linkage. Ev idence from elsewhere in Asia, a n d particularly from Bangladesh a n d Indonesia, suggests tha t good, reliable, responsive, long- term M F I s for the poor can go a long w a y in improving access to finance. (Morduch a n d Rutherford, 2003).

Recent studies also indicate the key r o l e that can b e played by MFIs that p rov ide composite services, given the w ide array of financial transactions (both borrowing a n d lendmg, o f t e n simultaneously, a n d at a l l levels o f income) that characterize the f inancial l i f e o f the poor (Ruthven, 2001; Patole a n d Ruthven, 2001). T h e WAS-2003 also supports h s conclusion. T h e poor are constantly borrowing, lending, saving, withdrawing, using a n d losing money, through contingencies, a n d calamities. T h e y need someone to he lp t h e m with al l these transactions. Composi te service prov iders are preferable from the v iewpo in t of reducing the n u m b e r of agencies with whom a poor household must deal, thus reducing transactions costs. Moreover , i f a composite agency has a good internal M I S , i t can use the savings history of a household as a “collateral” for loans62. Sunilarly, i f the same agency prov ides insurance for lives or livelihoods, i t wdl b e m o r e willing to give a loan. From the MFIs’ point of view, transaction costs come down as the same del ivery system can b e used, with the addi t ion of training, software a n d some staff. As discussed above, the growth of the MFI sector i s closely related to a m o r e conducive policy, legal a n d regulatory f ramework.

Similarly, use of savings history of depositors, particularly those in the postal system (114 d o n accounts), i f this i s collated and made available, could be of considerable interest and value to fmanciers.

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Overcoming geographic concentration in microfinance. Ano the r issue of concern i s that microf inance in I n d i a continues to b e skewed in i t s geographical distribution. T h e under ly ing causes for this inc lude the general malaise in the economy o f the central, eastern and north eastem states, with ve ry l i t t l e resultant demand for credit among the subsistence poor, a n d the absence (for historical reasons) o f good quality NGOs, that are wdhg to init iate microf inance programs in these states (there are a large number o f small NGOs but al l o f t h e m with l i m i t e d experience a n d outreach). (Mahajan and Ramola, 2003). Expand ing the reach o f microf inance to these areas i s not a challenge tha t can b e m e t overnight. Investments are required in areas such as watershed development, small-scale irrigation, l ivestock up gradation and forest regeneration. Unfortunately, n o n e of these are amenable to the " small, short and unsecured" nature of microcredi t loans. These require long term, lumpy publ ic investments. However , once made, they u n l o c k the potent ia l for enhancing the l ivel ihoods of d o n s of poor people, moving t h e m up from subsistence p roduc t i on to s u r p l u s p roduc t i on and thereby increasing the demand for credlt. O n e simple example o f t h i s i s the dramatic increase in the demand for credit once i r r igat ion becomes available to erstwhile rain-fed farmers. A proposal for increasing the number o f good NGOs in the lesser-served states was made by the T e n t h F i ve Year Plan Working Group on Pover ty A l lev ia t ion Programs (Planning Commission, 2002), w h c h recommended that w e l l established NGOs b e asked to set up branches in selected poor districts a n d that they b e funded for t h i s on an assured though decl ining basis for the f i rs t three to f ive years. T h e experience o f the Rashtriya G r a m i n Vikas Nidhi a n d the Rashtriya Mah i l a Kosh @MI(> in supporting hundreds of small NGOs al l over the eastern reg ion i s usefu l in this regard a n d lessons from such experience need to b e taken into account.

Attention to the demand-side. W e the impor tance o f microf inance in consumpt ion- smoothening should not b e underestimated, i t s success in buildmg up poor peoples' assets, over the m e d i u m term, would depend very m u c h on efforts h e c t e d at providmg assistance in sluUs development, technology and marke t i ng - all o f w h i c h are crit ical to ensuring that investments made by poor households reap returns a n d contr ibute to a sustained increase in incomes and improvements in ru ra l l ivelihoods.

51

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53

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Dhaka:

54

Annex 2: World Bank/NCAER Rural Finance Access Survey (2003) Summaty of Survey Methodology and Sampfing Framework

T h e survey covered 6,000 households and micro-enterprises (households that re ly on n o n - f a r m i n c o m e for m o r e than 50 per cent o f their income) in two states, AP a n d UP.

Wh_y Ap and UP? T h e choice of AP and UP as the two states in w h i c h the survey would b e conducted was based on the following considerations: i t was thought that AP, a leader in the area o f del ivering f inance to the rura l poor through microfinance, would present lessons that cou ld b e repl icated elsewhere in India. Also, AP’s fo rma l ru ra l f inance sector has undergone re fo rms in recent years, notable a m o n g w h i c h i s the adopt ion by AP of a n e w Cooperatives Law, a n d efforts by commerc ia l banks, regional ru ra l banks and credit cooperatives to p rov ide microfmance through establishing l i n k s with SHGs. Indeed, AP accounts for 55 percent o f the to ta l v o l u m e o f credit extended under the SHG-bank h k a g e program, India-wide, a n d a l i t t le over 50 percent of the to ta l n u m b e r of groups benefi t ing from t h i s p r o g r a m are located in AP. Moreover , a diversity of microf inance mode ls coexist in the state. UP, it was thought, would p rov ide a sharp contrast to AP, accounting for less than 2 percent o f the to ta l n u m b e r of SHGs benef i t ing from the SHG-l inkage p r o g r a m a n d t h e to ta l amoun t o f credit extended under the program. G i v e n that UP i s the most populous a n d a m o n g the poorest states in India, considerable at tent ion i s now be ing focused on how to i m p r o v e r u r a l access to finance in that state. Therefore, whde UP’S experience would he lp u s understand bet ter the constraints and challenges to improving ru ra l access to finance, AP’s experience would he lp highlight w h a t can b e done to overcome constraints and i m p r o v e access.

T h e sampling f ramework methodology for the survey used r a n d o m sampling techniques i nc lud ing stratif ied r a n d o m sampling. T h e sampling f ramework was formulated to select a representative sample o f 0

0

0

households (across landhold ing and occupation categories w i t h each vdlage), vdlages (geographical proximity to the nearest town a n d size o f village) a n d districts (per capita agriculture i ncome a n d p e r capita f o r m a l credit).

T h e detailed framework for each level - district, vdlage and household i s presented below.

Level Distnct

Village

Household

and per capita formal credlt for ranking villages Census data for listing o f all d a g e names and random selection o f d a g e s Secondary data o n distance f rom the nearest town and number o f households Village questionnaxe to obtam basic data o n the village

0

0

0 Listing proforma

0 Detailed survey questionnaire

0 Census information was used

0 Key informant in village was used

0 1 page sheet administered to all households in the 60 selected villages/state

administered to selected households o f each selected village.

Detai led questionnaire

56

Level Dis t r i c t

Vil lage

Househo ld

0 Two primary variables - Per Capita Agriculture Income and Per Capita Formal Credit - used t o rank all districts (UP has around 70 districts and AP has 23) i n to s i x strata for each variable. Stratified random sampling then used to select two districts f r o m each stratum. Used 1991 Census informat ion on listing o f villages and randomly select 10 villages per district. Classified villages i n to strata according t o distance from nearest t o w n (three categories: 4 0 kms , 10-25 k m s , >25 k m s ) and in terms o f number o f households (size). Selected five villages f r o m the origmally randomly selected l i s t o f 10 t o ensure a degree o f variation on both &stance and size

0

0

0

0

In each o f the selected villages a quick listing o f all households was undertaken. In each selected village, the households were stratified into nine categories that include:

Two landless categories (one who are laborers and the other w h o are micro- entrepreneurs) F ive landholding categories according t o land ho ld ing sizes T h e landholders’ category was further subdivided into two sub-categories (one those with <50 per cent dependence on non- fa rm income and the other with >50 per cent dependence o n non-farm income)

F ive households were randomly selected f r o m each stratum except the one with landless micro-entrepreneurs where 10 households were selected. Thus, a total o f 50 (8*5+10*1) households were selected fo r detailed survey f r o m each village.

12 districts pe r state

F ive villages per district; 60 d a g e s per state

Assuming on average around 200 households per village, the quick listing was for -12,000 households per state;

50 households per village are administered the detailed survey questionnaire;

A total o f 3,000 (50x60) households were administered the detailed questionnaire in each state

57

Annex 3: Summary Review o f the Performance o f Reta i l Rural Finance Inst i tut ions (RFIs) ''

Governance and Ownersl i ip Figure A.1: International Comparison of govt. owned

bank assets f%\ A distinct charactenktic of India ? banking gstem is the signzjkant extent ofstate ownership. Close to 80 p e r cent o f banlung assets are state-owned (Figure A.l) a n d m o r e than 90 pe r cent o f the outstanding ru ra l loans are accounted for by state o w n e d banks - the state o w n e d assets comprise the assets o f a l l the 27 pub l i c sector banks and the 196 I 1 R B s 6 4 , that are al l ma jo r i t y government o w n e d banks. This ownership structure dmorts bankers' incentives, affects p ruden t management a n d leaves t h e m vulnerable to the pressures of m o r a l

Philippines

Argentina

Brazil

Russia

India

0% 20% 40% 60% 80% 100%

Source: The Regulation and Supervision of Banks Around the World, Barth J, G Caprio, R Levine, 2001, World Bank

suasion. And w l d e the rura l cooperative banks have only minority gove rnmen t shareholdmg, the state continues to exercise considerable con t ro l - the state government through the Regs t ra r of Cooperative Societies, controls a l l matters relat ing to registration, membership, election, f inancial assistance, l oan ing powers, business operations, l o a n recovery a n d audi t o f cooperatives.

With the banking sector refDms initiated in 199 I, governance issues have started receiving increasing attention in commercial banks, especially with regard to the responsibhties of b o a r d of h e c t o r s , accountabhty to shareholders, criteria for selection o f independent members o f the board, size a n d composi t ion o f boards, appointments o f CEOs a n d committees of the b o a r d i nc lud ing those for audit, nominat ion, remuneration, investment. Increasingly pub l i c sector banks are raising capital from the public, w h i c h has helped i m p r o v e their corporate governance through greater shareholder part icipation.

However, cooperative banks and R R B s are lagging behind due to relative4 slower pace of adoption andlor implementation of r efoms that are undemy in the rest ofthe bankhg ystem. Addit ional ly, governance issues in cooperative banks are exacerbated by duali ty of con t ro l by state governments on the one hand, and, RBI/NABARD on the other. State con t ro l continues to m e a n that the R R B s a n d ru ra l cooperatives have to operate within the contours o f government d ik ta t a n d m a y not b e able to take decisions independently - hav ing to reduce interest rates on loans to farmers on account o f m o r a l suasion, reschedule agricultural loans, operate as channels

63 Those under the purview of the Banking Regulation Act, 1949 - these include the commercial banks, the RRBs and the StCBs and DCCBs. Together these account for almost al l the lending to and branch presence in rural areas. The 32,000 odd rural branches of the commercial banks and the R R B s are supplemented by14,OOO cooperative bank branches and 98,000 grass root level PACS. 64 R R B s ' ownership structure i s 50% central government stake, 15% by the state government and 35% belongs to the sponsor commercial bank. Of the 196 RRBs, only two R R B s have private sector banks as their sponsor bank, but are s t i l l majority owned by the government.

58

for the del ivery o f various government schemes a n d debt or interest waiver schemes65 a n d hav ing the i r elected boards being superceded,"6 are just some examples o f t h i s . These factors h inde r p roper management of ru ra l banks and reduce the attractiveness of ru ra l l endmg for these banks.

Management issues in RFIs

On-going banking sector rej%rms have accelerated the pmcesses of qualitative transfarmation of management and deplyment of technologp in commercial banks, but their mral branches as well as most RRBs and mral cooperative banks lag behind. M o r e needs to b e done for ru ra l banks in terms of training o f managers a n d s taf f for improving credi t appraisal, supervision and monitoring skdls , improving the quali ty of services p r o v i d e d to r u r a l clients as we l l as in creating the right incentive structures for ru ra l lending. Weak management systems and HR issues are most serious in cooperative banks, w h i c h lack in professionalism, and are faced with imbalances in staf fmg a n d poor quality personnel. C E O s for m a n y StCBs are o f ten government officials (rather than professionals) appointed by local state governments a n d those for the DCCBs are either govemment or StCB officials.

On the technology side, whi le the mainstream/urban commerc ia l bank ing system has seen i m p o r t a n t progress in in t roduc ing electronic banking, ATMs, electronic funds transfers, electronic clearing services, etc, r u r a l branches of commercial banks, the R R B s a n d the cooperatives are w a y b e h i n d in this regard.

Financial performance of RFIs

I n overall terms thejnancialpe$mance of R R B s and cooperative banks is quite weak; on4 the commercial banks' overalljnancialpodion can be considered satisfdctoy. However , commerc ia l banks' r u r a l operations cannot b e analyzed separately as these are subsumed in the overal l per formance o f commerc ia l banks. But as some select i n d c a t o r s on portfolio quality a n d asset composi t ion b e l o w reveal, the i r per formance on some crit ical i n d c a t o r s m a y not b e m u c h better t han that of the R R B s a n d ru ra l cooperative banks.

Capital adequacy Figure A.2: Status of Rural Banks in India

Commercial banks peform quite well on capital adequay. Capital adequacy for commercial banks was qui te comfortable at the end o f M a r c h 2003 - al l 27 publ ic sector banks, w h i c h account for m o r e than 90 per cent o f to ta l ru ra l portfolio o f al l commercial banks, have a very comfortable risk weighted capital adequacy rat io in excess of 10 p e r cent; only two banks (from amongst the smaller private banks) out of the n inety three commercial banks, have a ra t i o b e l o w 8 p e r cent.

Y 0 x

Unp.oflbb Wsr-wpitalirud Note : R R B s (196)

StCBs: (29) Figures m brackets represent total numbers of rural banks Source : RBI and NABARD

DCCBs (367)

65 Most significantly the Agriculture and Rural D e b t Relief Scheme of 1989-90 but several other subsequent schemes, including, most recently, the kharifinterest waiver in 2002-03. 66 The position at end-March 2001, was that the elected boards o f 75 o f the 367 district cooperative banks had been superceded.

59

However, the capital base of RRBs and cooperative banks is vey weak on account of sustained losses over time. (Figure A.2 67). M a n y o f these institutions continue to operate as banks despite hav ing unacceptably low, and even negative, levels o f networ th. M o r e than a quarter of RFU3s a n d DCCBs a n d a l i t t le over a fifth of StCBs h a d negative networ th. An addtt ional and significant proportion of these banks have a pos i t ive but extremely weak capital base. T h e average for a l l R R B s o f the n e t w o r t h to to ta l assets ra t i o (proxy for Capital to Risk Weighted Asset Ra t io (CRAR) w h i c h i s not c o m p u t e d at present) i s jus t 2.5 p e r cen t (despite re-capitalization by the government) a n d 4.9 pe r cent for a l l DCCBs and only StCBs with a 7.2 pe r cent ra t i o are, in aggregate, at a relatively comfor tab le position. Since these institutions68 consti tute an impor tan t pa r t in the flow o f f o r m a l sector credit in ru ra l areas, their extreme4 weak jnancialposition, especial4 that ofthe cooperative credit institutions, particular4 at the district level, is therej%re, an issue ofgreat concern.

As inadequately capitaliqed R R B s and cooperative banks continue t o operate and mobiliqe deposits, consequent4 a sigmzJicantpropoln of deposits are housed in such weak mral banks. For the R R B s , a l i t t l e m o r e than 40 per cent of total deposits was housed in weak banks (end-March 2002), whde for the r u r a l cooperative banks, the level was over 60 p e r cent (end-March 2001). W h i l e RRB and cooperative b a n k deposit liabilities are only a small proportion of the to ta l liabllities o f the larger b a n h n g system, given that these institutions account for a large percentage (60 pe r cent) o f the physical b r a n c h presence o f the bank ing system in rura l areas, perceived dtstress cou ld have m u c h larger impacts on the bank ing system than otherwise expected.

W h i l e risk to depositors in the R R l 3 s i s mi t igated on account o f their o w n e r s h p structure, deposit insurance and the financial stake of the sponsor commercial banks that themselves have a strong capital base, for the cooperatives such r isk-mit igating factors are absent.

Asset qua l i 9 and composition

Asset qual$ of WIs across the board, including commerezal banks, is weak and indicates that whatever lending that does take place is genera4 of poor qua@. Figure A .3 shows that NPL ratios are hgh for a l l categories of RFIP a n d even though the R R B s have shown improvemen t over the last f ive years, present NPL levels k m

rema in at uncomfor tab ly high levels. *m Disturbingly m u c h of the NPLs of R F I s are in the doubtful category o f classification. Reasons for poor asset quality are m a n y inc lud ing the directed nature of lending, lack of accountabil ity structures, poor management and h u m a n resource quality, weak credtt appraisal systems a n d lack of abi l i ty to enforce collateral.

Figure A.3: NPLs in RFIs - Cause for concern.. .

2aoo3

1500t

Source RBI reports and NABARD statlshcs

67 Data for R R B s i s for year ending March 2002; for cooperatives for the year ending March 2001. Since risk weighted CRAR i s not available for R R B s and rural cooperative banks (both state level, StCBs, and district level, DCCBs), networth to total assets (NW/TA ratio) has been used as a proxy measure for measure capital adequacy. The NW/TA threshold for capital adequacy for R R B s has been taken at 5% and for cooperative banks at 7.2% - the thresholds are based on the proportions o f risk weighted assets to total assets. Since R R B s ' asset composition i s majority held in investment portfolio with an expected lower risk weight, therefore, the threshold for R R B s i s lower than that for cooperatives. 68 Cooperatives and RRBs account for more than 50% of agricultural credit flow. Also, they have great branch outreach; the R R B s have around 14,000 branches, while the cooperative banks rural branch penetration i s very deep - there are 14,000 cooperative bank branches + 98,000 PACS. 69 For commercial banks, a proxy for rural asset quality has been taken as the NPL ratio on the priority sector advances o f public sector banks; the public sector banks account for more than 90% of the outstanding advances in rural areas of commercial banks.

60

I n t e m s of asset composition, the balance sheets of the cooperatives indicate clear emphasis on rztral lending; however, commercial banks and RRBs have been stead$ moving awg from rural advances and toward investments.

Figure A.4: RRBs - asset composition trends 1QQ.QX

For the W s , poor portfolio quality a n d lack o f incentives to undertake lending, have contr ibuted to increased risk aversion a n d l e d to a decl ining

P b . 0 ~

‘Ob’

4 ~ 0 7

Credi t D e p o s i t (CD) rat io hove r ing at z Q o y - ~ - ~ ~ I **‘ Ilh...-tlf~-n+rrnt.l,.c ).I a low 40 p e r cent a n d f a h g over t ime

o o y 1984- 144Q- 1991- 9442- 1 9 0 - 1444- 1441- 1446- 1497- 1441- 1949- 2QQQ- ZQQI-

40 91 92 93 9 4 45 96 47 98 99 QQ 01 Q2 with asset composi t ion skewing towards an investment dr iven portfolio (Figure A.4). Commerc ia l banks, especially in recent years, have faced a m u c h sharper declme in rural-CD ra t i o relative to overal l CD rat io - h s can b e par t ly a t t r ibuted to the poore r portfolio per formance on ru ra l loans. At present the ru ra l CD rat io stands a t 42 pe r cent decl ining f r o m a round 60 p e r cent in the mid-1980s a n d compared to an overal l level o f 54 p e r cent.

Source: NABARD

Liability composition

All R F I s in India have a h&h dependence on deposits as a funding sowce. Figure A.5 . For R R B s a n d pub l i c sector commerc ia l banks, deposits stand at m o r e than 80 p e r cent of to ta l assets a n d 90 pe r cent of to ta l debt, a n d even for the cooperative banks, the deposits to total assets ra t io exceeds 60 pe r cent for the state level banks and 65 p e r cent for the district level cooDerative banks. T h i s i s indicative o f a stable

H I

H m - c I b I c

H

Figure A.5: Deposits of RFIs - costs and simificance

Wh.FYQ1 RRBsNOP BtCRFlYOl oma2701 source o f fundmg for banks. As the figure also indicates, the cost of deposits, relative to that of - ~OSlb!rabl d S M k -C h S l Q 4 I R R B s and commerc ia l banks, i s m u c h higher for the cooperative banks a n d consequently impacts or m o r a l suasion on interest rate caps on aavances are far worse on these institutions.

Source: NABARD and RBI

Earnings quality

Overall recent earnings qualio of RRBs and commercial banks has been sati.$actoty; however, cooperative banks’pe$omance is weak. Figure A.6. Only commerc ia l banks have h a d a steady performance on earnings a n d FY2003 has seen fur ther improvements with re tu rn on assets at a round 1 p e r cent. However , t h i s i s not necessarily ref lect ive of their ru ra l operations a n d profits have been significantly dr iven by t rad ing i ncome that has been a ma jo r cont r ibutor to the operat ing profit (35 p e r cent).. For the R R B s too, whde in recent years they have showed i m p r o v e d p ro f i t abh ty , m u c h o f this i s not on account o f lending

Figure A.6: RFIs - profitability (Return on Assets. ROA’L

Source, RRB/Coop.. NABARD (RoAvg Assets), RB1:PSB data (RoTotal assets)

61

operations a n d does not represent a funahmental improvement in their lending business andjnancialpe fomance - as m u c h as 64 p e r cent o f to ta l i ncome came from sources other than advances of w h i c h 43 p e r cent was investment i ncome in FY2002. This makes the earning forecast for R R B s part icularly susceptible to market a n d interest rate risks. In fact, the low CD rat io for R R B s (hovering around 40 per cent for the last f ive years) indicates that lending has really stagnated. W h i l e the cooperative banks have h a d a lending focused approach with high C D ratios, the poor quali ty of assets a n d low financial margins have l e d to weak performance on earnings.

The continued weak earnings pe@mance of cooperative banks raises special concerns given their alrea4 weak capital base. I t i s ev ident that urgent attention to their f inancial heal th a n d management needs to b e given. T h e part icularly poor performance o f DCCBs i s of concern since in the three-tier shor t - term credit structure, DCCBs play a crucial ro le by m o b h z i n g deposits a n d channeling these funds to the grass root level PACS and a range o f other cooperatives. This i s particularly true since the analysis above would appear far worse if i t were undertaken with the application o f currently used prudent ia l norms for commerc ia l banks, m a n y of w h i c h presently do not apply to R R B s a n d cooperative banks, particularly for provisioning, income recogni t ion and capital adequacy.

R e g i o n a l and other variations

Regional and inter-bank variations are signzJZcant and indicate the additional complexities that need to be addressed in improving the pe$omance of R F I s . W e on a sector wise aggregate average basis, commerc ia l banks, R R B s a n d StCBs made profits a n d DCCBs as a w h o l e were close to break even, a high proportion o f the R R B s a n d cooperatives were loss m a k i n g - as m a n y as 15 pe r cent of R R B s (FY2002), 21 p e r cent o f StCBs a n d 32 p e r cent of DCCBs (both FY2001). Variat ions exist between RFIs across a n u m b e r of f inancial parameters across regions/states a n d these are h igh l ighted for p r o f i t a b h t y a n d capital adequacy in Figures A.7 and A.8, w h i c h clearly indicate that R F I s in the north east o f the

Figure A.7: RFI capital base across regions Figure A.8: RFI profitability across regions -

I . I X x c * 1.u

Bm%

x 5 5az I = B&L I . I X

3 . I . I X

I

"5 or. *mx 4 . I X

-%@4 . L I X

7 1 Source NABARD Stattsucs, FYOI for 7 coops, FY02 for R R B s

Source. NABARD Statlstlcs, F Y O l for coops, FY02 for R R B s Figure A.9: RRBs - variations by sponsor banks

country are m u c h worse off than those anywhere else. M o r e generally the north, south a n d western regions are better pe r fo rm ing than the other regions. For the R R B s , variat ion also exists in terms o f sponsor banks. Syndicate B a n k clearly appears to b e the most successful amongst the commerc ia l banks hav ing a stake in mul t ip le R R B s , wh i l e on the w h o l e the 30 R R B s sponsored by State B a n k o f I n d i a are under per formers (Figure A.9).

25.0% nr;r T 120.0% a 20.0%

15.0%

10.0%

5.0%

0.ox

Source: NABARD RRB Statistics, 2002

62

I n conclusion, while commercial banks’ overalljnancial position is and /age, sound, the jnancial viabilio of the mral operations ofthe RRBs and mral cooperative banks, is inherent4 weak. Adequate at tent ion to revamping urgently the operations a n d financial position o f these institutions i s critical, inc lud ing the rural operations o f commercial banks that are a hkely under-per forming segment for these banks. G i v e n the large, physical b ranch presence o f R R B s and cooperative banks in r u r a l India, their poor per formance on capital adequacy, prof i tabdi ty and asset quality i n d c a t e that there are serious issues across cri t ical f inancial parameters - systematic and drastic change in the w a y R F I s are operating needs to b e made urgently i f these institutions are to p lay an effective r o l e in the fu tu re in the provision of ru ra l f inance services.

63

A m e x 4: Apex Rural Finance Institutions

Three apex institutions are o f main relevance to ru ra l finance. These are the RBI, NABARD and S I D B I . A short summary o f the roles of each o f these institutions i s p r o v i d e d below.

lu3 1 B e i n g the central bank of the country, R B I ’ s p r imary respons ibh ty has been the management o f the country’s monetary a n d payment systems. However , start ing with the era of economic (central) p lann ing in early 1950s, RBI increased i t s focus on p r o m o t i o n a l and /o r developmental activities in the f inancial sector, using financial institutions as catalysts for supporting p l a n objectives a n d targets. T h e overal l po l i cy env i ronment inc luded admmste red resource al location at the m a c r o level, regulated interest rates, h e c t e d credit and presence of RBI a n d Go1 off icials on boards of f inancial institutions to assure po l i cy compliance and oversight.70

With the gradual implementat ion o f the financial (banking) sector re fo rms since the mid-l990s, RBI is, by a n d large, changing toward h t i n g i t s functions to tradit ional central bankmg, a l lowing retai l f inancial institutions to increasingly operate in a market-oriented, compet i t ive env i ronment backed by a regime of increasingly deregulated interest rates, supplemented by R B I ’ s enhanced prudent ia l supervision. However , in some areas, especially in ru ra l credit, the progress has been slow a n d RBI, in conjunct ion with GoI, continues to p lay a dominan t role, direct ly and/or i n h e c t l y , in policy- making, credit planning, priority sector lendtng, and regulat ing supply o f funds to NABARD.

RBI retains the responsibhty for the overal l nat ional r u r a l credit po l i cy a n d for issuing h e c t i v e s on ru ra l credit. T h e central bank, t h u s remains active in the sphere of (a) formulat ion o f r u r a l cre&t po l i cy (as p a r t o f the overal l monetary and credit policy); @) priority sector lendtng, a n d (c) in teract ion with Go1 a n d NABARD on issues concern ing ru ra l credit. As p a r t of i t s central bank ing functions, RBI i s also responsible for prudent ia l supervision o f commerc ia l banks i nc lud ing their ru ra l credit 0perations.7~ To fachtate t h i s role, RBI created a department called Rura l P lann ing a n d Credi t Depar tmen t (RPCD) with a n u m b e r o f staff a t i t s central o f f ice in M u m b a i a n d regional offices, generally one in each state. RBI staf f at the reg ional level part icipate in annual district/state level ru ra l credit p lann ing exercises done by the loca l gove rnmen t agencies a n d banks, a long with NABARD’s distr ict a n d state level staff.

However , over t ime the h e c t ro le o f the RBI in ru ra l f inance has been decl ining in relative terms part icularly after the creation o f NABARD in 1982. RBI has delegated to NABARD the responsibhty to supervise ru ra l cooperative banks a n d R R B s . R B I ’ s residuary functions include, ma in l y (a) sanctioning of a general h e of credit to NABARD (though in relative terms the impor tance of this for NABARD has been d e c h g ove r time) a n d @) m a k i n g annual allocations from profits to the two statutory funds now mainta ined by NABARD. RBI has three o f i t s own h e c t o r s (members of the RBI board) on NABARD’s board, w h i c h perhaps provides a n effective link between the RBI (as the central bank) a n d NABARD (the second tier apex bank) for requi red deliberations at the po l i cy level.

Clearly as the regulator o f the ru ra l f inance sector, the central b a n k continues to p lay a cri t ical role. Strengthening prudent ia l regulations a n d ensuring i m p r o v e d supervision part icularly o f the weak ru ra l

~

70 Established in 1935 as a shareholders’ bank, RBI was nationalized in 1948. The Reserve Bank of India Act, 1934, which was amended a number of t imes, provides for provisions that either enable Go1 to give directions to RBI or require RBI to consult with Go1 on specific matters. Go1 plays an important role, on its own and through RBI, in matters concerning rural credit policies and institutions. 7’ RBI Act, 1934 and Report o f the Agricultural Credit Review Committee, 1992.

64

cooperative banks and R R B s , facil i tating the creation o f an enabling env i ronmen t for ru ra l f inance inc lud ing improving the contract enforcement mechanism a n d fachtat ing credit i n f o r m a t i o n on ru ra l finance, improving policies related to interest rates and directed credit, regulations for MFIs, etc are a l l areas where the RBI needs to play a leading ro le going forward.

NABARD

NABARD was established in 1982 by an A c t o f Parl iament as a publ ic sector institution. I t s share capital i s cont r ibuted by RBI and GoI, currently at 73 per cent and 27 per cent of the to ta l ( R s 2,000 crores or US$435 d o n equivalent) respectively. NABARD has a nomina ted B o a r d of Di rectors compr is ing a Chairman, a Managing D i r e c t o r (both appointed by Go1 in consultat ion with RBI) a n d representatives from the RBI, GoI, state governments and other directors nomina ted by GoI. NABARD has three main functions: (a) inst i tut ional development; (b) credit provision; a n d (c) supervision.

T h e inst i tu t ional development functions include development a n d implementat ion o f ru ra l credit po l i cy with a focus on integrated rura l development a n d related training, research a n d consultancy/ - . advocacy. T h e credit function pr imar i ly covers re f inancing of co-operatives, R R B s and commerc ia l banks - the credit includes short, m e d i u m a n d long t e r m loans for agriculture; ref inancing for S H G - b a n k linkage, p roduc t i on and market ing credit, etc. NABARD can also make direct loans but currently t h i s window i s h t e d to loans p rov ided to state governments for ru ra l development and ru ra l infrastructure creation w h i c h i s f inanced through commercial banks' deposits with NABARD to the Source : NABAFD data

extent o f their shortfal l in meeung tne manaatea priority sector lending target o f 1 8 p e r cent of n e t b a n k credit for agriculture (see Table A. l for amounts ref lected against the R u r a l In f rast ructure Deve lopmen t Fund, RIDE). Addit ional ly, NABARD prov ides technical assistance a n d advice on ru ra l credit po l icy a n d inst i tut ional issues to GoI, state governments, loca l govemments, m ic ro - finance inst i tut ions a n d Self-Help Groups (SHGs).

As for supervision, by powers delegated by RBI, NABARD does on-site a n d off-si te survedlance o f short t e r m cooperative credit banks a n d RRBs. Besides this, NABARD undertakes supervision of the long t e r m cooperative banks on a vo luntary basis in i t s capacity as a m a j o r subscriber to their debenture portfol io. In 1999, NABARD established a n independent B o a r d of Supervision (BoS) for cooperative banks and R R B s to p rov ide guidance a n d d i rect ion on matters re la t ing to supervision.

65

This i s consistent with a s d a r init iat ive taken by RBI in setting up a B o a r d of F inancia l Supervision (BFS) in 1994 following the recommendat ion of the Naras imham Commi t tee I. In practice, under i t s delegated authority, NABARD sends al l supervision reports to the RBI as t h s continues to b e the regulatory author i ty a n d regulatory follow-up actions based on these repor ts are taken with R B I ’ s concurrence.

Clearly g iven NABARD’s mandate, i t s ro le in rura l f inance i s cr i t ical a n d a lot of the credit for the development o f this sector, the increase in the scale of the SHG-bank h k a g e program, etc, can b e at t r ibuted to NABARD. Nonetheless, going fo rward in addi t ion to the challenges to sus ta in the per formance o f the w e l l pe r fo rm ing init iatives (I<CCs, S H G - b a n k h k a g e , etc), there are certain issues that need consideration. NABARD’s ro le as the supervisor of the ru ra l cooperatives a n d R R B s (delegated by the RBI) as w e l l as a development and ref inancing agency to these institutions creates a potent ia l c o n f i c t o f interest. To the extent that i t s ref inancing r o l e m a y face a natura l decline in demand in a general f a h n g interest rate, this issue m a y w e l l b e addressed on i t s own in course of time, even though i t would mean that NABARD d need to explore other sources o f revenue generation. However , Naras imham Commit tee I1 suggested that over the longer term, a l l regulatory and supervisory functions over ru ra l credit institutions shou ld vest with R B I ’ s BFS. Therefore, the issue o f integration o f the B o a r d o f Supervision set up by NABARD with the B F S set up by RBI needs to b e explored further.

In the interim, NABARD needs to strengthen i t s supervisory functions fur ther even wh i l e mak ing i t s refinancing e l ig ibhty conditions72 stronger and l i nked clearly to the bank‘s a b h t y to service the debt ( including specific consideration to the bank‘s CRAR). In the interests o f not causing a sudden, large dip in ground level credit flow, the condit ions for ref inancing cou ld perhaps b e made m o r e stringent in a phased manner. Using an appropriately designed a n d balanced ‘carrot a n d stick‘ approach i s cr i t ical since i t prov ides signals to ru ra l banks o f the need to have a strong balance sheet to quali fy for the ref inancing from NABARD particularly in the context that the biggest challenge con f ron t i ng NABARD i s the weak financial position of the ru ra l cooperatives a n d R R B s tha t i t supervises a n d finances.

T h e institution also needs to rev iew i t s ro le in financing projects against gove rnmen t guarantees or lending to state governments with a charge on their fiscal resources (under R u r a l Infrastructure Deve lopmen t Fund, RIDF) - such f inanc ing needs c o u l d b e under taken but only for those cases where the under ly ing f inancing i s a financially viable proposition. Al ready there are beginning to b e instances where despite such arrangements, state govemments express inabl l i ty to service their debt to NABARD.

Also, in terms of i t s own capital structure, NABARD’s strong balance sheet (Table A. l above) can perhaps b e used to leverage greater marke t based fund-raising. Further, NABARD can also play an impor tan t ro le in creating a n enabling env i ronment for ru ra l finance. Init iat ives cou ld b e strengthened in supporting ru ra l banks in contract enforcement, faci l i tat ing i m p r o v e d credit i n fo rma t ion on ru ra l clients, fachtat ing technical inputs a n d capacity budding of r u r a l banks (utilizing i t s existing grant resources for such purposes), working with state a n d central govemments to ensure provision o f a conducive po l i cy f ramework for ru ra l f inance (avoidance of interest waivers, not a l lowing cooperatives to b e fo rced to b e used as channels for gove rnmen t schemes/Public Distribution System (PDS) without adequate margms) a n d working with regulators to w iden the scope o f business a n d fachtate n e w h e s o f businesses for ru ra l banks (bancassurance, SHG-bank

72 Presently applicable eligibility conditions are weak Fo r cooperative banks, if recovery i s more than 50% of demand in the previous year and the bank has a non-overdue portfol io equivalent t o the sue o f the refinancing f r o m NABARD (the latter condition does n o t mean much since loans are often rescheduled), refinancing can be extended. Further, even those cooperative banks that have eroded deposits less than SO%, are eligible for refinancing. For R R B s , a deposit erosion level o f 3O0/o, i s acceptable.

66

linkage, franchisees of publ ic and private sector banks, etc) thereby improving on the u t h z a t i o n o f the vast b a n k m g infrastructure already prevalent in the country.

SIDBI

A n o t h e r f inancial institution o f relevance to the r u r a l sector i s the Small Industr ies D e v e l o p m e n t B a n k (SIDBI), w h i c h was established by a 1989 A c t of Parl iament to func t i on as the pr inc ipa l financial institution for the promotion, f inancing a n d development of industry in the small-scale sector a n d to coordinate the functions of institutions engaged in s d a r activities. SIDBI ’s r o l e in ru ra l f inance i s most p rominen t in terms of the m i c r o finance sector, where the agency has been t a h n g a leadmg ro le in supporting the scaling up of m i c r o finance institutions ( M F I s ) through l e n d m g a n d capacity building efforts.

SIDBI ’s ro le in ru ra l f inance i s thus, particularly i m p o r t a n t from the point o f v i e w of i t s support to MFIs. In h s field, S I D B I can perhaps play a significant r o l e in terms o f acting as a catalyst to facilitate a n enabling regulatory env i ronment that prov ides the foundat ion for sustained growth o f MFIs. T h e areas where MFIs have expressed the need for regulatory changes are l is ted in A n n e x 5. In this regard, as a leadmg apex financier for MFIs, S I D B I needs to fur ther i t s role, perhaps in con junc t i on with MFI networks, to pre-empt any knee jerk regulatory reaction part icularly in case there i s any instance o f rura l poor clients losing their deposits by the odd, unscrupulous MFI. Moreover , SIDBI ’s ro le in fostering innovation, n e w technology, c rowd ing in private sector f inanc ing to M F I s has been impor tan t and i t needs to pursue these areas even m o r e in the future, to he lp increase the sustained growth of MFIs in the country. This growth o f MFIs i s impor tant , if for nothing else, t hen for serving as a demonstrat ion m o d e l for f o r m a l sector r u r a l banks, on how n e w a n d innovat ive approaches can b e used to address some of the key problems that banks face in r u r a l credit, that is, o f i n fo rma t ion asymmetry, transaction costs, contract enforcement a n d recovery. S IDBI ’ s ro le can also b e strengthened to address the needs of NGOs transforming into MFI-NBFCs in terms o f i n t roduc ing n e w financial instruments i nc lud ing equity capital and sub-ordinate deb t for MFIs. O n e other area, where SIDBI cou ld play a r o l e i s in terms o f con t r i bu t i ng to the creation of credit i n fo rma t ion on m i c r o finance clients, using i t s base o f NGO/MFI partners to develop the database.

67

Annex 5: Summary of recommendations of recent government committees on formal RFI reforins

1 i ts strengthening, 2000

Capoor Committee: Task Force to stu& the cooperative credit y tem and sagest measaresfor

Stlmma y of k :e_y recommendations/ observations

a

a

a

a

0

a

a

a

0

a

a

a

a

Cooperatives should b e al lowed to funct ion as member dr iven enterprises with minimum government con t ro l or interference

Imp lemen ta t i on of M o d e l A c t by a l l state govemments

H u m a n resource development in cooperatives inc lud ing objective a n d transparent policies for recru i tment o f staff, no appointment o f government officers as CEOs Professionalism in cooperative banks; need for professionals in the b o a r d a n d to consider doing away with caderization within cooperatives wherever t h i s i s not effective; a l lowing DCCBs with good deposit base to have their own staff; audit a l l levels by professional chartered accountants

N e e d to remove overlapping o f controls, eliminate duality o f con t ro l a n d m a k e the central b a n k con t ro l and regulate al l b a n b n g functions

Allow cooperative banks to diversify their businesses inc lud ing explor ing avenues for housing loans, consumer loans, f inancing of services sector, distribution of insurance products

Enab le f inancing to cooperatives such that their lending operations have suff icient margins a n d ensure that no un-remunerative business i s thrust upon cooperatives

D e v e l o p and facilitate funds management s k l l l s amongst cooperative banks a n d reduce the ro le and need to seek the permiss ion o f the regs t ra r o f cooperatives for m a k m g investments

Delayer ing cooperative banks: W h i l e the three-tier system maybe requi red in the future, re- organizing, restructuring wherever necessary should b e undertaken to make the entire system a viable one; consider m e r g m g the short and long t e r m cooperative structures into o n e

Phased compliance with capital adequacy n o r m s for cooperative banks

Recovery management: Avoid l o a n waivers announced by governments; a l l ow provisions of DRT to apply to cooperative banks; a l low foreclosure o f mortgages by p r i m a r y cooperative banks for willful defaulters

Rehabh ta t i on package for cooperative banks, not across the board, but for those with potent ia l to func t i on as viable units - revital izat ion to cover financial, operational: organizational a n d systemic aspects; establishment o f a cooperative development fund at NABARD by an in i t ia l con t r i bu t i on o f Rs 500 crores by the Go1 Funding mechanism to revive cooperative banks should b e f i r m e d up only subject to states takmg steps to ensure e h a t i o n of duality of control; share of central a n d state governments m a y b e in the form of bonds issued in favor o f DCCBs bearing a reasonable rate of interest

68

2 200 I

Patil Committee: Joint Committee on ReuitaLiTation Sqbport to Cooperative Credit Stmcture,

Summa y of ky recommenhtionslobsewations

Agreed with the Capoor Commit tee on the need for revital izat ion assistance

Pat tern o f sharing funding assistance to b e between Go1 a n d state govemments in the rat io o f 60:40 (except for the north east a n d J&I< where the rat io cou ld b e 9O: lO) Form o f funding suggested was bonds, as in the Capoor Commi t tee

Selectivity o f states and institutions suggested, rather than a n across the b o a r d revital izat ion package; condi t ions for the state governments included, c o m m i t m e n t to abolish cadre system, au tonomy to cooperative institutions, adopt ion of the M o d e l Cooperative A c t a n d removal of dual i ty o f control, audit by professional chartered accountants a n d transparent HRD policies; condi t ions for the institutions inc luded viable functioning, c o m m i t m e n t to enhance value of the shares a n d undertake t imely audits, de-regulations o f interest rates a n d fair share of margms between d i f ferent tiers, grass root level business planning, improving systems a n d rat ional izat ion o f procedures

Establ ishment o f a national level commit tee for monitoring per formance o f cooperatives

De-layering o f cooperatives but mak tng t h i s forced

Support for sett ing up a cooperative development fund at NABARD for inst i tut ional strengthening measures

3 Vyas Committee: Expert Committee on Rzlral Credit, 200 I

Summay of k y recommenhtions/obsewations

0

0

0

0

0

Adopt m o d e l cooperative act in al l states and make the B a n k i n g Regulat ion A c t applicable to cooperatives

Go1 to support revital izat ion o f cooperatives and RRJ3s Restore health of the PACS par t ly by doing away with the cadre system

Selective de-layering o f the short t e r m cooperative structure a n d in tegrat ion of the long a n d short te rm structures T ra in ing o f cooperative bank staff, study on h u m a n resource requirements for cooperatives

R R B s without accumulated losses should b e recognized as LABS With regard to government schemes, emphasis should b e on using groups as channels but efforts at ensuring group quali ty are cri t ical

Efforts at rura l n o n - f a r m sector f inanc ing should b e encouraged

69

4 Rao Committee: Working Gmup to sugest Amendments i n RRB Act, 2002

Szimmay of& recommendutions/obseruations

W i d e n scope of financial services to b e p rov ided by R R B s Capital adequacy norms, with due adaptation, needs to b e in t roduced in R R B s in a phased manner Based on f inancial health o f R R B s , dif ferentiated o w n e r s h p structures should b e a l lowed Prescribed minimum level o f shareholdmg should b e at 51 p e r cent for sponsor institutions

T h e area o f operation o f R R B s need to b e extended to cover a l l districts o f uncovered s tates/union territories K e e p i n g in v i e w the regional character and dist inct socio-economic ident i ty o f issues, R R B s f a k n g in one socio-economic zone m a y b e amalgamated so as to create one or a f e w R R B s in each State R R B s m a y have a minimum of f ive and a m a x i m u m o f eleven B o a r d members, i nc lud ing the Chairman. T h e n u m b e r o f Di rectors m a y not b e f i xed uniformly for a l l R R B s as at present As par t o f consolidation process, some sponsor banks m a y b e eased out a n d some FIs a n d other strategic m a n a p g partners m a y take over as sponsor institutions T h e regulatory f ramework for R R B s must b e on the l ines of those for commerc ia l banks with provision for such bank-specific relaxations as m a y b e necessary for specific t i m e period; R R B s m a y also b e subjected to the statutory norms o f l icensing a n d each RRB should b e requi red to obtain a license from the Reserve B a n k under the provisions of the B a n k m g Regulat ion Act , 1949 withm a specific t ime period; Half-yearly f inancial audi t m a y b e in t roduced in the R R B s R R B s m a y avail of a l l the services of their sponsor banks / institution or other established a n d authorized pub l i c sector portfolio management service providers based on their own judgement o f costs a n d benefits for professional izat ion of the investment func t i on for achieving op t i ona l returns on the bank's resources

Source: Adapted from RBI, Report on Trend and Progress of Banking in India, 2002-03

70

Annex 621: Regulation of rural banking - select international references

Economy I Australia

Canada r General financial system regulator x7 A

X

Specific regulation

X

Fragmented regulation

X

X

L Source: Adapted from - APEC, 2002 ‘Microbanking Development, Regulation and Sy Outlook, Singapore: Asia Pacific Economic Cooperation Secratariat

Comments

Since 1999, credit unions hare he ld the same license as banks and are subject t o the same single set o f flexible prudential standards fo r al l deposit takers Regulation o f credit unions involves pr imari ly provincial governments, although the federal government charters and regulates the Credi t Union Central o f Canada. T h e legislative and regulatory f ramework fo r these intermediaries generally parallels that o f federal financial institutions, such as banks E a c h type of microbanking intermediary i s regulated by i t s own specific law, the General Bank ing L a w and the General Cooperatives L a w All financial institutions are regulated by the central bank, but specific features apply depending upon the intermediary Commercial and ru ra l banks are regulated under the Bank ing A c t o f 1992. However, Rura l Fund and Credit Institutions (LKDPs) fal l under sub- national jurisdiction, wh i le Savings and L o a n Cooperatives are regulated by the M i n i s t r y o f Cooperatives and Small Enterprises Each type o f mic robank ing intermediaq i s regulated by i t s own specific law, witk commercial banks fall ing under tht General Bank ing A c t Fo l low ing the enactment o f the Popular Savings and Credi t L a w in 2001, practically all deposit taking institutions fal l under the same regulatory framework

jlon’, Chapter 2 o f 2002 APEC Economic

71

h n e x 613: Supervision of rural banking - select international references

Economy

Australia

Canada

Chile

People’s Republic of

China

Indonesia

Korea

Mex ico

Source: Adapi

Direct by the same

Institution that supervises the entire banking

system Australian Prudential Regulatory Authority

~

Superintendency o f Bank ing and Financial Institutions

People’s Bank o f China

Bank o f Indonesia(B1)

Financial supervisory Commission Nat iona l Bankmg and Securities Commission (NBSC)

I f rom - APEC, 2002 ‘b

Department o f Cooperatives of the M i n i s t r y o f Commerce

State Ministry fo r Cooperatives and Small Enterprises(Savings and Loans Cooperatives)

robanking Development, Reg

Federation o f Saving and L o a n Cooperatives (FECRECOOP)

Bank Rakyat Indonesia

Federations

ation and Supervision

Zredit unions h o l d the same icense and are supervised on the same basis as banks.

A l l credit unions are provincially ncorporated. Consequently, the sdustry i s almost exclusively regulated and supervised at the provincial level. T h e federal government does, however, play a regulatory role in the credit union movement through some o f the centrals. T h e national central i s chartered and regulated by the federal government . The Depar tment o f Cooperatives o f the & s t y o f Economy, wh ich supervises small saving and loan cooperatives, has delegated some o f i t s functions t o the FECRECOOP. Supervision i s done through separate departments.

Bank o f Indonesia (central bank) supervises commercial banks and mos t o f the rural banks. However, some smaller scale rural banks are supervised by BRI o n behal f o f the Central Bank.

Federations may group two types o f intermediaries: cooperative savings and loans societies and popular f inancial societies.

:hapter 2 of 2002 APEC Economic Outlook, Singapore: Asia Pacific Economic Cooperation Secratariat

72

Annex 7: Rural banking crises and policy reform - Recent international experiences

K o r e a

M e x i c o

P e r u

Chinese Ta ipe i

Tha i l and

Source: Adapted f rom - APEC Outlook, Singapore: Asia Pacif

M u t u a l savings and Finance Companies, City Banks

Savings and L o a n Cooperatives

Cajas Rurales and E D P Y M E S

Credlt Cooperatives a n d Credl t Depar tments of Farmers a n d Fishermen’s Associations (PAS)

B a n k for Agr icu l ture a n d Agr icu l tura l Cooperatives (BAAC) a n d Cooperatives

Author i t ies fostered ex i t a n d mergers as p a r t of an overal l po l i cy for the domestic f inancial sector following the 1997 crisis In 1999-2000 b a d management practices in - some non-regulated cooperatives fo rced the government to intervene to avo id a massive run against these institutions O v e r the past f e w years, p rob lems associated with poor risk management a n d lack of technical capacity l e d authorit ies to intervene, fo rc ing in some cases mergers amongst intermedlaries Cronyism a n d poor risk evaluation affected the sector; leadmg to a hgh non- p e r f o r m i n g l o a n ra t i o a n d poor portfolio quality. As a result, authorit ies have imp lemen ted broader re fo rms a imed at t ransforming credit cooperatives into commerc ia l banks a n d FAs into c o m m e r c i a l / a g r i c u l t a l banks In the aftermath o f the 1997 crisis, BAAC faced a crit ically low capital adequacy rate fo rc ing the government to in ject m o r e capital. Thai cooperatives were also affected by h s crisis, a l though less than 1 Der cent faced bankruDtcv

002 ‘Microbanking Development, Regulation and Supervision’, Chapter 2 o f 2002 APEC Economic Economic Cooperation Secratariat

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Annex 8: Enabling framework for MFIs - demands from the sector

Reducing minimum start-up capital requirements to furilitute the transfomation of MFIs into NBFCs. At present, t he minimum start-up capital requirement for registering as an NBFC in I n d i a i s hgh ( R s 20 d o n , or US$444,000), beyond the reach o f most MFIs. MFI representatives argue that these requirements should b e relaxed for MFI-NBFCs. In Indonesia, for instance, the comparable minimum capital requirement ranges from US$58,000 to US$232,000. In the Phil ippines, the low start-up minimum capital requirement for ru ra l banks i s between US$68,000-170,000; this has p r o m p t e d the conversion o f m a n y erstwhde microf inance NGOs into ru ra l banks.

Encouraging multiple sources of equig for MFIs. M F I s argue that they have p rob lems raising equity because (i) NGOs are not al lowed to invest in MFI equity, because of the charitable status of NGOs u n d e r the Section 11 a n d 12 of the I n c o m e T a x Act; a n d (ii) the minimum amoun t for equity investment by foreign donors, development finance institutions a n d non-resident Ind ians in an MFI i s far too high ($ 500,000) for most recipients, since foreign equi ty cannot b e m o r e than 51 p e r cent of to ta l equity, and raising 500,000 in foreign equity requires the recipient MFI to raise an equal amoun t (almost Rs 23 d o n ) from India. MFI advocates argue that these problems c o u l d b e addressed through, in ter alia, (i) al lowing NGOs to invest in MFIs (under Section 11 (4)(.ii) of the IT Act); (ii) lower ing the minimum local equity con t r i bu t i on in the event a n MFI raises equity funds from foreign donors, development finance institutions or non- resident Indians.

Facilitating MFIs t o raise debt,. W h i l e I n d i a n banks have been lend ing m o r e easily to MFIs than earlier, the supply i s s t d l h t e d . Moreover , untd 2002, a n u m b e r of fore ign donors and development finance institutions were l endmg m o n e y to MFIs under the R B I ’ s Ex te rna l Commerc ia l Borrowing (ECB) scheme, w h c h h a d been considerably s impl i f ied by the RBI over the years. However , in 2002, the RBI stopped a l lowing MFIs to raise funds through the ECB rou te as also from donor agencies. MFI representatives argue that RBI should consider a l lowing N G O - M F I s access to ECB, p r o v i d e d they mee t certain pre-agreed criteria.

Pemitting MFIJ to mobiliye Jauings, with sajguardr. Arguments for a l lowing M F I s to m o b h e deposits, a t least from their members, center on the impor tance attached to savings by poor households, a n d also on the need for MFIs to m o b h e deposits in order to acheve financial sustainabdtty. I t i s argued that borrowing cannot b e the sole source of funds for lendmg. W h i l e recognizing R B I ’ s concerns abou t a l lowing deposit t a h n g by loosely regulated entities, advocates of MFIs argue that deposit t akmg by MFIs can b e a l lowed i f appropriate safeguards are put in place. For example, deposit tak ing by MFIs can b e con f ined to the i r borrowers, a n d an appropriate level o f SLR imposed.

MFI representatives have also made the case that the regulator, jointly with the MFIs, c o u l d consider developing a set of prudent ia l norms that are m o r e appropriate to institutions serving the poor, and set up supervision mechanisms a round those.73 T h e case has also been made that, given the need for, and benefits of, composi te microf inance inst i tu t ions that p rov ide credit, savings, insurance, a n d other services, regulators should examine the po ten t i a l benefits o f a Microf inance Services Act, w h c h would recognize the composi te a n d special needs o f the poor and o f institutions serving them. Experience from around the world suggests that since microfinanciers are not monol i th ic , imposing regulatory standards a n d procedures where n o n e

73There are many examples indicating that the conventional wisdom of financial sector regulation i s not always right for the good of the majority. For a case study on the experience of the Bank for Agriculture and Agricultural Credit (BAAC) in Thailand, see Townsend and Yaron (2002).

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are cal led could constrain growth, a n d that regulat ion o f the sector s h o u l d b e f lexible a n d w e l l ta i lored (World Bank, 2003).

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