Chapter 1 Introduction to Rural Credit

Rural credit is any type of lending program or line of credit that is aimed at impacting a rural population in some manner. There are banks and cooperatives that specialize in extending this type of credit to farmers and others engaged in the agricultural task. Depending on the nature of the organization, credit plans may focus on providing mortgage assistance, securing new equipment, or even funds to support research into various aspects of land development within a rural community. Individuals have access to rural credit options under certain circumstances. For example, novice farmers and ranchers may be granted a loan or line of credit to manage the acquisition and upgrade of an existing farm operation, or the establishment of a new one. Farmers and ranchers are sometimes extended credit of this type when some sort of natural disaster has ruined crops and threatens the ongoing operation of the ranch or farm. Some lenders specialize in farm loans that offer highly competitive fixed and variable mortgage rates which make it possible to refinance a farming operation for the purpose of acquiring new machinery or meet some other pressing need relevant to the operation. Businesses can also secure rural credit under specific situations. This includes the acquisition or establishment of a commercial farming operation, or a commercial ranch. A business may also obtain funds earmarked for development, assuming that the project concerned will benefit the rural community where it is based.

In many countries, rural credit is extended under the auspices of national government programs. Often, these programs are focused on enhancing the agricultural effort within the country as a means of bolstering the economy. With government sponsorship, farmers and ranchers can often obtain resources that make it possible to sustain their productivity through growing seasons, than repay the loans once livestock and crops are sold. It is not unusual for rural credit of this type to be extended as a means of keeping a balance between imports and exports, by assuring that a certain percentage of crops and other rural products are produced domestically. Along with government funded programs, rural credit is sometimes obtained from organizations that are founded by and for farmers, ranchers, and dairy operators. Local cooperatives often provide much-needed credit to farmers and others, allowing them to receive what they need to operate their farms, effectively running a tab until the current round of crops are sold. Banks created to assist rural communities will often underwrite loans that can be used for everything from building improvements to purchasing large quantities of seeds or other elements required to produce a substantial crop. As with any type of credit option, anyone who wishes to obtain rural credit must meet the basic criteria of the lender, and demonstrate a reasonable ability to repay the amount of the loan or the funds borrowed on a line of credit.

Agricultural Credit:Agricultural credit is a financial term that refers to loans and other types of credit extended for agricultural purposes. Many regions have agricultural credit systems that promote the expansion and continued survival of farm & livestock operations. In some cases, agricultural credit can be used by farmers to purchase non-farm items, such as housing and infrastructure. Providing food is one of the major pursuits of any successful country; a country that cannot feed itself is eternally dependent on external sources which may cost more and may plunge a region further into debt. In recognition of the valuable and critical work done in the agricultural industry, many governments oversee special credit divisions that deal solely with farming and related pursuits. India, Russia, most European nations, Canada, and the United States all have long histories with agricultural credit systems. Depending on the region, there are several different types of agricultural credit available. Some loans are geared specifically toward new farmers and ranchers that are opening a new farming business and need start-up capital for land, supplies, and wages. Others are meant for established agricultural businesses that are looking to expand on the present level of operations. Some agricultural credit loans are emergency loans extended after natural disasters to help make fast repairs and restore a farm or ranch to operating conditions. Loans may also be available to young farmers, or those considered socially disadvantaged due to racial or gender prejudice. There are necessary requirements that must be met for agricultural credit extension, just as with any loan. Borrowers agree to a repayment length, must make regularly scheduled payments, and usually pay an interest rate on the loan. Since these credit programs exist to help farmers continue to grow and succeed and are
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usually in the interest of the region, interest rates on agricultural loans may be lower than on loans from private banks. Information and forms for agricultural credit application can usually be found on government agricultural websites. In the days of an expanding global community, many non-profit and government organizations are attempting to spread the idea of agricultural credit to developing nations. By helping a poor nation improve farming and infrastructure, starvation levels may go down, employment rates may increase, and developing regions may become more self-sufficient. Often, these subsidies and loans come with certain requirements, such as adherence to labor practices and environmental standards. Some non-profits have even set up programs known as micro loans, which allow wealthier donors to loan a specific amount of money to a farmer in a developing nation for a short period of time.

Evolution of the Rural Credit System in India:-

Rural financial market development is a complex process .The creation of the formal credit structure for financial agriculture and other rural activities commenced in India in the early part of this century with the introduction of cooperatives. It received a big push during the plan era. The All India Rural Credit Survey Committee (AIRCS) 1954 forms the edifice for the policy towards the development of the Institutional credit structures. The committee highlighted the awful inadequacy in the supply of institutional credit to the rural sector and proposed an integrated scheme of reorganization many more committees and recommendations. Priority sector lending, lead bank scheme, services area approach, setting up of NABARD, are some of the outcomes of the repeated scrutiny of the system.
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Coming to the recent committees, the Agriculture Credit Review Committee (ACRC) 1989 examined the existing rural credit system in detail. It highlighted the yawning gap between income generated and costs incurred by rural credit institutions, necessitating external assistance. The committee recommended greater autonomy for commercial banks; the weakness of RRBs were seen as endemic to the system with non-viability built into them. Co-operatives were sought to be strengthened through thrust on deposit mobilization and reduction of political interference. The Narsimham Committee on Financial Sector Reforms 1991, among other things, recommended a redefinition of priority sector, gradual phasing out of directed credit programmes to 10% of aggregate bank credit and deregulation of interest rates. Looking at the situation today, the exercise seems to have resulted in a scenario where "an imposing superstructure of credit institutions has been built which one committee after another has kept reshuffling or adding to" (Dandekar, 1993). Commenting broadly on the exercise in developing countries (to which the India experience seems to be no exception), Braveman and Guasch, 1986, see most of the changes in institutional design as largely superficial, window dressing type rather than substantial. "The institutions have been perceived more like a welfare agency than a commercial undertaking. There seems to be little effort to integrate deposit taking activities or to generate saving mobilization-a vital activity for the long run success of a credit institution. No provisions were made to deal with noncompliance, or to implement a reasonable system of incentives to both lenders and borrowers to induce the desired objectives." The major problems of the rural credit system thus evolved are as follows:

1.

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

quality of the flow of credit. 2. It is afflicted by alarming high overdue, bad debts, loan defaults,

unavailability, low profitability, overburdening of staff, declining control and deteriorating customer services. It is estimated that the over dues of credit institutions have increased from Rs. 2,818 crores to Rs. 9,661 crores during 198393. 3. The complex tiring of funds through RBI-NABARD-Commercial Banks-

State Cooperative Banks (SCBs)-District Co-operative Banks (DCBs)-Primary Agricultural Credit Societies (PACS), has tended to unduly increase the cost of banking. 4. Features of rural credit markets in developing countries may be understood

as responses to the problems of adverse selection, moral hazard and enforcement. Imperfect information in this sense creates problems from the perspective of constrained Pareto efficiency. In Indian case too, information imperfections have contributed to inefficiencies like high transaction costs and low recycling of credit. 5. From the institutional perspective, role of an appropriate institution as an

enforcer and transmitter of incentives and motivator and inducer of saving is essential for development. The institutional design should serve to promote and facilitate functioning at the levels of both the leaders and borrowers. This factor seems to have been largely overlooked in the Indian case. Motivating to perform has not been given due importance. 6. Directed credit program and subsidized lending have badly affected viable

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

characterized by tiring of funds from above to borrowers who often tale as a gift that need not be returned.

Chapter 2 Rural financial services

PURPOSE The purpose of this chapter is to examine the particular features of rural financial services that need to be considered in deciding what forms of, and approaches to, decentralization may be appropriate. KEY POINTS

Credit is a private good but the fact that it involves an exchange of access to resources now for an undertaking to repay in the future makes it different to other services. This generates screening, incentives and enforcement problems for those supplying loans.

Centralized and directed credit provision was based on the misconceptions that the priority need for rural borrowers was to finance agricultural production and that farmers were too poor to pay market rates for credit.

The new paradigm advocates the development of rural financial systems and the decentralization of rural credit provision through a variety of institutional and organizational devices.

An important policy setting and regulatory and promotional role remains for central government.

The most far-reaching objective of decentralization of rural financial services is to mobilize the potential of rural financial markets.
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The nature of rural financial services The risks of credit provision Rural financial services are nowadays concerned with a variety of services including not only agricultural lending but lending to farm households for nonagricultural production and consumption purposes, loans made to non-farm rural firms, rural savings deposit services and other financial services such as insurance. However, this Chapter mainly focuses on the provision of agricultural credit. Broadly speaking, the provision of credit in the form of loans allows uneven income and expenditure streams to be smoothed out. Credit provision is a private good as it is excludable and rivalrous. However, it is a different type of service to others discussed in this Sourcebook as a loan involves an exchange of access to resources now for an undertaking to repay at some future date. In effect, a property right in current consumption is exchanged for a property right in future consumption. From the lenders point of view this involves two risks, namely, that the borrower will be unable to repay (the use made of the funds is less productive than anticipated perhaps due to unfavorable weather or lower market prices) or that they will be unwilling to repay (opportunistic behavior due to asymmetric information). In total, the lending activity entails: a. Exchange of consumption today for consumption in a latter period b. Protection against default risk

c. Information acquisition regarding characteristics of loan applicants (the screening problem) d. Measures to ensure that borrowers take those actions that make repayment more likely (the incentives problem) e. Actions to increase the likelihood of repayment by borrowers who are able to do so (the enforcement problem). This risk of non-repayment means that the private sector is usually unwilling to provide credit unless collateral is available or the lender has particular ties to the borrower. The high transaction costs associated with imperfect information (search, monitoring and enforcement), and risk, increase the costs of credit transactions and lower the effective demand. The dispersed nature of rural populations increases the transaction costs of servicing rural areas compared to urban areas for many credit providers. In principle, the government should be a more willing lender than the private sector as it is less risk-averse and has greater powers of coercion and hence ability to obtain repayment. However, it is generally disadvantaged relative to the private sector in terms of local knowledge and loyalty from borrowers, leaving it exposed to an adverse selection problem and unwillingness by borrowers to repay loans. The demand for and supply of rural financial services The effective demand for rural credit Many of the problems relating to rural financial services have derived from a misunderstanding of the nature of the effective demand for these services. The first misconception was that farmers and other rural dwellers mainly needed credit for
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agricultural production purposes. In fact, an effective demand for credit, backed up by a willingness and ability to pay, can exist to smooth out a variety of situations where income and consumption streams are poorly phased. Credit for nonagricultural purposes may be as important as agricultural loans. Indeed, for many rural dwellers the most important reason for demanding credit is as a consumption loan to meet the costs of living in the months before the next harvest is due, not to purchase inputs to raise agricultural productivity. The second misconception was that the majority of poor farmers were too poor to pay for credit, which is, there was a need for credit but little effective demand. The evidence now is that poor households are both willing and able to service loans if they borrow for their own perceived needs and are adequately screened and monitored. The paradigm of directed credit provision These misconceptions led to agricultural credit policies during the 1960s and 1970s that were based on a paradigm summarized in. The policy implications of the paradigm were that:

It was the function of the central government (normally of the Ministry of Agriculture, or those acting on delegated authority to government-owned financial institutions) to decide: - What farmers should do with credit? - What the cost of credit to rural borrowers should be - Who should actually benefit from the loans? - What the total amount of agricultural credit should be.

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It was the central government function to provide: - Savings mobilization mechanisms in rural areas - lending facilities on a subsidized basis.

Responding to farmers demand for credit for other purposes than agricultural production was not a government priority.

The paradigm of centralized and directed agricultural credit policies

Agriculture is a major source of livelihood and the main engine of economic growth in developing countries therefore the development of agricultural production is a public priority

Technology innovations and more input use are essential to increase production

Farmers need more financial resources to adopt technology innovations Most farmers are poor, hence there is a gap in cash resources which blocks the adoption of new technologies and credit is needed to fill the gap

Agricultural production is a risky business; returns in agriculture are less than in the other sectors of the economy

Market interest rates reflect opportunities in other sectors: the market cost of money is too high for farmers to borrow for productive purposes

Government must intervene with subsidized lending (seeking no profit, amortizing high transaction costs, spreading the risk on a national basis)

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Subsidies are justified if loans aim at specific government objectives Therefore agricultural loans must be targeted to selected crops and technologies of interest to government

Loan repayment capacity is shown by viable crop/farm budgets models To extend subsidized credit for specific purposes, specialized government financial institutions must be established and financed with public funds

Specialization advises that the savings collection and the lending function of financial intermediation are kept distinct

Since most borrowers in rural areas are small farmers (i.e. poor), low cost credit responds to poverty alleviation considerations as well

Subsidized credit also compensates farmers for high taxation of agriculture (such as price control on basic grains, export taxes, artificial exchange rates, etc.).

The supply of rural financial services Unique problems of supplying agricultural finance FAO/GTZ (1998b) discusses a series of special factors that are likely to influence the supply of agricultural finance. These include:

The high financial transaction costs of attending dispersed and small farm households The seasonality and the importance of opportune timing of on-farm finance for cultivation practices, input application, harvesting (and related output

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marketing), the heterogeneity in farmers lending needs (seasonal and term lending) and the relative long duration of agricultural lending contracts

The dependence on sustainable natural resources management and the relative low profitability of on-farm investments The various weather and other production risks, together with marketing risks related to agriculture, that require appropriate risk management techniques, both for producers and financial intermediaries The limited availability of conventional bank collateral that farm households can offer, that highlights the need to increase the security of existing loan collateral or develop appropriate collateral substitutes The reality that farm households are confronted with emergency needs and that their loan repayment capacity is highly dependent on consumption and social security contingencies The need for adequate training of both bank staff and farmer clients.

The formal sector In most developing countries there are typically two types of suppliers or financial intermediaries. The formal sector consists of bank and non-bank financial institutions that provide intermediation services between depositors (or the government) and borrowers and, as they fall under the banking law, are regulated and supervised. As noted above, in the past these typically charged relatively low rates of interest that were usually subsidized by the government. The flow of funds in a typical centralized and directed agricultural credit system is shown. In many cases little attention was paid to voluntary savings mobilization in rural areas as small farmers, being poor, were considered to have a low propensity to save.

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The informal sector The informal sector typically comprises private individuals - professional moneylenders, traders, commission agents, landlords, friends and relatives - who lend money generally out of their own equity and are not regulated or supervised by the national monetary authorities. One of the major differences between these two types of supplier is the mechanisms used for dealing with the screening, incentives and monitoring problems with the informal sector relying much more heavily than the formal sector on their intimate knowledge of their clients to overcome these problems.

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

Crowding out the informal sector Informal financial markets have always existed in rural areas, but were ignored by government policy for a very long time. The agricultural credit paradigm (Box 8.1) excludes informal markets from playing a role on two grounds. First, that the operators in informal financial markets do not share the same commitment as government to promoting agricultural production. Second, they would charge exorbitant interest rates which, allegedly, agricultural producers could not afford to
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pay. In many countries and for almost 30 years, governments hindered the spontaneous development of informal financial intermediaries by occupying, through subsidized operations, the market space that informal operators could have exploited and developed. This has been defined as the crowding out effect of government agricultural credit policy. Appropriate forms of decentralization Introduction With few exceptions, the consequences of the centralized and directed approach to agricultural credit were catastrophic. A fair number of agricultural credit banks were liquidated during the 1980s and early 1990s across the world, when it became clear that governments could not afford to:

Continue to subsidize low interest lending rates Make good poor loan recovery Compensate for very high operating costs and overheads.

In addition, the results achieved in terms of impact on agricultural production were rather modest. This situation has prompted the elaboration of alternative policies based on a very different paradigm. Liberal economics and decentralization principles inspire the reform of the rural financial sector. Box 8.2 briefly states the new paradigm. The major objectives of decentralization of rural financial services are to:

Bring about closer links between service providers and beneficiaries Respond to the demand for a variety of financial services by the rural people

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Improve the transparency and accountability of financial institutions dealing with rural people Reduce the high costs and risks of financial transactions in rural areas.

The paradigm of decentralized rural financial services

Demand for credit is one thing, demand for agricultural technology is another: they may or may not coincide for individual borrowers

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

Banks must lend to creditworthy clients responding to clients independent assessment of their own requirements and preferences

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

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

Competition among financial services providers improves efficiency and lowers the cost of lending

Access to local financial services/institutions reduces transaction costs to clients and improves lenders contacts with clients

Sustainable banking is based on savings mobilization Financial institutions that offer local savings facilities at competitive and appropriate conditions are more likely to mobilize enough deposits to support

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a sound lending policy

Financial institutions which lend to creditworthy clients recover all the loans made, and can earn enough interest to cover their cost hence they are sustainable

Sustainable institutions will grow in the course of time Sooner or later, non-sustainable institutions will fail completely Prospects of profitability and sustainability and growth encourage private and voluntary sector enterprises to develop financial service institutions.

Reform of government-owned institutions Two approaches to decentralization of rural financial services can be distinguished. One approach involves a drastic reform or restructuring of government-owned financial institutions operating in rural areas, by shifting power away from the centre and changing responsibility and accountability systems through a combination of deconcentration and devolution measures.

Diversifying ownership The other approach aims at diversifying the ownership of the financial institutions operating in rural areas. This objective can be achieved in three major ways:

Changing the capital structure of government-owned agricultural development banks by selling a controlling interest to the private sector

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Encouraging the development of private banks and by eliminating subsidies and liquidating, restructuring or reducing the scope of operations of banks retained in the public sector Promoting and regulating the emergence of new types of grassroots-based rural financial intermediaries.

Naturally, all these ways of diversifying ownership can be implemented at the same time. When many service providers operate in capital markets a multiplicity of services delivery channels, distributing the power and influence associated with the control of financial flows, is created. Competition and a variety of policies, new financial technologies and products are introduced. Each of these approaches will be considered in the ensuing sections. The new role of central government Different strategies, different actors In rural areas, the starting point for elaborating the policy implications of the new paradigm is a clear separation of the agricultural credit and the extension functions. Promoting the adoption of new agricultural technologies is the task of extension, not of credit. There is a strong case for governments to decentralize their rural financial services, let rural financial services develop in the private and non-profit mutualistic sectors and, where and when appropriate, reduce the overwhelming presence of public financial institutions. Decentralized and private and voluntary sector financial institutions are better placed to respond to peoples preferences, to identify creditworthy borrowers, and to introduce effective mechanisms for savings mobilization. The new role of government is thus support of institutional development, rather than promotion of targeted incremental crop production
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through financial intermediation. This new role embraces the setting of a favorable environment, the introduction of appropriate legislation, a regulatory role and, perhaps, financial and technical support to promote new organizations. Regulation of rural MFIs As the importance of rural micro-finance institutions (MFIs) in the local capital markets increases , their functions become diversified and not directly connected with agricultural production. The need then arises for government to deal with them in similar terms to those used for formal institutions. The monetary authorities thus increasingly assume responsibility for the supervision of their activities, with a view to sound management of money, rather than Ministries of Agriculture whose primary interest is agricultural production. The promotion of rural MFIs raises questions such as:

What rules should govern the operations of decentralized rural financial institutions? What form, content, and degree of control should apply to ensure that the rules are respected? Who should exercise the control?

Regulation and supervision may cause more problems than those they are intended to overcome. For example, regulations related to registration, licensing, and inspection may offer opportunities for interference and corruption and supervisors, in addition to their task of overseeing banks, may not devote enough staff and time to inspect adequately a large number of new types of small rural financial institutions. Rules and controls of financial institutions normally:

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Concern the technical aspects of national money management Are designed to establish good governance in the institutions Aim at sound and prudent banking practices and respect, by the management, of the law and of the by-laws of the institutions as set by the shareholders.

Such rules deal with problems common to all financial institutions, and must be respected by all. Detailed regulations, however, differ depending on the nature of the regulated institutions. The main objectives of the monetary authorities control over financial intermediaries are to:

Manage the national money supply: this requires the continuous verification of the level of the financial aggregates such as money in circulation and volume of credit, and taking measures to influence their trend Protect the interest of depositors and the stability of the overall national financial system: this requires ensuring that the administrators of financial institutions act in accordance with the law and with sound banking practices Promote efficiency in the national financial markets.

Accordingly, the main objectives of the rules and controls over decentralized rural financial institutions should be to ensure that:

The decision-making and accountability procedures of the organizations are in accordance with the law and with the by-laws of each organization and that management follow them properly, for instance, ensuring that accurate and timely banking records are kept, etc.

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Accounting and audit procedures are transparent, adequate, properly and timelessly followed by the management, and that shareholders have access to independent internal and external audit reports. Lending and savings mobilization policies, procedures, and management are conducive to financial sustainability, and minimize the risk of fraud and loan delinquency.

Responsibility for regulation The elaboration of such rules, and the controls required for their enforcement, is not in the field of competence of Ministries of Agriculture, but is in the natural domain of the monetary authorities. Rules need to be established centrally, whereas controls can either be centralized or delegated. One option is for the central monetary authorities to take over direct responsibility for inspections of rural MFIs, as they do in the case of banks and other formally-established financial intermediaries. Another option is to delegate the control of decentralized financial service institutions to the apex body of cooperatives or MFIs. The latter would, in turn, be directly controlled by the monetary authorities, and would be responsible to them for controlling their member MFIs. A special opportunity for delegation is presented when MFIs are promoted and supported by a commercial or a development bank. In these cases, the commercial or development bank, which is under the control of the national monetary authorities, will supervise in its own interest the operations of the MFIs that they help to develop. Financial support Expenditure of public money may be necessary to support new institutions of the cooperative bank type, which emerge in the private or non-profit or mutualistic
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sector. Subsidies would assist primarily with capacity building aimed at increasing the staff and managerial skills of the new institutions. These subsidies may be justified on the grounds that institutional development and diversification of service providers are public goods that help to deal with financial market failures. They are not intended to fill gaps in operating income or interfere with interest rates and the free play of market forces. Support activities eligible for subsidies would include:

The initial help to groups wishing to start a savings and loans association (spontaneous groups animation, market studies, help to define by-laws, help with registration procedures, etc.) Experimentation/adoption and training in new financial technologies and products and better banking practices for financial officers of emerging institutions Initial assistance in keeping adequate accounts and drafting balance sheet and income statements Initial free assistance in routine inspection and audit of accounts.

Loans, but not grants, at market or near market terms to the new rural financial institutions, may also be justified (providing banks follow normal risk assessment practices in making loans) with a view to expanding their operations beyond the resources that they are able to mobilize by way of savings deposits. Governments may also support the start-up process of designing innovative credit guarantee approaches for banks (FAO, 1998b). However, banks ought to assume a good share of the risk in order to ensure that they assess their clients effectively. Sustainability requires financial institutions, irrespective of their size and nature, to respect sound banking practices. They should not borrow funds that they may not
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be able to remunerate at market rates of interest. The market will determine to what extent MFIs are sufficiently creditworthy customers for higher level and larger financial intermediaries to lend money to them. Diversifying ownership Privatization of agricultural banks Several new liberal governments have tried to privatize government-owned agricultural banks. In practice, there have been many difficulties due to the problem of capital valuation and to the poor expectations of profit from future operations. Short of outright fraud, government banks are in financial trouble for two main reasons:

Excessive operating costs (overstaffing, unprofitable branches, low staff productivity, wrong personnel policies, inadequate spread between active and passive interest rates, etc.) The poor quality of their portfolio (high loan delinquencies).

Excessive operating costs can eventually be corrected by new management, provided labour legislation does not impose too much rigidity, but the poor quality of the loan portfolio may often be difficult to remedy in the short- to medium-term. Thus governments are unlikely to find a buyer for take-over unless they clear the portfolio of bad loans. In some cases, the bulk of bad loans are held by bankrupt government enterprises. However, buying out delinquent debtors is a poor solution, because it does not establish an encouraging environment for making new loans. Transferring non-performing assets to a separate company responsible for recovering them has also been tried, but it did not always ensure the financial recovery of the original lender.
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Liberalization of the formal financial market The second option involves the liquidation of non-viable government banks, coupled with allowing the entry of foreign capital and the encouragement of local private groups to form joint ventures with foreign banking groups. Naturally, private investors, particularly foreign capital, tend to be cautious given past experiences with nationalization and political interference with staffing and lending policy. However, in the short term, this option may not be a solution for rural areas because private enterprises usually invest in commercial banking in urban areas before expanding to rural areas. However, an important effect in rural areas would be to restore lending to viable crop purchasing, equipment and input trading enterprises. Part of the finance made available to input suppliers and traders is likely to be passed on to farmers in the form of suppliers credit.

Micro-finance institutions The most far-reaching objective of decentralization of rural financial services is to mobilize the potential of informal rural financial markets and to rationalize their operations. The operators in the informal market include all those intermediaries who are not subject to the regulations and supervision of the monetary authorities, such as money lenders, ROSCAS (rotating savings and credit associations), informal savings groups, informal safe-deposit providers, village level savings and loans associations, etc.

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The third option, then, is to encourage the expansion of MFIs in the voluntary or mutualistic sector as rural financial intermediaries. The common feature of mutual or cooperative financial institutions is that their members own them. Members savings are mobilized and people appointed and controlled by members oversee the use of these savings. The cooperative nature of these institutions improves the chances that loans respond to the borrowers requirements. Moreover, the loans are made to borrowers who are well known to the institution and whose creditworthiness most members of the institution can easily assess. In this case, loan delinquency tends to be limited, since the social pressure to repay results from lending the members own hard-earned savings. Safeguarding of ones own money is a much stronger incentive for repayment than a generic sense of duty or interest in becoming eligible for an additional loan. The social pressure for loan repayment in classical group-lending schemes of agricultural development banks, where it was the governments (or the donors) external funds rather than the members own money that was loaned, in general has not worked. Experience suggests, however, that even with own funds the group liability mechanism tends to weaken whenever the local financial institution becomes too large or a large share of loan resources is obtained from outside sources.

The role of NGOs NGOs have played a significant role in promoting the development of informal rural financial services. Although NGOs continue to play an important role in promoting micro-finance in many developing countries, during the 1990s the
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growth of decentralized financial systems has evolved far beyond what NGOs initiated. Professionalization and new actors coming into the picture have become determining features. Some NGOs play a role in implementing a deliberate rural financial services decentralization policy within the framework of more articulated initiatives promoted by private banks, local interest groups, governments and donors. The provision of both financial and non-financial support services, by the same or by different organizations, as well as sustainability of the provided services, has become main concerns. There are a wide variety of new approaches, policies, objectives, and actors. Broadly speaking, four types of actors promote the development of rural MFIs, besides NGOs acting on their own initiative:

Government agricultural development banks Specialized cooperative finance development organizations of foreign origin, contracted by donors or governments Private commercial banks Donor/government special programme units.

A well-established network of micro-finance cooperative institutions can change the flow of financial resources in a very significant way. Figure 8.2 describes, in a simplified manner, the transfer of resources and of decision-making power in financial intermediation in the cooperative banking sector. The differences between the flow shown in & that of should be evident.

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The flow of resources in a cooperative banking system

Apex organizations The apex organizations of MFIs play a very important role. Accordingly, encouraging the emergence of such organizations is an important component of decentralization policy in rural financial markets. Apex organizations help to provide a unified culture within member institutions, which is a feature of social cohesion and a factor of success. They also provide valuable technical support in the form of accounting, auditing, training and a
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central liquidity facility. They assist in securing lines of credit from commercial or development banks and manage the liquidity requirements by transferring funds from member MFIs with surplus deposits to member MFIs with an excess of effective credit demand. Last but not least, they can join together with other apex organizations to lobby politicians and influence government policy. Conclusions The paradigm of agricultural credit has changed fundamentally from a policy that promoted centralized and directed agricultural credit to one that supports decentralized rural financial services and rural financial markets and systems development. The new paradigm emphasizes the distinction between the supplyled finance of new agricultural technologies and the effective demand by rural households for credit that can be used for their own perceived needs. It advocates the decentralization of credit provision, the encouragement of competition between loan services providers to lower the costs and risks of lending, and the use of market rates of interest as a rationing device for credit allocation. It recognizes also the importance of mobilizing local savings through offering competitive interest rates and a variety of savings products and flexible procedures. In the new paradigm the role of the government is to support institutional development, rather than the promotion of targeted incremental crop production through involvement in direct financial intermediation. Support to institutional development and decentralization involves reforming public development banks, privatizing institutions that can perform better in the private and mutualistic sectors, encouraging the growth of financial markets and the development of sustainable rural financial services. Subsidies can be justified for capacity building to increase competition. There are two approaches to
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decentralizing financial services in rural areas. One approach involves a drastic reform or restructuring of government-owned development financial institutions operating in rural areas. The other is to diversify the ownership and governance structure of rural financial institutions by changing the capital ownership of existing government institutions and/or by promoting the development of a multiplicity of financial services providers belonging to different owners. This includes the encouragement of the expansion of MFIs in the mutualistic sector. The most far-reaching objective of decentralization of rural financial services is to mobilize the potential of informal rural financial markets and to rationalize their operations. This may lead to a fast growth of micro- financial institutions in the rural areas and it is important to find effective ways of regulating them. Providing appropriate methods are followed, considerable gains can be expected from decentralization and a sustainable network of rural financial services providers may emerge.

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Chapter 3 RURAL BANKING

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INTRODUCTION Rural banking in India started since the establishment of banking sector in India. Rural Banks in those days mainly focused upon the agro sector. Today,
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commercial banks and Regional rural banks in India are penetrating every corner of the country are extending a helping hand in the growth process of the rural sector in the country. BANKS: FUNCTIONING FOR THE DEVELOPMENT OF RURAL AREAS The area of operation of a majority of the RRBs is limited to a notified area comprising a few districts in a State.SBI have 30 Regional Rural Banks in India known as RRBs. The rural banks of SBI are spread in 13 states extending from Kashmir to Karnataka and Himachal Pradesh to North East. Apart from SBI, there are other few banks which functions for the development of the rural areas in India. Few of them are as follows.

Haryana State Cooperative Apex Bank Limited NABARD Sindhanur Urban Souharda Co-operative Bank United Bank of India Syndicate Bank Co-operative bank

CO-OPERATIVE BANKS AND RURAL CREDIT The Co-operative bank has a history of almost 100 years. The Co-operative banks are an important constituent of the Indian Financial System, judging by the role assigned to them, the expectations they are supposed to fulfill, their number, and the number of offices they operate.
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Their role in rural financing continues to be important even today, and their business in the urban areas also has increased phenomenally in recent years mainly due to the sharp increase in the number of primary co-operative banks. Co-operative Banks in India are registered under the Co-operative Societies Act. The RBI also regulates the cooperative bank. They are governed by the Banking Regulations Act 1949 and Banking Laws (Co-operative Societies) Act, 1965. Co-operative banks in India finance rural areas under:

Farming Cattle Milk Hatchery Personal finance

Institutional Arrangements for Rural Credit (Co-operatives)

Short Term Co-operatives Long Term Co-operatives

Short Term Co-operatives | District Central Co-operative Banks

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| State Co-operative Banks | Primary Agriculture Credit Co-operative Societies | Branches Long Term Cooperatives | State Agriculture & Rural Development Banks | Primary Agriculture & Rural Development Banks | Branches

Primary Agricultural Credit Societies (PACSs) An agricultural credit society can be started with 10 or more persons normally belonging to a village or a group of villages. The value of each share is generally nominal so as to enable even the poorest farmer to become a member. The members have unlimited liability, that is each member is fully responsible for the entire loss of the society, in the event of failure. Loans are given for short periods, normally for the harvest season, for carrying on agricultural operation, and the rate of interest is fixed. There are now over 92,000 primary agricultural credit societies in the country with a membership of over 100 million.
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The primary agricultural credit society was expected to attract deposits from among the well to-do members and non-members of the village and thus promote thrift and self-help. It should give loans and advances to needy members mainly out of these deposits. Central Co-operative Banks (CCBs) The central co-operative banks are located at the district headquarters or some prominent town of the district. These banks have a few private individuals also who provide both finance and management. The central co-operative banks have three sources of funds,

Their own share capital and reserves Deposits from the public and Loans from the state co-operative banks

Their main function is to lend to primary credit society apart from that, central cooperative banks have been undertaking normal commercial banking business also, such as attracting deposits from the general public and lending to the needy against proper securities. There are now 367 central co-operative banks. State Co-operative Banks (SCBs) The state Co-operative Banks, now 29 in number, they finance, co-ordinate and control the working of the central Co-operative Banks in each state. They serve as the link between the Reserve bank and the general money market on the one side and the central co-operative and primary societies on the other. They obtain their funds mainly from the general public by way of deposits, loans and advances from the Reserve Bank and they are own share capital and reserves.
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COMMERCIAL BANKS AND RURAL CREDIT The commercial banks at present provide short term crop loans account for nearly 45 to 47% of the total loans given and disbursed by the commercial banks. Term loans for varying periods are given for purchasing pump sets, tractors and other agricultural machinery, for construction of wells and tube well, for development of fruit and garden crops, for leveling and development of land, for purchase of ploughs, animals, etc. commercial banks also extend loans for allied activities viz., for dairying, poultry, piggery, bee keeping, fisheries and others. These loans come to 15 to 16%. Commercial Banks and Small Farmers The commercial banks identifying the small farmers through Small Farmers Development Agencies (SFDA) set up in various districts and group them into various categories for credit support so as to enable them to become bible cultivators. As regard small cultivators near urban areas and irrigation facilities, commercial banks can help them to go in for vegetable cultivation or combine it with small poultry farming and maintaing of one or two milch cattle.

IRDP and commercial banks Since October 1980, the Integrated Rural Development Programme (IRDP) has been extended to all the blocks in the country and the commercial banks have been asked by the government of India to finance IRDP. The lead banks have to prepare banking plans and allocate the responsibility of financing the identified

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beneficiaries among the participating banks. Commercial banks have been asked to finance all economically backward people identified by government agencies. REGIONAL RURAL BANKS AND RURAL CREDIT The Narasimham committee on rural credit recommended the establishment of Regional Rural Banks (RRBs) on the ground that they would be much better suited than the commercial banks or co-operative banks in meeting the needs of rural areas. Accepting the recommendations of the Narasimham committee, the government passed the Regional Rural Banks Act, 1976. The main objective of RRBs is to provide credit and other facilities particularly to the small and marginal farmers, agricultural laborers, artisans and small entrepreneurs and develop agriculture, trade, commerce, industry and other productive activities in the rural areas. The progress of RRBs in the initial stage was quite rapid. For instance, the Sixth Five-year plan (1980-85) had envisaged the setting up of 170 RRBs covering 270 districts by the end of March 1985.The target was exceeded. There are now 196 RRBs in 23 states of the country with 14,200 branches.

Structure of regional rural bank

The establishment of the Regional Rural Banks (RRBs) was initiated in 1975 under the provisions of the ordinance promulgated on 26.9.1975 and thereafter Section 3(1) of the RRB Act, 1976. The issued capital of RRBs is shared by Central
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Government, sponsor bank and the State Government in the proportion of 50%, 35% and 15% respectively.

RRBs established with the explicit objective of: * Bridging the credit gap in rural areas * Check the outflow of rural deposits to urban areas * Reduce regional imbalances and increase rural employment generation Micro-Finance Micro-finance is a novel approach to "banking with poor" as they attempt to combine lower transaction costs and high degree of repayments. The major thrust of these micro-finance initiatives is through the setting up of Self Help Groups (SHGs),Non-Governmental organizations(NGOs),Credit Unions etc. Kisan(Farmers') Credit Card Another notable development in recent years is the introduction of Kisan Credit Cards(KCC) in 1998-99.The purpose of the Kisan Credit Cards(KCC) scheme is to facilities short term credit to farmers. The scheme has gained popularity and its implementation has been taken up by 27 commercial banks, 187 RRBs and 334 Central cooperative banks. Agricultural Insurance As Agricultural is highly susceptible to risks such as drought, flood, pests etc. It is necessary to protect the farmers from natural calamities and ensure their credit
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eligibility from the next season. Towards this purpose, the Government of India introduced a comprehensive crop insurance scheme through the country in 1985 covering major cereal crops, oilseeds and pulses. Among commercial crops, seven crops viz., sugarcane potato, cotton, ginger, onion, turmeric and chillies are presently covered. MARKETING OF MUTUAL FUND UNITS - RRBS With a view to expanding the scope of business of RRBs and considering that marketing of Mutual Fund (MF) units provides a profitable avenue for banks, it has been decided by RBI on 17th May 2006 to allow Regional Rural Banks (RRBs) to undertake marketing of units of Mutual Funds, as agents. Accordingly, RRBs may, with approval of their Board of Directors, enter into agreements with Mutual Funds for marketing their units subject to the following terms and conditions: * The bank should only act as an agent of the customers, forwarding applications of the investors for purchase / sale of MF units to the Mutual Fund / Registrar Transfer Agents. * The purchase of MF units should be at the risk of customers and without the bank guaranteeing any assured return. * The bank should not acquire such units of Mutual Fund from the secondary market. * The bank should not buy back units of Mutual Funds from their customers.
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* The bank holding custody of MF units on behalf of their customers should ensure that its own investment and investments belonging to their customers are kept distinct from each other. * Retailing of units of Mutual Funds may be confined to some select branches of the bank to ensure better control. * The bank should comply with the extant KYC/ AML guidelines in respect of the applicants. * The RRBs should put in place adequate and effective control mechanisms in consultation with their sponsor banks.

CONCLUSION RRBs' performance in respect of some important indicators was certainly better than that of commercial banks or even cooperatives. RRBs have also performed better in terms of providing loans to small and retail traders and petty non-farm rural activities. In recent years, they have taken a leading role in financing SelfHelp Groups (SHGs) and other micro-credit institutions and linking such groups with the formal credit sector. RRBs should really be strengthened and provided with more resources with which they can undertake more of these important activities. And most certainly they should be kept apart from a profit-oriented corporate motivation that would reduce
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their capacity to provide much needed financial services to the rural areas, including to agriculture. Ideally, the best use of the resources raised by RRBs through deposits would be through extensive cross-subsidisation. This, in turn, really requires an apex body that would cover and oversee all the RRBs, something like a National Rural Bank of India (NRBI). The number of rural branches should be increased rather than reduced; they should be encouraged to develop more sophisticated methods of credit delivery to meet the changing needs of farming; and most of all, there should be greater coordination between district planning authorities, panchayati raj institutions and the banks operating in rural areas. Only then will the RRBs fulfill the promise that is so essential for rural development.

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4. Role of NABARD in Rural Credit

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ROLE OF NABARD IN RURAL CREDIT:NABARD is set up by the Government of India as a development bank with the mandate of facilitating credit flow for promotion and development of agriculture and integrated rural development. The mandate also covers supporting all other allied economic activities in rural areas, promoting sustainable rural development and ushering in prosperity in the rural areas. With a capital base of Rs 2,000 crore provided by the Government of India and Reserve Bank of India, it operates through its head office at Mumbai, 28 regional offices situated in state capitals and 391 district offices at districts. It is an apex institution handling matters concerning policy, planning and operations in the field of credit for agriculture and for other economic and developmental activities in rural areas. Essentially, it is a refinancing agency for financial institutions offering production credit and investment credit for promoting agriculture and developmental activities in rural areas.

NABARD today Initiates measures toward institution-building for improving absorptive capacity of the credit delivery system, including monitoring, formulation of rehabilitation schemes, restructuring of credit institutions, training of personnel, etc. Coordinates the rural financing activities of all the institutions engaged in developmental work at the field level and maintains liaison with the government of India , State governments, the Reserve Bank of India and other national level institutions concerned with policy formulation
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 Prepares, on annual basis, rural credit plans for all the districts in the country. These plans form the base for annual credit plans of all rural financial institutions Undertakes monitoring and evaluation of projects refinanced by it Promotes research in the fields of rural banking, agriculture and rural development Functions as a regulatory authority, supervising, monitoring and guiding cooperative banks and regional rural banks

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

This activity involves: Framing policy and guidelines for rural financial institutions Providing credit facilities to issuing organizations Preparation of potential-linked credit plans annually for all districts for identification of credit potential Monitoring the flow of ground level rural credit

Developmental and Promotional function:Credit is a critical factor in development of agriculture and rural sector as it enables investment in capital formation and technological upgradation. Hence
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strengthening of rural financial institutions, which deliver credit to the sector, has been identified by NABARD as a thrust area. Various initiatives have been taken to strengthen the cooperative credit structure and the regional rural banks, so that adequate and timely credit is made available to the needy.

In order to reinforce the credit functions and to make credit more productive, NABARD has been undertaking a number of developmental and promotional activities such as: Help cooperative banks and Regional Rural Banks to prepare development actions plans for themselves
Enter into MoU(Memorandum Of Understandings) with state governments

and cooperative banks specifying their respective obligations to improve the affairs of the banks in a stipulated timeframe Help Regional Rural Banks and the sponsor banks to enter into MoUs specifying their respective obligations to improve the affairs of the Regional Rural Banks in a stipulated timeframe Monitor implementation of development action plans of banks and fulfillment of obligations under MoUs Provide financial assistance to cooperatives and Regional Rural Banks for establishment of technical, monitoring and evaluations cells
Provide organization development intervention (ODI) through reputed

training institutes like Bankers Institute of Rural Development (BIRD), Lucknowwww.birdindia.org.in, National Bank Staff College, Lucknow www.nbsc.in and College of Agriculture Banking, Pune, etc. Provide financial support for the training institutes of cooperative banks
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 Provide training for senior and middle level executives of commercial banks, Regional Rural Banks and cooperative banks Create awareness among the borrowers on ethics of repayment through Vikas Volunteer Vahini and Farmers clubs Provide financial assistance to cooperative banks for building improved management information system, computerization of operations and development of human resources

Supervisory functions:As an apex bank involved in refinancing credit needs of major financial institutions in the country engaged in offering financial assistance to agriculture and rural development operations and programmes, NABARD has been sharing with the Reserve Bank of India certain supervisory functions in respect of cooperative banks and Regional Rural Banks (RRBs). As part of these functions, it Undertakes inspection of Regional Rural Banks (RRBs) and Cooperative Banks (other than urban/primary cooperative banks) under the provisions of Banking Regulation Act, 1949. Undertakes inspection of State Cooperative Agriculture and Rural Development Banks (SCARDBs) and apex non-credit cooperative societies on a voluntary basis Undertakes portfolio inspections, systems study, besides off-site surveillance of Cooperative Banks and Regional Rural Banks (RRBs)
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 Provides recommendations to Reserve Bank of India on issue of licenses to Cooperative Banks, opening of new branches by State Cooperative Banks and Regional Rural Banks (RRBs) Administering Credit Monitoring Arrangements (CMA) in SCBs and CCBs.

Core Functions
NABARD has been entrusted with the statutory responsibility of conducting inspections of State Cooperative Banks (SCBs), District Central Cooperative Banks (DCCBs) and Regional Rural Banks (RRBs) under the provisions of Section 35(6) of the Banking Regulation Act (BR Act), 1949. In addition, NABARD has also been conducting periodic inspections of state level cooperative institutions such as State Cooperative Agriculture and Rural Development Banks (SCARDBs), Apex Weavers Societies, Marketing Federations, etc., on a voluntary basis.

Current Focus :Under the revised strategy, a sharper focus of the NABARDs inspection was given on the core areas of the functioning of banks pertaining to Capital Adequacy, Asset Quality, Management, Earnings, Liquidity, Systems and Compliance (CAMELSC). Thus, NABARDs focus in its statutory on-site inspections is on core assessments leaving the collateral appraisals to banks. The micro level aspects are to be taken care of by the banks themselves by way of internal inspections or by other agencies such as auditors. In this direction, through a series of workshops and meetings held with the Chief Executives and the Chief Auditors of cooperative
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banks, NABARD has been attempting to ensure that the other areas, particularly relating to the internal checks and controls, revenue and income realization by way of interest on loans and advances, investments and other routine features of carrying out general banking transactions were suitably taken care of by the banks and their concurrent/statutory audit systems.

Institutional Building: Help cooperative banks and RRBs to prepare development actions plans for themselves Enter into MoU with state governments and cooperative banks specifying their respective obligations to improve the affairs of the banks in a stipulated timeframe Help RRBs and the sponsor banks to enter into MoUs specifying their respective obligations to improve the affairs of the RRBs in a stipulated timeframe Monitor implementation of development action plans of banks and fulfillment of obligations under MoUs. Provide financial assistance to cooperatives and RRBs for establishment of technical, monitoring and evaluations cells. Provide organization development intervention (ODI) through reputed training institutes like Bankers Institute of Rural Development (BIRD), Lucknow, National Bank Staff College, Lucknow, College of Agriculture Banking, Pune, etc. Provide financial support for the training institutes of cooperative banks Provide training for senior and middle level executives of commercial banks, RRBs and cooperative banks
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 Create awareness among the borrowers on ethics of repayment through Vikas Volunteer Vahini/farmer's clubs Provide financial assistance to cooperative banks for building improved management information system, computerization of operations, development of human resources, etc.

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Chapter 5 Case Study on Rural Credit

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CONCLUSION ON RURAL CREDIT

Rural credit given by bank is still not familiar with the farmers and also accustomed to lending money without security. Rural clearly started to grow after bank nationalization and it has been growing since then. Over the years there has been a significant increase in the access of rural cultivators to institutional credits and simultaneously the role of formal agencies, including money lender as source of credit has declined. A review of performance of agricultural credit in India reveals that though the overall flow of institutional credit has increased over the years, there are several gaps in the system like inadequate provision of credit to small and marginal farmers, medium and long term lending and limited deposit mobilization and heavy dependence on borrowed funds by major agricultural credit purveyors. These have major implications for agricultural development as also the well being of the farming community, Efforts are therefore required to address and rectify these issues.

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