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									                                                                                     Will
                                                                                     Reforms Enable
                                                                                     Outreach?
                                                                                     M-CRIL Review of Rural Banking in India: Working Paper 1




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Table of Contents
Section                                                                  Page
          Background                                                      v
          Executive Summary                                              vii
1         Introduction                                                     1
2         The Importance of Rural Banks                                   3
3         Recent Performance of the Rural Banking System                  7
4         Reforms and the Rural Banks                                     8
          4.1 A huge effort to reform the cooperative system              8
          4.2 Sensible proposals for reorienting the Regional
              Rural Banks but…                                            12
5         Will Reforms Enable Inclusion?                                  15
          5.1 Cooperative reform – is it good money after bad?            15
          5.2 RRB reform – has the inclusion objective been sidelined?    17
6         Conclusion                                                      18
M-CRIL Review of Rural Banking in India

Background
This study follows from the discussion of issues in the performance of Regional Rural Banks (RRBs) written by Sanjay
Sinha, Managing Director, M-CRIL and published in The Economic Times (newspaper) on 17 March 2007. In relation to
financial inclusion, many of the issues raised there affect the performance of cooperative banks as well as the RRBs.
These issues include
    •   The effect of government ownership of RRBs on their ability to operate efficiently and effectively to fulfil
        the financial inclusion mandate; the domination of (district) cooperative bank managements by government
        functionaries and by landed elites with (usually) little interest in financial inclusion.
    •   Social control of interest rates on small value loans (less than Rs2 lakhs); the restriction on interest rates
        that can be charged by commercial banks on small value loans means that rural bank managements also
        feel constrained to offer credit services at the same rates. This renders financial services to micro-clients
        uneconomical and, thereby, disincentivises the development of systems appropriate to financial inclusion.
Another issue of importance in the context of rural banks and financial inclusion is
    •   Conflict of interest in the ownership structures of rural banks that make it impossible for them to operate
        in a manner that will facilitate financial inclusion through innovation and efficiencies. For cooperative
        banks, effective control is either in the hands of state governments that have contributed a substantial
        proportion of share capital or with borrowers (who are voting members of the banks), thereby, creating an
        inherent conflict of interest between financial viability and the interests of owners. In the case of RRBs,
        the sponsor commercial banks see their own subsidiaries as competition resulting in the parent company
        keeping a very tight leash on the RRB.
Over the past 3-4 years there has been substantial activity in the area of rural finance reform covering both RRBs
and the cooperative credit structure. This activity includes the ongoing process of amalgamating and merging
RRBs into state level banks to enable them to take advantage of economies of scale in operations. In parallel there
is the ongoing process of reforming the cooperative credit structure of the country along the lines recommended
by the Task Force on the Revival of Cooperative Credit Institutions (Vaidyanathan Committee).
The study being undertaken by M-CRIL proposes to
    (i) Review the progress made and initial effects of these reform and restructuring processes: compare what
        has been done so far with the tasks outlined at the start of each process, and using secondary information
        on productivity, systems and financial performance, assess the initial effects of the measures implemented
        so far to determine whether these reforms are moving the rural financial system in the right direction from
        the perspective of financial inclusion.
    (ii) Identify and track the performance of key RRBs and cooperative banks that could have a significant impact
         on the agenda of financial inclusion. Through this process, identify key constraints to the provision of
         financial services to low income families and determine bank as well as system level strategies for addressing
         these constraints.
The RRBs/cooperative banks to be covered by the study will satisfy two or more of the following criteria
    •   Operations in areas with substantial numbers of families classified as poor – more than 35% poor
        families
    •   Contribution to the agenda of financial inclusion – the selected bank must be in the highest quartile (top
        25%) of banks in that category (RRBs or cooperative banks) by proportion of small value loan accounts
        (of less than Rs25,000)



M-CRIL Review of Rural Banking in India: Working Paper 1
                                                                      v
    •   Equal representation of selected banks in each of the top two quartiles of banks (in each category) in
        terms of financial performance as measured by a combination of returns on assets and portfolio quality.
    •   Selection of the sample in a manner that would provide coverage of the various regions of the country – in
        order to take likely regional issues into account. The selection will also take into account interesting cases
        of turnaround (or failure) resulting from the reform process.
The selected banks (8 RRBs and 12 district cooperative banks) will be studied by M-CRIL using its financial and
social rating/poverty audit methodologies.
The first round of the study will identify constraints to the effective contribution of the selected banks to financial
inclusion and will make specific suggestions on improvements in operations that could increase their contribution.
An analytical synthesis report emerging from this round of studies will provide sector wide feedback to the bank
managements, government and RBI/NABARD on the strengthening of these rural banks to promote financial
inclusion. While M-CRIL’s financial rating and social/poverty audit methodologies will form the basis of the study,
these will take in a more detailed coverage of aspects like cost parameters of small value financial services and client
feedback on the design and suitability of products relative to the needs of micro-clients.
This will be followed by annual studies over the next three years using M-CRIL’s rating methodology to track the
performance of the selected banks over time
    •   to assess the effectiveness of the specific measures taken by them to promote financial inclusion, and
    •   to understand the impact of emerging issues in the political economy of the country that affect the
        fulfillment of this agenda.
Each annual round will be completed with the preparation of a synthesis report that will provide a trend analysis
of the emerging issues in the participation of the rural banking system in financial inclusion. The results of each
round will be widely publicized
    •   at meetings organized by Sa-Dhan and Microfinance India
    •   through articles in the print media as well as
    •   in specifically convened meetings with NABARD and the RBI.
This is the first Working Paper emerging from the M-CRIL Review of Rural Banking in India. It outlines the
importance of the rural banking system for financial inclusion and sets out the rationale and dimensions of the
rural banks’ reform process before questioning the suitability of that process for enabling rural banks to promote
financial inclusion. This will be followed by other working papers that set out the results of M-CRIL’s study of
rural banks and offer suggestions for adjusting the reform process to maximize the rural banks’ contribution to
financial inclusion.




                                             vi          M-CRIL Review of Rural Banking in India: Working Paper 1
Executive Summary
The financially excluded are the poorest and the most vulnerable sections of society. These are usually socially
marginalized groups, female headed households, households in remote areas, the old, physically challenged and so
on. Financial exclusion reduces the ability of such groups and individuals to benefit from participation in productive
processes, realize their potential and cope with adversity. While financial inclusion may have gained currency
internationally in recent times, financial inclusion has been on the radar of policy makers in India for at least four
decades. The key mechanisms through which the Government has attempted to address the issue of financial
inclusion has been through
    1   maximizing the spread of the commercial banking system
    2   the development of the co-operative banking system including primary cooperatives as well as cooperative
        banks, and
    3   the creation of an extensive network of Regional Rural Banks (RRBs).
This paper looks at the role of the rural banking system (RRBs and the cooperative banking system) in promoting
financial inclusion.


The role and performance of rural banks
Within the Indian financial sector, the role of the rural banks is important but not apparently pre-eminent. The
contribution of the commercial banks to the rural/semi-urban banking network is far higher (at 38% of the total)
than the 28% contribution of rural banks to the total of 87,000 bank branches in India. Despite the apparent
importance of commercial banks even in the rural areas however they are neither able nor willing to serve the
poorest sections of the population. By comparison, in the credit categories of direct relevance to financial inclusion,
RRBs hold 26.2% of agricultural credit accounts and as many as 55.0% of all artisan/tiny industry loan accounts.
This amounts to much lower proportions of overall credit available under these categories – just 10.9% and 11.0%
respectively – since RRB loan sizes average just Rs25,000 and Rs13,000 for these two categories, much smaller than
those offered by the commercial banks.
Yet, it is precisely this fact that shows the importance of the rural banks for otherwise financially excluded sections
of the population. Low income families have a much lower absolute and proportionate need for credit than better
off sections of the population that are, in any case, better able to access the commercial banks. Similar data
for cooperatives is not available but with an estimated 130 million members the average loan outstanding with
cooperatives amounts to just over Rs9,000 per member, emphasising their suitability to the needs of low income
families. Taken together, the rural banks record a credit-deposit ratio of 81.7% in March 2007, somewhat higher
than the average of 76.1% for the entire banking system.
Rural banks have, for a number of years, been regarded as the step-child of the banking system in India. Both
types of rural banks have been subject to extensive interference in their operations, being seen as a conduit for
government subsidies and a means of political patronage. It is not surprising, therefore, that both the cooperative
credit system and RRBs have encountered serious financial difficulties and were virtually crippled in the early 1990s,
needing a substantial injection of capital at that time. The performance of such banks in recent years has been
somewhat better though. Thus, 85% of the RRBs and around 75% of cooperative banks are now profitable on
a year-on-year basis. While all the RRBs taken together now regularly register a profit, the DCCB performance is
erratic with significant numbers slipping into losses before recovering from one year to the next. In March 2003, as
many as 144 out of 367 DCBs were reported to have completely eroded their net worth and to have eroded Rs3,100
crore worth of deposits as well.




M-CRIL Review of Rural Banking in India: Working Paper 1
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Reforms and the rural banks
Not surprisingly, the Vaidyanathan Committee of 2004 made a comprehensive set of recommendations for the
revival of the cooperative credit system. These included
    1    Special financial assistance to wipe out the accumulated losses and to strengthen the capital base of the
         cooperative credit institution.
    2    Radical changes in the legal framework to empower the Reserve Bank of India to take action directly to
         ensure the prudent financial management of cooperative banks.
    3    Improvement in the quality of personnel at all levels of the cooperative credit system through capacity
         building that would lead to an improvement in efficiency.
A revival programme for cooperative institutions based on these recommendations was announced by the
Government of India in January 2006. The cost of this programme has been estimated at nearly Rs13,600 crore
(just over $3 billion) shared by the central government (68%), state governments (28%) and cooperative institutions
(4%).
By contrast with the mega-effort to reform the cooperative system, the parallel effort to reorient the Regional Rural
Banks as a vital lever of economic activity in rural areas is remarkably small. The initial RRB reform programme
of the 1990s is the one that injected Rs2,188 crore in recapitalization funds for 187 of the 196 RRBs in existence at
the time. This was accompanied by permission to rationalize the branch network, permission to lend to non-target
group customers as well as a freeze on the recruitment of new staff along with revised prudential norms on income
recognition, asset classification and provisioning that followed banking benchmarks.
The current effort involves no more than a process of amalgamating the RRBs of the same sponsor bank within
each state. Minor changes have been made to improve the availability of experience and skills to RRBs from the
sponsor banks. In addition, the amalgamated RRBs have been encouraged to find new channels of non-interest
income, to introduce more efficient banking services through the use of “core banking solutions” and to participate
in consortium lending. However, other important recommendations – on the change of sponsor banks, induction
of new sponsor banks, introduction of CRAR norms and transfer of supervision responsibilities to the RBI – have
not been implemented.
For the cooperative reform programme to be successful a number of conditions must be met
    a    Professional governance of the cooperatives free from political partisanship
    b    PACS seen as the members’ own institutions and not as an extension of the historical system for extending
         state subsidies
    c    Competent financial management undertaken professionally at both societies and DCCBs.
Herein lies the challenge; in a politically charged environment where public elections are held virtually every year to
select representatives for different levels of government – national parliament, state assemblies, local government
– the re-activation of the PACS and DCCB governance structures is more than likely to reinforce considerations
of political patronage. Ensuring that such considerations remain subdued and subordinate to the overall goal of
cooperative revitalization will take a concerted effort at restraint at all levels of the political system; something that
has not been in evidence in recent years.
Compounding this problem is the message to members of credit cooperatives conveyed intermittently by the
political establishment; those who repay their loans on time are likely to incur a financial loss in the long term. The
impact of the 2008 debt waiver and loan remission programme of the central government for agricultural debt is
only the most dramatic of the counter-disciplinary messages being sent out by the political establishment.
Finally, in a tradition of lack of competence and discipline in financial management combined with rent-seeking
by PACS managers, the likelihood of improved management resulting from training alone is not high. However, a
focus on rigorous audits and inspection along with repeated efforts at follow up training could start to create some
impact in the long run. It is a decadal rather than a short term programme which will work well only in tandem with

                                            viii        M-CRIL Review of Rural Banking in India: Working Paper 1
improved local governance. To the extent that this latest attempt at reform will inject the cooperative credit system
with the resources to continue to provide large numbers of people with at least partial financial services – before
another capital injection is required – this exercise is worthwhile; that it will provide a major, long-lasting impetus
to the process of financial inclusion is unlikely.
While the approach to RRB reform may be seen as politically pragmatic by some, the indifference of the approach
adopted to the financial inclusion objective of RRB operations is manifest. Neither is it apparent that amalgamation
was entirely necessary for financial sustainability, nor does it hold much promise of accelerated support to financial
inclusion. Amalgamation was supposed to enable the RRBs to take advantage of economies of scale and to improve
their competitive position vis-à-vis the commercial banks. However, while there may be economies of scale in some
functions, the real advantage of scale in banking comes from account size. As larger banks, amalgamated state-wide
RRBs would undoubtedly appear to have an attraction for larger clients but in a situation where commercial bank
branches are easily accessible, separate state-wide RRBs for each sponsor bank are still small banks and are hardly
likely to be the preferred service provider. Yet, to the extent that the self-perception of bank staff would change
to that of larger banks, the RRBs could be expected to pursue larger accounts to the detriment of low income
clients.
While amalgamation was also supposed to enable the weak banks to gain from merging with the strong ones, there
is no evidence that being small was the real reason for their weakness. Various study groups have pointed out the
correlation between sponsor bank and financial performance, concerns about dormant boards and also conflicts of
interest with sponsor banks. Since many pre-amalgamation RRBs were clearly profitable, it is more likely that the
failure to address these issues rather than size was the cause of the weakness of some banks.
Similarly, the reform effort does not address another key issue that is partly related to the linkage of RRBs with
public sector sponsor banks. In practice, RRBs are not allowed to charge cost covering interest rates on their lending
to SHGs, cottage industry and smallholder agriculture. In the case of SHG and cottage industry lending this is
dictated by the career goals of public sector managers who continue to see these banks as instruments of social
policy despite the pressure on them to earn a profit. In the case of short term agricultural lending, the government
itself mandates a 7% rate of interest to be paid by farmers with compensation of 2% paid by NABARD; if the
cost of making small agricultural loans is higher than 9%, the difference between cost incurred and interest received
becomes a forced subsidy on the banks. This is one of the issues that this M-CRIL research programme expects
to throw further light on.
The purpose of this research programme is to assess the recent operational experience of both RRBs and cooperative
banks to determine their contribution to financial inclusion and to document the constraints such banks face in
furthering that process.




M-CRIL Review of Rural Banking in India: Working Paper 1
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M-CRIL Review of Rural Banking in India: Working Paper 1

Will reforms enable outreach?
India’s Rural Banks on the Route to Financial Inclusion

1           Introduction
Financial inclusion has increasingly attracted attention of the global community in recent years. The Blue Book
on inclusive finance, a UN publication of 2006, raises the question fundamental to financial inclusion “why are
so many bankable people unbanked?” A look at the efforts aimed at financial inclusion worldwide: a Financial
Inclusion Task Force and a financial inclusion fund in the UK, a civil rights law, Community Reinvestment Act
(CRA) in the United States, and a host of initiatives like the Committee on Financial Inclusion in India leading to
the establishment of a Financial Inclusion Fund – indicates that financial inclusion has been recognized as an issue
of central importance in both developed and developing countries.
What is financial inclusion? Put simply, financial inclusion means giving people access to relevant financial services
at an affordable rate. The ambit of financial inclusion can differ depending on how policy makers define it. The
definition, in turn, depends on the evolution of banking services in a country and the ambition of the policy
makers. In a country where a large proportion of the population is unbanked, a characteristic of many developing
countries, financial inclusion has a different meaning compared to a developed country where only a small minority
does not have a bank account. In the case of the former, opening a basic bank account might amount to financial
inclusion whereas in the case of the latter financial inclusion might imply making available a gamut of financial
services such as credit, insurance and pension plans.
Figure 1 (following page) shows the correlation of the density of bank accounts relative to the population with
the per capita income (in 2006) of 36 developing and emerging economies. India’s position in this graph is marked
by a red diamond. While the figure indicates a reasonable correlation between bank accounts and income levels,
this correlation is particularly weak, at higher levels of income (beyond $4,000 per capita) so that some countries
– such as Russia – have nearly two bank accounts per person despite having a per capita income of less than $6,000
whereas Lebanon with a similar average income has just 383 accounts per thousand population and Mexico with
an income of nearly $8,000 has just 310 accounts per thousand. It is apparent that there is no guarantee of total
financial inclusion even where
       •    the average income level is relatively high, or where
       •    large numbers of bank accounts have been opened.
In the former case, this may be on account of uneven distribution of income and in the latter case on account of
multiple account holding by individual account holders.
The importance of financial inclusion can be explained in terms of maximising the proportion of population
covered by the formal financial sector, to enable the channelling of funds for productive investment, controlling
inflationary tendencies, and monitoring and widening the tax base among other things. The nature of financial
exclusion and the reasons for it could vary between countries and within a country but the consequences of such
exclusion are uniformly




1
     United Nations, 2006. Building Inclusive Financial Sectors for Development. New York: UNDESA/UNCDF.



    M-CRIL Review of Rural Banking in India: Working Paper 1
                                                                                      1
                                                     Figure 1
                     Correlation between bank accounts and national per capita income levels




negative. The financially excluded tend to be the poorest and the most vulnerable sections of society. These are
usually socially marginalized groups, female headed households, households in remote areas, the old, physically
challenged and so on. Financial exclusion reduces the ability of such groups and individuals to benefit from
participation in productive processes, realize their potential and cope with adversity. Financial exclusion reinforces
the existence of these vulnerable groups on the fringes of society and accentuates their vulnerability.
While financial inclusion may have gained currency internationally in recent times, in India the process of financial
inclusion has been on the radar of policy makers for at least four decades. The key mechanisms through which the
Government of India has attempted to address the issue of financial inclusion has been through
    1   maximizing the spread of the commercial banking system
    2   the development of the co-operative banking system including primary cooperatives as well as cooperative
        banks, and
    3   the creation of an extensive network of Regional Rural Banks (RRBs).
This paper looks at the role of the rural banking system (RRBs and the cooperative banking system) in promoting
financial inclusion. It discusses the genesis of the RRBs and credit cooperatives supported by the district central
cooperative banks (DCCBs) and the role of the two types of institution in enabling the provision of financial
services to low income families. Both types of institution are currently the subject of reform programmes intended
to make them more efficient and effective as providers of financial services if not necessarily as promoters of
inclusion. This paper serves as a background for the study currently being undertaken by M-CRIL of reforms in
the rural banking system in India and the implications of these reforms for financial inclusion.




                                             2         M-CRIL Review of Rural Banking in India: Working Paper 1
2            The importance of rural banks
Reforms to the Indian financial sector over the past 15 years have resulted in significant growth and availability
of financial services. These have unleashed increased competition, diversification of financial services and wider
capital markets enabled by regulatory liberalisation along with more stringent prudential regulation and better
supervision. Yet substantial proportions of the population continue to be deprived of financial services. As Figure
2 shows, the Rural Financial Access Survey (RFAS) of the World Bank in 2003 found that 59% of rural households
in Uttar Pradesh and Andhra Pradesh do not have deposit or savings accounts with the formal financial sector and
79% do not have access to credit from a formal source. As a separate group, 87% of marginal farmers and 70% of
small farmers have no formal credit while 70% of marginal farmers and 45% of small farmers do not have deposit
or savings accounts with a formal financial institution.

                                                                         Figure 2
                                                     Access to finance in rural India - 2003




Within the Indian financial sector, the role of the rural banks is important but not apparently pre-eminent. As
shown by the information in Table 2.1, RRBs and DCBs (taken together) accounted for 32% of the nearly 87,000
bank branches in India at the end of March 2007. Of all the bank branches in the country, 49% are classified as
rural branches while another 30% are regarded as semi-urban. While rural branches clearly serve people who might
otherwise be excluded from the financial system, semi-urban branches are also of importance for the outreach of
financial services to the urban poor.




2
     Throughout this paper the expression rural banks is used to describe Regional Rural Banks and District Cooperative Banks as a single category.
3
     A deposit account is a term deposit, generally not held by poorer people, usually paying a reasonable rate of interest. A savings account is a deposit or
     withdraw on-demand account, with virtually no minimum balance (Rs 100), no fixed term, and little or no interest in most places. The distinction is
     important. In the figure, Marginal farmers are households with landholding <1 acre, small have 1-4 acres, large >4 acres while commercial households are
     those with or without land who have income from non-farm sources exceeding half their total income. Others are mixed households with land and non-
     farm incomes but with the latter being less than half the total household income.
4
     Based on the periphery of large urban agglomerations or in small towns.
5
     This is not to say that inner city branches do not have the potential to serve slum dwellers but such branches have substantial commercial business and,
     therefore, far less incentive for making an effort to serve the poor.



    M-CRIL Review of Rural Banking in India: Working Paper 1
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                                                                     Table 2.1
                                     Institutional framework of rural banking services in India
                                                                                                                  March 2007, number of branches
    Bank group                Rural Semi-urban                  Urban               Metro      Total          Proportion rural/semi
    SBI group                  5,126      4,168                      2,788            2,383      14,465                         64.3%
    Nationalised banks        12,991      7,630                      8,106            8,200      36,927                         55.8%
    Foreign banks                             2                         44              230         276                          0.7%
    Other commercial             990      2,099                      2,234            2,072       7,395                         41.7%
                              19,107     13,899                    13,172            12,885      59,063                         55.9%
    RRBs                      11,453      2,585                        668                67     14,773                         95.0%
    Coop banks                 7,022      3,400                      2,075              565      13,062                         79.8%
                              37,582     19,884                    15,915            13,517      86,898                         66.1%
    Rural banks (%)           49.2%      30.1%                      17.2%              4.7%      32.0%
Source: Statistical Tables Relating to Banks in India 2006-07. Mumbai: Reserve Bank of India


Figure 2 depicts the distribution of rural and semi-urban branches in India amongst different types of banks. It
is apparent that the contribution of the commercial banks to the rural/semi-urban banking network is far higher
(at 38% of the total) than the contribution of rural banks. Commercial banks have 33,000 of the rural and semi-
urban branches, 57.4% of the total number of such branches. Within the rural banking system, the RRBs have
more branches than the DCCBs but the latter, with their primary agricultural cooperative societies (PACS) provide
far more business outlets to rural and semi-urban clients. The 97,000 PACS in March 2007 constitute nearly one
business outlet for every six villages in the country. At the end of March 2005, outstanding credit from formal
sources in rural areas was estimated at Rs454,200 crores with the commercial banks accounting for 53%, the
cooperative credit system for 38.5% and RRBs for 8.5% of the total. Rural credit constituted just 26% of total
bank credit.

                                                                     Figure 2
                                    Rural/semi-urban branches of banks as % of total branches




6
     ADB 2006. “Proposed Program Loan and Technical Assistance Grant. INDIA: Rural Cooperative Credit Restructuring and Development Program”.
     Manila: Asian Development Bank, November.



                                                           4           M-CRIL Review of Rural Banking in India: Working Paper 1
Despite the apparent importance of commercial banks even in the rural areas however they are neither able nor
willing to serve the poorest sections of the population. Table 2.2 begins to provide an approximation of the
importance of rural banks for financial inclusion. Along with their 16.2% contribution to the number of branches,
RRBs hold just 15.7% of the 85.4 million loan accounts held with the banking system in the country (excluding the
cooperative sector). However, in the credit categories of direct relevance to financial inclusion RRBs hold 26.2% of
agricultural credit accounts and as many as 55.0% of all artisan/tiny industry loan accounts. This amounts to much
lower proportions of overall credit available under these categories – just 10.9% and 11.0% respectively – since
RRB loan sizes average just Rs25,000 and Rs13,000 for these two categories, much smaller than those offered by the
commercial banks. Yet, it is precisely this fact that shows the importance of the rural banks for otherwise financially
excluded sections of the population. Low income families have a much lower absolute and proportionate need for
credit than better off sections of the population that are, in any case, better able to access the commercial banks; a
factor that is important, and not often recognized.

                                                    Figure 2.2
                Relative contribution of rural banks to inclusive financial services – types of credit
                                                                                          account size in thousand Rs, March 2006
                                   All loan accounts         Agricultural credit        Artisan credit
                               All        Amount A/c size A/c size % of loan a/cs A/c size % of loan a/cs
SBI group                   18,879,658     349,943   1.85     0.63           35.9%    1.62             1.27%
Nationalised banks          31,713,638     725,130   2.29     0.73           41.9%    0.91             0.78%
Foreign banks                9,715,237       99,185  1.02   14.05             0.1%    3.96             0.03%
Other Sched Comml           11,733,089     302,941   2.58     0.99           11.9%    1.09             0.18%
Banks
                            72,041,622 1,477,199        2.05      0.72            29.8%        1.27                   0.71%
RRBs                        13,393,759    36,644        0.27      0.25            56.8%        0.13                   4.66%
                            85,435,381 1,513,843        1.77      0.59            34.0%        0.64                   1.33%
Coop Banks                130,000,000*   118,885
% share of RRBs in all          15.7%      2.4%                 26.2%                        55.0%
credit accounts
* estimated
Source: Compiled from Statistical Tables Relating to Banks in India 2006-07. Mumbai: Reserve Bank of India


Similarly, the information in Table 2.3 shows that RRBs have a far higher proportion of small loan accounts (with
amount sanctioned less than Rs25,000) than other types of banks. Compared to an all-India average under 41%,
as many as 67% of RRB loan accounts have credit limits less than Rs25,000. Conversely, only 31% of RRB loan
accounts are in the category with Rs25,000 to Rs2 lakh limit, much less than the 47.9% average for all banks. While
RRBs account for 23.4% of all small loan accounts, their share in the larger category is only 10.9%. This reinforces
the impression of the RRBs’ substantive contribution to the provision of credit services for low income families.
Similar data for cooperatives is not available but with an estimated 130 million members (Table 2.2) the average loan
outstanding with cooperatives amounts to just over Rs9,000 per member, emphasising their suitability to the needs
of low income families.
Partly because the rural banking system serves a larger proportion of low income clients, it makes a relatively
small contribution to the value of financial services available. Thus, despite providing 32% of the branches (and
with RRBs alone holding 15.7% of loan accounts), as Table 2.4 shows, the rural banking system accounts for just
8.6% of the total value of deposits and 9.2% of total credit outstanding. Taken together, the rural banks record a




M-CRIL Review of Rural Banking in India: Working Paper 1
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                                                                     Table 2.3
                      Relative contribution of rural banks to inclusive financial services – size of credit
                                                                                                                                    March 2006
 Bank group                                     All accounts                Loans <Rs25,000                     Loans>Rs25,000, <Rs2 lakh
                                                                       Accounts                % of total        Accounts       % of total
 SBI group                                         18,879,658              8,379,400                 44.4%          8,311,223        44.0%
 Nationalised banks                                31,713,638             14,144,208                 44.6%         14,344,327        45.2%
 Foreign banks                                      9,715,237              2,962,378                 30.5%          6,117,629        63.0%
 Other Sched Comml Banks                           11,733,089              3,940,356                 33.6%          5,727,491        48.8%
                                                   72,041,622             29,426,342                 40.8%         34,500,670        47.9%
 RRBs                                              13,393,759              8,992,762                 67.1%          4,202,551        31.4%
 Coop Banks
                                                   85,435,381             38,419,104                 45.0%         38,703,221        45.3%
 % share of RRBs & Coop Banks in                       15.7%                  23.4%                                    10.9%
 all credit accounts
Source: Compiled from Statistical Tables Relating to Banks in India 2006-07. Mumbai: Reserve Bank of India


                                                                     Table 2.4
                                   Contribution of the rural banking system to financial services
                                                                                                                                        Rs crore
 Bank group                                                           Deposits                         Credit               C-D ratio
 SBI group                                                                        578,384                      452,220               78.2%
 Nationalised banks                                                             1,258,038                      925,266               73.5%
 Foreign banks                                                                    145,931                      127,712               87.5%
 Other Sched Comml Banks                                                          534,409                      396,197               74.1%
                                                                                2,516,762                    1,901,395               75.5%
 RRBs                                                                              82,059                       48,170               58.7%
 Coop Banks                                                                       154,461                      145,171               94.0%
                                                                                2,753,282                    2,094,736               76.1%
 % share of RRBs & Coop Banks                                                       8.6%                         9.2%
Source: Statistical Tables Relating to Banks in India 2006-07. Mumbai: Reserve Bank of India



credit-deposit ratio of 81.7% in March 2007, somewhat higher than the average of 76.1% for the entire banking
system. The C-D ratio for RRBs alone is, however, much lower at 58.7%. But this does not make the RRBs any
less valuable for financial inclusion, since not all low income families want to or need to borrow. The C-D ratio
of RRBs is lower partly because a significant part of the low income population uses RRBs to deposit savings or
transfer funds – services for which the cooperative banks do not enjoy an equal level of trust.
The importance of rural banks for inclusion is reinforced by the data depicted in Figure 3. It shows that rural
banks, responsible for just 12.7% of loans outstanding account for nearly 22% of priority sector lending and over
32% of the amount in agriculture loans.




                                                           6           M-CRIL Review of Rural Banking in India: Working Paper 1
                                                       Figure 3
                        Contribution of rural banks to priority sector lending (by amount)




3       Recent performance of the rural banking system
The above discussion shows that financial services provided by the rural banking system are clearly more inclusive
of low income families than those provided by the commercial banks. Yet rural banks have, for a number of years,
been regarded as the step-child of the banking system in India. Both types of rural banks have been subject to
extensive interference in their operations, being seen as a conduit for government subsidies and a means of political
patronage – an issue that is discussed in the following section.
It is not surprising, therefore, that both the cooperative credit system and RRBs have encountered serious financial
difficulties and were virtually crippled in the early 1990s, needing a substantial injection of capital at that time. As
Table 3.1 shows, the performance of such banks in recent years has been somewhat better. Thus, 85% of the
RRBs and around 75% of cooperative banks are now profitable on a year-on-year basis. However, while all the
RRBs taken together now regularly register a profit, the DCCB performance is erratic with significant numbers
slipping into losses before recovering from one year to the next. In March 2003, as many as 144 out of 367 DCBs
were reported to have completely eroded their net worth and to have eroded Rs3,100 crore worth of deposits as
well.

                                                       Table 3.1
                                Financial performance of rural banks in recent years
RRBs                           2000-01       2001-02      2002-03     2003-04      2004-05       2005-06      2006-07
Profitability
RRBs in profit                      170           167          156            163       166           111           81
% with current profit              87%           85%          80%            83%       85%           83%          84%
Current profit, Rs cr             676.5         699.9        734.0          952.3     902.6         807.8        926.4
RRBs in loss                        26            29           40             33        30            22           15
% with current loss               13%           15%          20%            17%       15%           17%          16%
Current loss, Rs cr               75.9          92.1        214.7          183.6     154.5         190.7        301.2
All RRBs, profit Rs cr            600.6         607.8        519.3          768.7     748.1         617.1        625.2
Portfolio quality
Gross NPA, %                       18.8         16.5          14.4          12.6       8.5            7.3         6.6


M-CRIL Review of Rural Banking in India: Working Paper 1
                                                                       7
    DCCBs                                                2001-02             2002-03             2003-04             2004-05              2005-06
    Profitability
    Profit earning banks, number                                 262                243                264                 295                    278
    Loss making banks, number                                   105                122                101                  72                     88
                                      Total                     367                365                365                 367                    366
    Proportion profitable                                       71%                67%                72%                 80%                    76%
                Profit earned, Rs crore                          702                742                863               1,355                  1,116
                      Losses, Rs crore                          737                948                888                 439                    913
                                                                (35)             (206)                (25)                916                    203
    Portfolio quality
    % of overdues to demand                                    35.1               37.4               37.0                32.9                   31.7
Sources: NABARD, RRB Key Statistics, various & NAFSCOB.


Similarly, in the case of portfolio quality, the RRBs appear to be performing better than the cooperative banks. RRB
portfolio quality has improved steadily in recent years from a Gross Non-Performing Asset (Gross NPA) level of
18.8% in 2000-01 to 6.6% in 2006-07. DCCBs, on the other hand, have a more or less steady overdue level of 35%
(translating to Gross NPAs of around 20%) in 2004-05.
Yet, as is apparent from Table 2.4, despite their relatively poor financial health, the DCCBs generate nearly twice
the volume of deposits and provide over three times the amount of credit supplied by RRBs. Given that DCCBs
provide outreach and financial services not only from their over 13,000 branches but also through the medium of
over one lakh primary societies (PACS) to as many as 130 million members, this is not surprising. The importance
of the cooperative banking system for financial inclusion, particularly in rural and semi-urban areas, is apparent. It
is only recently that the financial health of the cooperative credit system has led to serious concern though RRBs
have also attracted attention. The nature of the problems facing the rural banks is discussed and the proposed
measures for reforming the two systems are described in the next section.


4           Reforms and the rural banks

4.1         A huge effort to reform the cooperative system
The performance of the cooperative credit system has been the subject of ongoing debate, not just in recent years,
but over many decades. Some of the early efforts to develop and build a strong cooperative credit system have
been well summarized in the report of the most recent study group to suggest ways to improve its functioning, the
Vaidyanathan Committee of 2004. Within the past ten years, however, there have been three other committees
       1    Capoor Committee, 1999: Task Force to study the functioning of the Cooperative Credit System and
            suggest measures for its strengthening.
       2    Vyas Committee, 2001: Expert Committee on Rural Credit.
       3    Vikhe Patil Committee, 2001:                 Joint Committee on Revitalisation Support to Cooperative Credit
            Structure.
The Vaidyanathan Committee documents the deterioration in the functioning of the cooperative credit system, particularly
in the 1980s. “The State gave primacy to cooperatives as the sole means of delivering institutional credit to ruralareas and
injected large and increasing amounts of funds directly. Upper tier cooperative banks were encouraged to accept
public deposits and borrow from other financial institutions.” The cooperative credit system was also used by the
7
     GoI, 2004. Task Force on Revival of Cooperative Credit Institutions (Vaidyanathan Committee). New Delhi: Government of India, December.



                                                           8           M-CRIL Review of Rural Banking in India: Working Paper 1
state to channel its development schemes, especially subsidy programmes for the poor. The committee’s report
notes that “As the financial involvement of the government in cooperatives increased, its interference in all aspects
of the functioning of cooperatives also increased…often compelling them to compromise on the usual norms for
credit worthiness, [which] ultimately began to affect the quality of the portfolio of cooperatives.” In short, the
cooperatives “became a conduit for distributing political patronage.”
The report documents how instead of tackling the cause of the weakness of cooperative credit institutions, the
State tried to strengthen them through fresh capital injections and attempting to provide them with a “professional”
workforce. This led the State and the workforce to behave like patrons instead of providers of financial services
and was compounded by the Government of India’s 1989 scheme of writing off loans of farmers. This “greatly
aggravated the already weak credit discipline in the cooperative system and led to the erosion of its financial health.”
It also set off a wave of competitive populism as a precedent for State Governments to announce loan waivers
ranging from interest write-offs to partial loan write-offs and “severely impaired the credibility and health of the
cooperative credit structure.”
The report notes that since the early 1990s there has been “an increasing realization of the destructive effects of
intrusive State patronage and the consequent impairment of the role of cooperatives” and that there has been “a
quest for reviving and revitalizing the cooperative movement.” Thus, a model law was proposed by the Chaudhary
Brahm Perkash Committee and others, while endorsing this proposed law, have also recommended improving the
regulation and supervision mechanism, introducing prudential norms and financial assistance for recapitalization.
However, implementation has been slow because of the states’ unwillingness to share costs and reluctance to
dilute powers and cede regulatory powers to the Reserve Bank of India. As a result, apart from the passage of
the Mutually Aided Cooperative Societies Act by the state of Andhra Pradesh in 1995 and by eight other states
subsequently, nothing much was done. The old acts were not repealed, nor was any serious effort made to encourage
the conversion of old cooperatives to come under the new law which would make them ineligible for refinance
under the existing legal and structural arrangements. Thus, the committee lamented that “there has not been much
impact [of these measures] on the way cooperatives function” and the movement continued to deteriorate to such
an extent that the Vaidyanathan Committee was appointed to suggest an “implementable action plan…for carrying
the reforms forward.”
The Vaidyanathan Committee made a comprehensive set of recommendations for the revival of the cooperative
credit system. These included
       1     Special financial assistance to wipe out the accumulated losses and to strengthen the capital base of the
             cooperative credit institution. Responsibility for funding these losses was divided amongst the Government
             of India (agricultural loans of cooperative banks and all credit businesses of PACS), the state governments
             (non-credit businesses of PACS, credit guaranteed by them and other receivables from them) and cooperative
             credit societies and banks themselves (return of state government equity and direct loans made by them
             voluntarily ).
       2     Radical changes in the legal framework to empower the Reserve Bank of India – as the banking regulator
             – to take action directly to ensure the prudent financial management of cooperative banks. This entailed
             the enactment of legislation at the state level for facilitating an appropriate governance and supervisory
             structure including provisions to be incorporated in existing Cooperative Societies Acts to enable this
             process.
       3     Improvement in the quality of personnel at all levels of the cooperative credit system through capacity
             building and other interventions that would lead to an improvement in efficiency. This would include
             improvements in efficiency through the establishment of a new and enhanced common accounting system,
             management information system, internal controls and audit mechanisms, enhanced credit appraisal and
             risk management, business diversification, product development and HR as well as financial literacy and
             awareness of rights and responsibilities amongst PACS members.

7
     Independent of any diktat.



    M-CRIL Review of Rural Banking in India: Working Paper 1
                                                                         9
Thus, the measures recommended required the state governments first to sign up to the Government of India’s
scheme including legal and regulatory changes to be followed by the enactment or amendment of appropriate
legislation. The release of funds to the states for this reform process would then be linked to a number of
administrative measures
       •     Retirement of contribution to the share capital of credit societies
       •     Reconstitution of boards of management, elected with no state government nominees
       •     Cooperative banks accept criteria of eligibility for board membership
       •     Professionally qualified (as prescribed by RBI) persons are appointed as CEOs of banks and properly
             trained personnel as secretaries of PACS
       •     All employees are answerable to the boards of cooperatives and CEOs and staff are appointed by them
       •     Boards are limited to policy decisions and reviews while the CEO and staff screen, appraise and decide on
             loan applications and take actions necessary to ensure recoveries.

A revival programme for cooperative institutions based on these recommendations was announced by the Government
of India in January 2006 designed to transform “potentially viable” financial cooperatives into democratically
governed, efficiently managed, financially sustainable self-reliant institutions that could provide a wide range of
financial services to the rural poor on affordable terms. Thus, it potentially provided strong support for the agenda
of financial inclusion. NABARD (the National Bank for Agriculture and Rural Development) was involved in
the process as the implementing and coordinating agency on behalf of the Government of India and states were
required to sign MoUs with the central government and NABARD for participation in the programme.
The cost of this programme has been estimated at nearly Rs13,600 crore (just over $3 billion) shared by the central
government (68%), state governments (28%) and cooperative institutions (4%). Recognising that the financial and
political cost of liquidating the cooperative credit institutions would be far higher than the cost of restructuring the
potentially viable ones, the Government of India requested the support of the Asian Development Bank, the World
Bank and other development partners. Agreement was reached first with the Asian Development Bank and KfW,
the German development bank. The support agreed was
       •     Asian Development Bank: $1 billion loan from the Asian Development Bank “to support policy and
             institutional in the cooperative credit structure” expected over a period of four years (2007-2010). The ADB
             support was to finance this programme of comprehensive cooperative credit society reform in five states –
             Andhra Pradesh, Maharashtra, Madhya Pradesh, Gujarat and Rajasthan. These states incorporated 5 SCBs,
             136 DCCBs and 43,227 PACS with about 41 million members and the estimated overall adjustment cost of
             the programme was $1.43 billion. The financial restructuring support would enable the recapitalization of
             potentially viable cooperative institutions by wiping out accumulated losses and bringing them to a capital to
             risk-weighted assets ratio of 7%. The PACS would then be required to increase their CRARs to 9% within
             three years while cooperative banks would need to do this in accordance with RBI requirements. This
             increase in capital would be from the cooperatives’ own resources. PACS with minimum recovery rates of
             30% were classified as “potentially viable” and all institutions would receive recapitalization support up to
             the extent of their losses as on 31 March 2004, prior to the design of the revival programme, apparent from
             specially audited balance sheets. The financial restructuring of the PACS would precede that of the upper
             tiers of the cooperative system to ensure that weaknesses at the base do not continue to sap the vitality
             of the entire structure. This would also reduce the recapitalization burden at the upper levels by enabling
             the PACS to clear their dues to the upper tiers thereby reducing the accumulated losses of the DCCBs.
             Performance targets for the ADB programme re-emphasise the institutional sustainability and legal and

9
     As set out in World Bank, 2007. “Project Appraisal Document on a Proposed Loan and Credit to the Republic of India for a Strengthening Rural Credit
     Cooperatives Project”
10
     ADB 2006. “Proposed Program Loan and Technical Assistance Grant. INDIA: Rural Cooperative Credit Restructuring and Development Program”.
     Manila: Asian Development Bank, November.


                                                          10           M-CRIL Review of Rural Banking in India: Working Paper 1
        regulatory reform objectives of the Government of India programme. NABARD was designated as the
        implementing agency for the programme and given the responsibility of organizing and coordinating the
        institutional reform measures proposed.
    •   World Bank: $600 million over a period of five years (2008-2012) for central government grant support
        to the cooperative institutions in five of the participating states – Gujarat, Haryana, Orissa, Uttar Pradesh
        and Uttaranchal. These funds were to be used for technical assistance ($20 million for training, member
        education, MIS and other systems), information technology ($80 million), financial restructuring support
        ($495 million) and monitoring ($5 million). Similar conditions to the ADB were attached to the release of
        World Bank support.
    •   KfW: Support of €140 million from KfW was agreed concurrently with the ADB. This included an
        amount of €10 million earmarked for technical assistance. KfW’s assistance was synchronized with the
        ADB.
In addition to these assistance programmes, there was a $2 million grant from the UK’s Department for International
Development (DFID) for the setting up and implementation of a programme performance monitoring system,
building the capacity of state and district level implementation units, and implementing innovative schemes for
enhancing credit outreach to poor rural women.
At the time of writing (October 2008), this ambitious reform programme had made a reasonable start but was
behind schedule. NABARD, responsible for the day-to-day implementation of the programme established its
Department of Cooperative Revitalisation and Reform some two years ago and has been engaged in establishing a
monitoring system for the programme as well as organizing special audits and selecting service providers for MIS
and other proposed systemic improvements. The key achievements until end-September 2008 were
    –   Memoranda of Understanding (MoUs) signed between 25 states and the Government of India and
        NABARD
    –   Cooperative Societies Acts amended in 8 states and proposed amendments by another 9 states being vetted by
        NABARD
    –   Special Audits taken up in nearly 62,000 PACS and fully completed in 7 states; training for Special Audits
        in other states being started
    –   Special Audit of DCCBs completed in Haryana, Orissa and Rajasthan and in progress in Andhra Pradesh,
        Maharashtra, Uttarakhand and West Bengal
    –   Release of recapitalisation grants to the extent of Rs3,348 crore (just under 25% of the estimated total)
        released to PACS in seven states as detailed in Table 4.1 (below).
    –   HRD training: Identified state level nodal agencies and imparted training to Master Trainers in 11 states;
        48,000 PACS secretaries, 60,000 elected members of PACS and over 450 staff of DCCBs trained. Modules
        designed for second phase training for PACS secretaries in business development and diversification and
        for audit departments, supervisors and inspectors of CCBs on a common accounting system.
    –   Common Accounting System and MIS for PACS designed and shared with states along with handbooks
        and training on operationalisation started. Guidelines on computerization issued and tendering process for
        software development started in Rajasthan and Haryana.
Though undertaking the functions included in the revival programme does not, by itself, constitute successful
implementation of the programme, it is apparent that a significant effort at the revival of the cooperative credit system
has been substantively launched.




M-CRIL Review of Rural Banking in India: Working Paper 1
                                                                        11
                                                       Table 4.1
                                         Recapitalisation grants released to PACS
                                                                                                              Rs Crore

State                  Central Govt share released      State Govt share released        CCS share           Total
Andhra Pradesh                             1,101.15                          170.93            127.34         1,399.42
Gujarat                                      121.58                            10.13            12.48           144.19
Haryana                                      432.04                            20.32            30.59           482.95
Madhya Pradesh                               561.59                            38.44            52.76           652.79
Maharashtra                                  510.70                            16.74           144.25           671.69
Orissa                                       279.97                            36.84            21.08           337.89
Uttar Pradesh                                340.85                            44.12           196.66           581.63
Total                                      3,347.88                          337.52            585.16         4,270.56

4.2       Sensible proposals for reorienting the Regional Rural Banks but…
By contrast with the mega-effort to reform the cooperative system, the parallel effort to reorient the Regional Rural
Banks as a vital lever of economic activity in rural areas is remarkably small – minor even relative to the significantly
smaller role played by RRBs in the economy. Yet, like the cooperative system, RRB reform has been on the agenda
for a long time, particularly since the beginning of the overall reform process in 1991, and has been the subject
of many official committees. Unlike the cooperatives, there has been a previous attempt at reforming RRBs and
this, partly, explains the focus of the current effort on using administrative measures without any application of
additional resources by the government
The Regional Rural Banks were established from 1975 as a major initiative to reinforce the inclusion objectives
of bank nationalization and promote the flow of credit to the rural poor. The initiative was based on the
recommendations of a Working Group under the chairmanship of a former governor of the RBI, M Narasimham.
The idea of establishing small rural banks was that such institutions would have a “local feel and familiarity with
rural problems”, a feature that was thought to characterize the cooperatives. RRBs, it was expected, would combine
this with the professionalism and large resource base of commercial banks.
Starting with just 6 RRBs covering 12 districts in December 1975, the RRBs expanded through the 1980s into a
network of 196 such banks covering 525 of the roughly 600 districts in the country through some 14,500 branches.
In the event, as the earlier discussion shows, RRBs have been relatively successful at mobilizing deposits but much
less so at enhancing the credit flow to the rural poor – at least not in a professional manner. If the poor governance
and financial weakness of the cooperative credit system turned it into the subject of official patronage, it was their
proximity to the rural poor (not much less than that of the cooperatives), combined with government ownership
that turned the RRBs into an instrument for extending subsidized credit to large numbers of people. As a result,
in the words of the latest RBI working group on the RRBs, “Since their inception the financial health of the RRBs
has been indifferent.”
According to the RBI working group, the key factors that had an effect on their performance are
      •   Limited area of operation with a narrow range of business activities and small base of clients leading to high
          covariant risk
      •   Focus on small customers such as small and marginal farmers, small transport operators, small and
          micro-enterprises and self help groups with limited credit requirements making it impossible to earn bulk
          incomes from larger, high income borrowers to cross-subsidise lending to the main customer group
      •   Perception as an instrument of social policy without viability considerations while there was pressure
          to improve financial performance, resulting in uneven growth
      •   A capital base that is too low for their business volume resulting in a serious prudential hazard whereby
          hundreds of crore rupees of deposits were underpinned by just Rs1 crore of capital. Even on 31 March

                                              12        M-CRIL Review of Rural Banking in India: Working Paper 1
             2004, 26 RRBs had a deposit base in excess of Rs500 crore and as many as 172 of the 196 RRBs had
             deposits in excess of Rs100 crore. This low capital base has deprived banks of the cushion normally
             provided by promoters’ capital and has been directly responsible for the magnitude of erosion of depositor
             funds with 39 out of 96 banks extant on 31 March 2007 together reporting accumulated losses in excess of
             Rs2,700 crore.
       •     Small organizational structure and limited financial assets come in the way of garnering a larger share
             of the rural financial market by making it difficult to provide a full range of financial services, thereby
             discouraging large depositors and borrowers.
       •     High loan delinquencies resulting from their use for directed lending by the State
       •     High cost of servicing numerous small accounts while the interest cost of funds from NABARD and
             sponsor banks was higher than market rates but rates of interest charged to customers had to be kept in
             line with the competing commercial banks
       •     Poor financial skills resulting in an inefficient allocation of resources and parking of large amounts with
             sponsor banks
       •     Conflict of business interests with sponsor banks that operate in the same areas but have been
             responsible for the financial and business initiatives of their RRBs
       •     Lack of professionalism in management as senior managers (including Chairmen) are appointed out
             of the serving officers of the sponsor bank which results often in the reference of small matters to the
             sponsor with consequential delays in decision making. [It also results in short terms for Chairmen, and the
             notion that the job is a ‘punishment’ to be borne for the minimum period possible before ‘coming home
             to the parent bank’.]
       •     Lack of skilled staff resulting from inappropriate training and lack of exposure to new products and
             development activities for catering to the changing requirements of the rural sector. An ageing staff
             profile resulting from the ban on recruitments has constrained efficiency in operations and uniform norms
             and policies across the country ignoring local issues and conditions have lowered staff morale reducing
             involvement in development tasks
       •     Inappropriate wage structure which was brought in line with the higher wages of the commercial banks
             even as RRBs were required to retain their rural flavor to identify with the rural population, yet they were
             required to adhere to an
       •     Administered interest rate regime that depressed rates since they were lending to the “weaker sections”
             and yet were required to pay a slightly higher rate than commercial banks on deposits.
It is not surprising that by 1991, the RRBs as a banking network were on the verge of collapse with 172 of the 196
RRBs recorded as unprofitable in 1993 and a recovery performance of just 40.8% with a consequent erosion of
public deposits in addition to the meager Rs25 lakhs of paid up capital.
At this point, a reform programme had to be launched to revive the RRBs. As part of this process, 187 of the
196 RRBs were recapitalized to the extent of Rs2,188 crore between 1994 and 2000. In addition, a freeze on
the recruitment of new staff was introduced along with revised prudential norms on income recognition, asset
classification and provisioning for loan losses that followed banking benchmarks. This was accompanied by
       •     Rationalisation of the branch network including relocation and merger of loss-making branches. As Bose
             (2005) points out, this led to a relocation of 459 of the 14,672 offices of RRBs from rural to semi-urban
             or urban centres between 1996 and 2003 with a consequent reduction of 6% in the rural portfolio from
             77.5% to 71.5% during this period.

11
     RBI, 2005. “Report of the Internal Working Group on RRBs” Mumbai: Reserve Bank of India.
12
     Bose, Sukanya, 2005. “Regional Rural Banks: The past and present debate”.
13
     With an investment-deposit ratio as high as 72% in the latter year.



 M-CRIL Review of Rural Banking in India: Working Paper 1
                                                                                       13
    •   Permission to lend to non-target group customers and deregulation of interest rates on such loans. RRBs
        were allowed to finance non-target groups up to 60% of their incremental lending from 2004. By 2001,
        priority sector lending had dipped to 73% of the total amount outstanding. As reported by RRB managers
        during M-CRIL’s previous study of RRBs, this was a deliberate strategy to improve viability by making low
        risk collateralized loans at market based interest rates. Agricultural lending by RRBs had reduced to 23% at
        this point and the C-D ratio was down to just 41%. As a result, the investment-deposit ratio rose to 72%
        as the Mumbai money market became a more attractive source of income for RRBs than their traditional
        clients. To a substantial extent, the period from 1990 to 2001 can be classified as a period of retreat from
        financial inclusion with the overall RRB C-D ratio falling from 86% in 1990 to just 41% in 2001 as such
        banks redirected their efforts to commercial viability instead.
As the recent working group of the RBI points out, the performance of RRBs cannot be judged on the same
parameters used for the commercial banks “without taking into account the policy and administrative constraints
impinging on their performance”.
Based on its analysis of the RRBs, the RBI working group of 2005 recommended
    1   Mergers and amalgamations to take advantage of economies of scale across wider geographical areas
        and larger groups of clients as well as to strengthen the weak banks through amalgamation with strong
        ones. However, mergers were to be restricted to RRBs within a particular state. In order to preserve the
        spirit of setting up RRBs as local entities the option of merging them with the sponsor banks was not
        recommended.
    2   Change of sponsor banks since its analysis showed that the performance of RRBs under some sponsor
        banks was “markedly better” than under others. A change in sponsor banks of some RRBs could improve
        competitiveness, work culture, management and efficiency. It suggested bringing in new sponsor banks
        – either public or private – for this purpose.
    3   Prudential capital requirements to adhere to the principle that the owners’ stake in the business should
        be in proportion to the size and risk of the business. It suggested an initial CRAR of 5% while requiring
        the RRBs to align with Basel-1 norms over time. Since 98 RRBs fell short of the 5% CRAR requirement as
        of 31 March 2004, the working group calculated that to wipe out accumulated losses, properly provide for
        NPAs and reach 5% CRAR for Rs3,050 crore of capital would be required. It suggested that this capital
        be infused by the stakeholders in proportion to their existing shareholding in the RRBs. More profitable
        banks could be allowed to raise capital by way of Tier II instruments as well.
4       Governance and management could be addressed by
    a   Appointing Chairmen – rather than sponsor banks – from the open market through a transparent
        process
    b   Improving board capacity to take proactive interest in performance by inducting professionals such as
        agricultural experts, bankers and management experts
    c   Flexibility in recruitment to offset the aging staff structure and enable the induction of new skills
    d   Appropriate advice to be provided by the sponsor banks on matters of human resource management
    e   Better financial management through the posting of specialized staff by the sponsor banks – skills in risk
        management and investment could be inducted in this way
    f   All external staff should have minimum fixed tenures to ensure continuity in postings
    g   An appropriate incentive structure, career plan and training programme should be devised for all staff to
        improve productivity and to enable them to take up new activities their new skills
    h   Introduction of new products and streamlining of business processes.

    5   Regulation and supervision to be undertaken by the RBI rather than NABARD which has been
        responsible for supervision. The group argued that “there is a clear distinction between supervision that is


                                           14         M-CRIL Review of Rural Banking in India: Working Paper 1
             carried out to ensure that the affairs of the RRB are carried out in a manner that is not detrimental to the
             interests of the depositors and that done by a refinancing institution to satisfy itself that the on-lending
             operations have been conducted with due care and diligence”. It also pointed out that there could be
             situations of conflict of interest between NABARD’s supervisory and developmental functions. The RBI
             Act, 1934 vests the responsibility for the supervision of scheduled banks upon the RBI and it is there that
             this responsibility should be exercised.
       6     Improving profitability would require the RRBs, in addition to their normal business functions to undertake
             such activities as asset-liability management, increase non-interest income by distributing products such as
             those of insurance companies and mutual funds, rationalize the branch network, participate in consortium
             lending, collect state-level taxes , have a currency chest facility, and foster links with rural development
             organizations to provide avenues for innovative financing.
But, though a process of amalgamating the RRBs of the same sponsor bank within the states was started in
September 1995 under Section 23A of the Regional Rural Banks Act, 1976 not all the recommendations of the
working group were accepted. Until March 2008, 48 amalgamations had taken place, reducing the number of RRBs
to 91 operating in 26 states operating across 585 districts. With further amalgamation and the formation of a new
RRB in the Union Territory of Puducherry (sponsored by the public sector Indian Bank), the total number of RRBs
reduced to 88 by end-May 2008.
At the same time minor changes were made to improve the availability of experience and skills to RRBs from the
sponsor banks. In addition, the amalgamated RRBs were encouraged to find new channels of non-interest income,
to introduce more efficient banking services through the use of “core banking solutions” and to participate in
consortium lending to projects situated in their areas of operation. However, other important recommendations of
the committee – on the change of sponsor banks, induction of new sponsor banks, introduction of CRAR norms
and transfer of supervision responsibilities to the RBI – have not been implemented.


5            Will reforms enable inclusion?
Given that India has an extensive network of bank branches in rural areas established by commercial banks, the
main rationale for concern about the parallel rural banking system is provided by its implications for financial
inclusion. As the discussion in Sections 2 & 3 showed, the rural banking system has a direct beneficial effect on
financial inclusion and it follows, therefore, that an institutionally sustainable and financially viable rural banking
system would greatly enhance progress towards the goal of access to financial services for all those who need
them. This section discusses the reform programmes described above in the context of its potential to enable the
achievement of the financial inclusion objective.


5.1          Cooperative reform – is it good money after bad?
After nearly two years of the reform process for financial cooperatives, one of the key lessons that has emerged
is that the lack of a common accounting system and ineffective audit procedures over the years have resulted in a
chaotic financial picture. Lacking appropriate accounting for non-performing assets (NPAs), no accounting for
depreciation and other similar problems have made it impossible to determine the correct aggregate financial status
of the cooperative credit system. In some cases the accounts have been found to be incorrect by as much as 90% of
the total size of the balance sheet of a primary cooperative. As a result, the initial focus of the reform programme
has been on using the new common accounting system (CAS) to calculate a corrected figure for accumulated
losses so that recapitalization can be expedited. Once this has been completed, possibly by end-March 2009, it will
become easier to determine the true financial position of the DCCBs to facilitate, in turn, their recapitalization.



14
     Bad debts.



 M-CRIL Review of Rural Banking in India: Working Paper 1
                                                                          15
The use of CAS to calculate the true financial position of PACS clearly has potential to be reasonably accurate and
the subsequent recapitalization of the societies is likely to create reasonably clean balance sheets. However, the
possibility of this process being seen by some PACS as a “bonanza” to extract extra recapitalization funds on the
basis of massaged balance sheets cannot be ruled out. Nevertheless, the reasonably clean balance sheets of most
societies resulting from this exercise would (subject to the conditions set out below) provide the PACS and DCCBs
with a new opportunity to revitalize and provide their services to members in an effective and efficient manner. If
this were to happen, it would encourage the members to make better use of the cooperatives’ financial services. In
practice, however, this will only happen if a number of conditions are met. These conditions include
    a    Professional governance free from political partisanship
    b    PACS seen as the members’ own institutions and not as an extension of the historical system for extending
         state subsidies
    c    Competent financial management undertaken professionally at both the society and DCCB levels.
Herein lies the challenge; in a politically charged environment where public elections are held virtually every year to
select representatives for different levels of government – national parliament, state assemblies, local government
– the re-activation of the PACS and DCCB governance structures is more than likely to reinforce considerations
of political patronage. Ensuring that such considerations remain subdued and subordinate to the overall goal of
cooperative revitalization will take a concerted effort at restraint at all levels of the political system; something that
has not been in evidence in recent years.
Compounding this problem is the message to members of credit cooperatives conveyed intermittently by the
political establishment; those who repay their loans on time are likely to incur a financial loss in the long term. The
impact of the 2008 debt waiver and loan remission programme of the central government for agricultural debt is
only the most dramatic of the counter-disciplinary messages being sent out by the political establishment. It has
been combined in recent years with an interest subsidy on short-term agricultural loans (7% paid by the farmer, 2%
reimbursed to the lender by NABARD) and with a plethora of additional subsidies and annually varying interest or
debt waivers by state governments. The likelihood that this environment will encourage PACS members to service
debt in a disciplined manner is truly remote.
Finally, in a tradition of lack of competence and discipline in financial management combined with rent-seeking
by PACS managers, the likelihood of improved management resulting from training alone is not high. However, a
focus on rigorous audits and inspection along with repeated efforts at follow up training could start to create some
impact in the long run. It is a decadal rather than a short term programme which will work well only in tandem
with improved local governance.
Small wonder then that the credit-deposit ratios of cooperatives in India are high resulting from the reluctance of
their members themselves to trust their savings to such shaky financial management. As Figure 4 shows, the credit-
deposit ratios of DCCBs have actually risen from less than 80% to over 100% during the current decade.
Regrettably, it is most likely that the present effort at reviving the cooperatives will see a sharp, but temporary,
improvement in the functioning of the cooperative credit system before a gradual decline again sets in. Periodic
improvements of this type have become the norm since the creation of the cooperative system in 1904; there is
little in the latest programme to give hope of any better results this time around. The only silver lining is that the
high economic growth of recent years has provided the central government with more resources to repay the debt
it is incurring for this purpose from the international development agencies – the ADB and the World Bank. To the
extent that this latest attempt will inject the cooperative credit system with the resources to continue to provide large
numbers of people with at least partial financial services – before another capital injection is required – this exercise
is worthwhile; that it will provide a major, long-lasting impetus to the process of financial inclusion is unlikely.




                                              16        M-CRIL Review of Rural Banking in India: Working Paper 1
                                                                       Figure 4
                                        Contribution of RRBs and DCCBs to the rural economy




In the meanwhile the few thousand well functioning PACSs that there are, among the 97,000 overall, and even the
few reasonably efficient DCCBs will continue to enable effective financial inclusion but that has (and will have) little
to do with the huge volume of resources being committed to this reform programme. Studies of well functioning
DCCBs being undertaken by the M-CRIL study team will provide feedback on the potential impact of the reform
programme on these institutions and will also enable lessons to be learned on the institutional characteristics
necessary for effective financial inclusion to be enabled.


5.2          RRB reform – has the inclusion objective been sidelined?
Despite the efforts of the RBI’s Internal Working Group on RRBs to emphasise that partial implementation of
its recommendations was unlikely to result in a comprehensive change in the fortunes of the RRBs piecemeal
introduction of its suggested measures is ultimately what has happened. While this approach may be seen as
politically pragmatic by some, the indifference of the approach adopted to the financial inclusion objective of RRB
operations is manifest. Neither is it apparent that amalgamation was entirely necessary for financial sustainability,
nor does it hold much promise of accelerated support to financial inclusion.
First, amalgamation was supposed to enable the RRBs to take advantage of economies of scale and to improve
their competitive position vis-à-vis the commercial banks. However, while economies of scale in matters like the
introduction of core banking solutions and improved MIS would undoubtedly enable operational efficiencies, the
real advantage of scale in banking comes from account size. As larger banks, amalgamated state wide RRBs would
undoubtedly appear to have an attraction for larger clients but in a situation where commercial bank branches are
easily accessible, separate state-wide RRBs for each sponsor bank are still small banks and are hardly likely to be the
preferred service provider. Yet, to the extent that the self-perception of bank staff would change to that of larger
banks, the RRBs could be expected to pursue larger accounts to the detriment of low income clients.
While amalgamation was also supposed to enable the weak banks to gain from merging with the strong ones, there
is no evidence that being small was the real reason for their weakness. Various study groups (including the RBI
group) have pointed out the correlation between sponsor bank and financial performance, concerns about dormant
boards and conflicts of interest with sponsor banks. Since many pre-amalgamation RRBs were clearly profitable, it


15
     Even the smallest private banks undertook business in excess of Rs10,000 crore and public sector banks of at least Rs100,000 crore. This compares with
     a maximum business of some Rs5,000 crore for the largest RRB.



 M-CRIL Review of Rural Banking in India: Working Paper 1
                                                                                             17
is more likely that the failure to address these issues rather than size was the cause of the weakness of some banks.
It is precisely these issues that the latest reform effort does not address.
Similarly, the reform effort does not address another key issue that is partly related to the linkage of RRBs with
public sector sponsor banks. In practice, RRBs are not allowed to charge cost covering interest rates on their lending
to SHGs, cottage industry and smallholder agriculture. In the case of SHG and cottage industry lending this is
dictated by the career goals of public sector managers who continue to see these banks as instruments of social
policy despite the pressure on them to earn a profit. In the case of short term agricultural lending, the government
itself mandates a 7% rate of interest to be paid by farmers with compensation of 2% paid by NABARD; if the
cost of making small agricultural loans is higher than 9%, the difference between cost incurred and interest received
becomes a forced subsidy on the banks. This is one of the issues that this M-CRIL research programme expects
to throw further light on.
Yet, from a financial inclusion perspective, since their substantial withdrawal from lending after the first reform of
the 1990s, the RRBs have, in fact, been returning gradually to their original mandate of serving clients in rural areas.
As Figure 4 (above) shows, the C-D ratios of RRBs have been rising continuously over the past few years even as
their investment-deposit ratios fall. The extent to which this heralds a return to lending to low income clients is
another matter that needs to be determined but it certainly indicates an increasing commitment to rural lending.


Conclusion
It is apparent from the discussion above that the RRB amalgamation and reform process has lost touch with
the original objective of promoting these banks as an instrument of financial inclusion. Though that goal is
increasingly being force-fed to the banking system as a whole through the mechanism of “no-frills” accounts
and implemented through under-paid business correspondents, it is unlikely that this strategy is sustainable. The
purpose of this research programme is to assess the recent operational experience of both RRBs and cooperative
banks to determine their contribution to financial inclusion and to document the constraints such banks face in
furthering that process. As indicated in the introduction, during 2008-09, M-CRIL is undertaking assessments
of 8 RRBs and 12 DCCBs for this purpose. Consolidated results of these assessments will throw further light
on some of the issues referred to in this paper and will enable the study team to devise a comprehensive set of
recommendations on ways in which the rural banking system can be supported in maximizing its contribution to
providing financial services to low income clients.




                                             18         M-CRIL Review of Rural Banking in India: Working Paper 1

								
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