Risk Management Methodologies Adopted by a Rural Co Operative Bank - PDF - PDF by nqt11888

VIEWS: 111 PAGES: 52

More Info
									Technical Assistance Consultant’s Report

Volume 1: Executive Summary

Project Number: 36343
December 2003

INDIA: Rural Finance Sector Restructuring and
(Financed by the Government of the United Kingdom)

                                    FINAL REPORT

Prepared by
PriceWaterHouse Coopers PVT. Limited (Finance & Governance), India in association with
Bhartiya Samurdhi Investment and Consulting Services Limited (BASIX), India

For Ministry of Finance, Department of Economic Affairs (Banking Division)
    TA Management Committee formed by the Ministry of Finance,
    Department of Economic Affairs (Banking Division)

This consultant’s report does not necessarily reflect the views of ADB or the Government concerned, and
ADB and the Government cannot be held liable for its contents. All the views expressed herein may not
be incorporated into the proposed project’s design.


      The Rural Finance Sector Restructuring and Development Technical Assistance (TA)
      has been initiated by the Asian Development Bank (ADB) in support of the Government
      of India’s goal of rural poverty reduction and income expansion through increased
      access to sustainable rural finance services.

      Field work for the TA was carried out during May-September 2004. An interim report
      covering the various components was submitted in September 2004. The Draft Final
      Report was submitted during December 2004 to February 2005.


      This Final Report is being presented in the following volumes.

      Volume 1:           Executive Summary
      Volume 1A:          Rajasthan Credit Cooperative Structure Project
      Volume 1B:          West Bengal Credit Cooperative Structure Project
      Volume 1C:          Andhra Pradesh Credit Cooperative Structure Project
      Volume 2:           Regional Rural Banks
      Volume 3:           Microfinance Institutions
      Volume 4:           Risk Mitigation
      Volume 5:           Commodity Futures
                                                                   Technical Assistance (TA) No. 4247-IND
                                                       Rural Finance Sector Restructuring and Development
                                                                             Volume 1: Executive Summary

India has one of the world’s most extensive formal rural credit systems, with nearly
47,0001 bank branches and approximately 100,0002 cooperative credit outlets in rural
areas. However, the physical outreach of the rural credit has not been effective in
achieving income expansion and poverty reduction, and access to needed financial
services is still an issue in rural area.

Commercial Bank credit to rural areas is 10% 3 of total bank credit as against rural
contribution to GDP of 40%. The Regional Rural Banks (RRBs) account for just 8%4 of
the total formal sector credit, with nearly 60% 5 thereof being lent to the “non-target
group”. Similarly, the Cooperative Credit Structure (CCS) is known to serve the interests
of middle and larger farmers. The landless, who constitute the largest proportion of the
rural poor, do not get much credit from any formal financial institutions. A variety of
microfinance institutions (MFIs) working with the poor, while being effective, lack scale
due to their limited ability to raise resources in the absence of facilitative regulations.
None of the existing institutions have been able to provide savings services to the poor.
The near absence of risk mitigation instruments and mechanisms such as insurance for
life, health, crops and assets and commodity derivative contracts to deal with price
risks, only exacerbates the vulnerability of the poor.

The Government of India (GOI) requested the Asian Development Bank (ADB) to
provide technical assistance (TA) for preparing a rural finance (RF) project for reforming
rural finance institutions (RFIs) to enhance their poverty reduction and income
expansion contributions. Accordingly, the ADB implemented a TA for preparing the
Rural Finance Sector Restructuring and Development Project. The TA Consultant
provided an Interim Report on all components in September, 2004. Draft Final Reports
outlining the issues, objectives, scope, cost, implementation arrangements and terms of
reference for the assistance for each of the components of the TA were submitted
during December 2004 to Feb 2005. This final report includes an integrative summary.

  RBI Branch Banking Statistics, 2002 (includes semi-urban and rural branches)
  Report of the Task Force on Revitalization of Cooperatives, 2004
  Assocham Analysis: Commercial Banks’ Deposits and Credit Mobilization Pattern (1990-91 to 2003-04)
  NABARD Data for 2003-04
  RBI Basic Statistical Returns, 2003

October 2005                                                                                     Page 3
                                                                    Technical Assistance (TA) No. 4247-IND
                                                        Rural Finance Sector Restructuring and Development
                                                                              Volume 1: Executive Summary

India with a GDP per capita of USD 6006 continues to be predominantly rural with over
72% 7 of its population living in rural areas as per the 2001 Census. Yet, the Indian
village today is very different from the Indian village of fifty years ago in spite of the
popular perception of the Indian village as unchanging. Key elements of this dynamic
context include diversification of the rural economy, the continuing high vulnerability of
rural household income and changing profile of Indian Agriculture. At the same time,
while the rural finance sector has been relatively static, commercial banking in India in
undergoing a transformation and there is increasing interest of the organized private
sector in doing business in rural India. This presents an opportunity as well as a
challenge to RFIs.

2.1 Reduced Role of Agriculture, Changing Land Ownership and Income
    Profiles and Diversification of the Rural Economy

Agricultural GDP to total GDP has declined to 24% in 2003-04 as compared with 48% in

Put another way, agriculture contributes only 54% to rural NSDP as compared with 72%
in 1970-71. Rural non farm sector contributes the balance 46% and is rising. 30% of
rural males are in non-agricultural occupations.

Rural land ownership has been changing slowly but steadily due to generational
fragmentation etc. to smaller and smaller land holdings (85% of land holdings are less
than 5 acres, 63% are less than 3 acres).

At the same time rural per capita income is growing as much as urban per capita
income in spite of the decline in agricultural GDP. Thus ‘rural’ is not equal to ‘poor’. Yet
urban households incomes are 2.1 times rural household incomes and 75% of the poor
live in rural areas.

RFIs must transform themselves to address economic activity in rural areas other than
only agriculture, taking into account both the endemic poverty as also the rise in rural
per capital incomes.

2.2 Rural Household Income continues to be highly vulnerable: stochastic
    phenomenon, mainly due to Agricultural Risk

The rural households are vulnerable to a number of risks. Some of these are frequent,
such as minor illnesses but have relatively little impact, while others can be infrequent,
  Calculated using data available in Economic Survey of India, 2004-05
  Census of India, 2001
  Economic Survey of India, 2004-05

October 2005                                                                                      Page 4
                                                              Technical Assistance (TA) No. 4247-IND
                                                  Rural Finance Sector Restructuring and Development
                                                                        Volume 1: Executive Summary
such as a cyclone, with great impact. While the former are best handled by dipping into
one’s savings, or occasional borrowing, the latter require outside support, either in the
form of insurance payouts or disaster relief. One can also distinguish between
idiosyncratic and covariant shocks. Covariant shocks, such as drought, can affect all
households in a locality while an idiosyncratic shock, such lightening, may be restricted
to only a given household. Key risks include untimely death, health and accident risks,
crop and livestock risks, other property risks besides disasters.

Rural households adopt a mix of strategies depending on the severity and co-variability
of the shocks. (See figure below). For the rural poor households, self-insurance
strategies include a) reduced consumption of food grains b) taking children out of school
c) temporary migration d) diversification of income sources. It may be noted that some
of the above strategies reduce the ability to withstand future shocks and thus if there are
successive droughts or bouts of illness, then the family becomes more and more prone
to risk. As a result, the poor forgo potentially viable new technologies, production
choices, and income opportunities due to risk aversion.

                                                           Asset sale,
                                 Borrowings,               Migration
                 Savings,        Asset pledging


The absence of suitable risk mitigation mechanisms has been a key reason for
persistent poverty as also the poor health of RFIs in rural areas. Any effort at reforming
the rural finance system in the country must address risk both at the rural household
level as well as at the RFI level.

2.3 Changing Profile of Indian Agriculture

Over the past few years, Indian agriculture has witnessed a marked shift from food grain
orientation to commercial and horticulture crops. Crops like sugarcane, oilseeds, spices,
fruits and vegetables are acquiring greater importance. The area devoted to non-food
crops has increased from about 25% in 1971-72 to over 35% in 1999-20009. Similarly,
on the back of changing dietary preferences, the share of allied sectors in agriculture,
mainly dairying, fisheries and poultry is on the increase. From being less than 16% in
1970-71, allied sectors now comprise more than a quarter of the value of agricultural

    Vyas Committee Report
     Vyas Committee Report

October 2005                                                                                Page 5
                                                            Technical Assistance (TA) No. 4247-IND
                                                Rural Finance Sector Restructuring and Development
                                                                      Volume 1: Executive Summary
Another trend that has been observed is the increased share of purchased inputs (like
hybrid seeds) as opposed to owned inputs in agriculture. This indicates modernization
of agriculture and results in stronger backward linkages. A very small proportion of
farmers have also taken to organic farming in an attempt to exploit the increasing
preference for organic food especially in foreign markets. However, the area under
organic farming is only 0.03% 11 of the total cultivated area and this suggests
tremendous potential for scaling up and growth.

RFIs must thus gear themselves to financing newer crops and technologies, both in
order to benefit from the changing profile of agriculture as well as to facilitate the
change for higher productivity while at the same time mitigating risk in a cost optimal

Further, it is hoped that with the emergence and growth of commodity futures markets,
there will be greater transparency in the price discovery process and farmers will be
able to produce crops in alignment with market forces instead of relying on the
government controlled prices. However, in order for farmers benefit from futures
trading, a lot needs to be done to ensure dissemination of price information, availability
of warehouses, institution of a warehouse receipt system and a framework for financing
against warehouse receipts.

2.4 The Changing face of commercial banking in India

India’s rural credit delivery system comprises a large number of agencies including
cooperatives, RRBs, NBFCs and Commercial Banks. Of these, the commercial banks
have the largest share, contributing over 55%12 of the annual credit flow to agriculture
and allied activities.

Subsequent to nationalization of banks, there has been a significant increase in the flow
of direct institutional credit by commercial banks to agriculture and allied activities.
Whereas the share of cooperatives has decreased from 98% in 1971-72 to 38%13 in
2003-04, the share of commercial banks has increased from about 2% to 55% during
the same period. The RRBs contribute the remaining 8%14 share.

It may be noted that while nationalization resulted in significant thrust on agriculture
lending, the more recent banking sector reforms have resulted in slowing down of
agriculture lending. This is reflected in the changing Credit-Deposit ratios of the rural
branches of commercial banks. At the time of nationalization in 1969, the CD ratio of the
commercial banks’ rural branches was 37%. This peaked to about 58% in 1981.
However, after the introduction of banking sector reforms which among others
introduced tighter income recognition and asset classification norms and reduced

   Calculated using data from APEDA website.
   RBI and NABARD data for 2003-04
   RBI and NABARD data for 2003-04
   RBI and NABARD data for 2003-04

October 2005                                                                              Page 6
                                                               Technical Assistance (TA) No. 4247-IND
                                                   Rural Finance Sector Restructuring and Development
                                                                         Volume 1: Executive Summary
directed lending, the rural CD ratio has declined to 42%15. Even among RRBs, the CD
ratio is only around 44%16 and has shown a marked decline in the post-reform era.

At the same time, commercial banks are fast becoming much more retail oriented.
There has also been increased attention to microfinance. Examples include:

•     The very large outreach built over a five year period since 2000, mainly by the public
      sector commercial banks and RRBs, to poorer households through the self-help
      group (SHG)- bank linkage program, which had reached over 1.6 million SHGs
      (about 24 million households) with cumulative loans of over Rs 7000 crore by March
      31, 2005.

•     Strong interest demonstrated by certain banks – notably SBI and ICICI – in the rural
      markets, not only ion response to “priority sector” requirements but out of a strategic
      appreciation of the growth potential of the rural market.

•     The lending to microfinance institutions (MFIs), the top five of which had a loan
      outstanding of Rs 400 crore as on March 31, 2005, and which collectively reached
      over 1.5 million rural poor households. It should be noted that all these MFIs are
      “for-profit” non-banking finance companies and have availed loans from commercial

In a major policy initiative, the Reserve Bank of India permitted commercial banks to
use agents to provide microfinance. Several private banks have mounted initiatives in
this area. It is expected that the combination of a facilitative policy environment,
improved ICT connectivity and the focus on retail can begin to address the huge
problem of exclusion in access to financial services much better than the state owned
and subsidized RFIs could do in the past.

2.5 The changing role of organized private sector in the rural economy

Over the last few years, the organized private sector seems to be realizing the vast
potential of the Indian rural economy and is increasingly engaging with the rural
household as a producer and a consumer. Some examples:

•     The spread of telecom through rural India, with a nationwide network of both optical
      fibre as well as cellular technologies. This has provide the pre-condition for several
      applications to be offered, and though those are still slow in coming, there are
      several which have a promise to transform the way rural business is done. This
      includes the availability of land records through “Bhoomi” in Karnataka, the local sale
      of agricultural produce through ITC’s e-choupals and so on.

     RBI Banking Statistics
     RBI Banking Statistics

October 2005                                                                                 Page 7
                                                             Technical Assistance (TA) No. 4247-IND
                                                 Rural Finance Sector Restructuring and Development
                                                                       Volume 1: Executive Summary

•   ITC’s much talked about e-choupals have used IT and communications technology
    to enhance income opportunities and access to new markets in the rural areas. ITC,
    along with petroleum product retailers BPCL and HPCL, is also setting up chains of
    shopping plazas/ hyper markets in villages to tap rural shoppers.

•   Hindustan Lever Limited, a multinational private sector company, has sponsored
    Project Shakti wherein groups of 15-20 people (often, women) start small business
    ventures (including, but not necessarily, distributorship of HLL’s products like soaps,
    detergents, etc.) HLL provides free training in business management to the self help
    groups, irrespective of whether they work as HLL’s distributors or strike out on their
    own. The project, which started as a small experiment in 2002, has now expanded to
    over 22,000 villages and helped improve income levels and living standards of more
    than 9,000 entrepreneurs.

•   ICICI Bank, a private sector commercial bank, has facilitated supply chain
    integration for apples produced in Himachal Pradesh. Himachal Pradesh accounts
    for nearly 40% of the 1.5 million tonnes of apples produced in India. While these
    apples have always been known to be of good quality, lack of proper cold storage
    infrastructure resulted in excessive wastage and value destruction. ICICI Bank
    identified entrepreneurs willing to invest in logistics and cold storage chains for the
    Himachal apples and provided financing to such entrepreneurs. It is in the process of
    carrying out a similar supply chain integration and development for the banana
    farmers in Maharashtra.

•   The dramatic rise in the business of the newly established commodities exchanges,
    led by the NCDEX, which has an average business per day of over Rs 5000 crore.
    Several other commodities exchanges are active and thriving. This is in spite of the
    fact that options contracts are not yet permitted on these exchanges, and the trades
    are only in futures contracts.

•   The emergence of several new private insurance companies, both life and non-life,
    which are aggressively seeking to build a presence in the rural markets, way beyond
    the mandatory requirement of the IRDA. These include Aviva Life Insurance, ICICI
    Lombard (which has pioneered the rainfall based crop insurance product) and Royal
    Sundaram (active on both health and livestock insurance).

While these initiatives are still too few to make a dent on the issue of exclusion, their
numbers are increasing. This provides an opportunity for RFIs to explore new channels
and opportunities in an integrated and sustainable manner.

October 2005                                                                               Page 8
                                                                        Technical Assistance (TA) No. 4247-IND
                                                            Rural Finance Sector Restructuring and Development
                                                                                  Volume 1: Executive Summary

2.6 Rural Finance sector: Static: Dominated by fragmented uncorporatized
    intermediaries because policy and regulatory framework is geared to
    state sponsored and subsidised credit focussed on credit to land

In culmination of a major study of Rural Financial Markets in Asia, the ADB had made a
simple set of recommendations in regard to:
•     Creating an Appropriate Policy Environment including in relation to interest rate
      reforms, loan targeting, institutional support, emergency loans, institutional
      autonomy and political interference;
•     Building Financial Infrastructure including legal and regulatory systems and
      information systems; and
•     Institutional Development and special challenges for Institutional Development.

Assessing the RF sector in India over the last five decades in the light of these
recommendations, it is seen that the ruling paradigm has been that of credit expansion
through Government owned or subsidized RFIs and targeted programs for priority
sectors. This helped establish a largely state-owned RF system with one outlet for
approximately every 5,000 population 17 . At the aggregate level there are nearly 85
million rural borrowers as against 300 million rural savers, including those who save at
post offices.

India’s RF network is subject to systemic policy issues and pervasive institutional
weaknesses. Lack of autonomy and weak governance have affected sustainability of
RFIs and constrained outreach. This, among others, impedes diversification to non farm
activities for supporting value addition and employment generation. Further, the risks in
RF due to droughts and floods are accentuated by the weak rural infrastructure and by
production and marketing bottlenecks. The resulting low prices, productivity, and
profitability make it difficult for the rural sector to compete for capital with urban areas.
Rural credit is only 10% of total commercial bank advances. Thus, a demand and
supply gap exists, despite the extensive RF network. The rural poor and women, in
particular, have inadequate access to RF services. The disadvantages that the rural
poor face due to limited access to RF are accentuated by the inadequacy of risk-
mitigating instruments to insure against the risk they face.

India relaxed interest rate controls several years ago but RFIs are far from developing
capability to set rates consistent with costs and risks. This is exacerbated by direct and
indirect ownership and control of RFIs and Apexes.

The RFIs and apex institutions were conceived in an era when the challenges were
quite different – the predominant one being to ensure food self-sufficiency in India.
Thus, these institutions need to revisit their raison d’etre, and devise a strategy, which

     Approximately 150,000 branches for a total rural population of about 750 million

October 2005                                                                                          Page 9
                                                          Technical Assistance (TA) No. 4247-IND
                                              Rural Finance Sector Restructuring and Development
                                                                    Volume 1: Executive Summary
would make them dynamic and responsive players to the emerging challenges and
opportunities of rural financing in India in the post-reform era.

World over, the new approach to rural finance is a market – oriented role for
Government that focuses on creating a favourable policy environment and a facilitative
legal and regulatory framework for rural finance intermediation.

In India too, some initiatives suggest that this direction is being explored but the
appropriate level and form of direct government intervention remains an issue to be

There is agreement on building institutional capability for improved financial
intermediation. But there is still no consensus on the most important requirement for
developing institutional capability, i.e., a high level of management autonomy and
accountability for the performance of an RFI.

October 2005                                                                           Page 10
                                                           Technical Assistance (TA) No. 4247-IND
                                               Rural Finance Sector Restructuring and Development
                                                                     Volume 1: Executive Summary

The TA focussed on reforming RFIs, in particular the credit cooperative system and the
RRBs. At the same time, the TA explored and recommended initiatives beyond those
related to the expansion of credit. In particular, the TA comprehensively reviewed risks
that a rural household is exposed to and proposed strategies to facilitate market based
offering of risk mitigation instruments, specifically insurance and derivative products
addressed to the rural households. The TA also reviewed the progress made in India by
microfinance initiatives and made recommendations to mainstream both the initiatives
as also the best practices learnt through these initiatives.

In overall terms, the strategy recommended under the TA may be summarized as

•   Initiate Reform in the CCS and RRBs focusing on

          o Laws, governance, management, control and supervision in credit
            cooperative structure, supporting entities that respond positively to the
            change imperatives and have the potential to be viable
          o Clarifying ownership and accountability issues in RRBs and incentivizing
            commercial banks to manage their own and their sponsored RRB
            portfolios in a holistic manner
          o Introducing microfinance best practices and technology to reach out to the
            poor and those hitherto excluded from the outreach of the RFIs

•   Implement and action plan for developing and improving products, delivery channels
    and contracts for risk mitigation focusing on
       o Deepening life insurance coverage through group micro insurance
       o Improving health services through public private partnerships
       o Innovative products such as weather derivatives for crop insurance
       o Expanding livestock coverage through dairy cooperatives and lending
       o Rationalizing pay-ins and pay-outs for disaster relief
       o Moving from subsidies to a contributory system for social security
       o Continuing the directions of insurance regulatory reforms already underway
       o Activating and intimately involving peoples organizations, cooperatives, self
          help groups, community based organizations, trade unions etc. in developing
          and distributing insurance for members.

•   Create an enabling environment for small farmers to participate in and benefit from
    the commodity futures markets focusing on
       o facilitating development of adequate warehousing infrastructure in rural India
          and promote warehouse receipts as a reliable instrument of market
          transactions, including developing systems which would promote a supportive

October 2005                                                                            Page 11
                                                             Technical Assistance (TA) No. 4247-IND
                                                 Rural Finance Sector Restructuring and Development
                                                                       Volume 1: Executive Summary
         market environment for small farmers, thus providing them with more
         accessible market outlets and reducing their cost of financing
       o Providing stakeholders, particularly small farmers, with reliable, real time price
         data through a robust price dissemination system with widespread reach.

A summary of findings, recommendations and proposed projects for ADB assistance is
provided in the next section.

October 2005                                                                              Page 12
                                                                                 Technical Assistance (TA) No. 4247-IND
                                                                     Rural Finance Sector Restructuring and Development
                                                                                           Volume 1: Executive Summary


4.1 The Cooperative Credit Structure (CCS)
4.1.1 Overview

The CCS caters to both, the short term and long term credit needs of the rural
consumers. Except in Andhra Pradesh and Jharkhand, the short term cooperative credit
structure and the long term cooperative credit structure are separate. The short-term
cooperative credit structure functions through three tiers in each state. These are a
State Cooperative Bank (SCB), District Central Cooperative Banks (DCCBs) and
Primary Agricultural Credit Societies (PACS). The long-term structure works through
two tiers in each state viz. the State Cooperative Agriculture and Rural Development
Bank (SCARDB) at the state level and the Primary Cooperative Agriculture and Rural
Development Bank (PCARDB) at the district level.

In March 2003, there were 30 SCBs, 367 DCCBs and 98,247 PACS. The total loans
outstanding of these institutions were INR 646.65 billion. On the long term side, the
loans outstanding were INR 153.85 billion extended through 768 PCARDBs and 20

In the last few years, the central and state governments have tried to grapple with
problems besetting the Cooperative Credit Structure (CCS) and therefore, have
commissioned task forces/ committees to propose solution to the growing problems.
From all these Task Forces’ reports one element is common – the system is broken and
it has to be fixed, if the intention of the government is to provide financial services in the
rural area. Moreover, while the recommendations differ in the detail and all of them
agree that a restructuring plan will have, in order to succeed, to address each and every
component of the CCS.

The TA covered a specific study of the CCS in five states of India, namely:

•      Rajasthan
•      West Bengal
•      Andhra Pradesh
•      Madhya Pradesh, and
•      Kerala.

The study focused on a review of organization, ownership, governance, management
and human resources, operations, systems, including bookkeeping and internal control,
     Source: NABARD: Cooperative Credit Structure: an Overview: 2002-03

October 2005                                                                                                  Page 13
                                                              Technical Assistance (TA) No. 4247-IND
                                                  Rural Finance Sector Restructuring and Development
                                                                        Volume 1: Executive Summary
portfolio quality, profitability and transaction cost. This was done through review of
documentation including byelaws, audit inspection reports, MIS, policies and loan files
and interviews with key personnel and sample employees as well as a sample of
customers/ potential customers. A suite of instruments including questionnaires was
used to ensure uniformity.

4.1.2 Key Issues and Recommendations

The five states studied are somewhat to very different from each other in size, agro-
climatic conditions, social conditions as well as in the evolution and recent history of the
CCS. The physical outreach of the CCS is unmatched by any other banking institution in
the country except perhaps the post office savings institutions. However, the CCS in
none of the states we studied can be said to be performing well on the twin criteria of
financial performance and outreach. In some states like West Bengal, the CCS is a
major mobilizer of rural savings. But even here, these savings, instead of being lent
back in the rural areas are finding their way in the urban/industrial sector just like the
commercial banks; however, unlike with most of the commercial banks, these savings
are at substantial risk as there is extensive asset erosion in the CCS, the extent of
which is unknown. Some states like West Bengal and Kerala have regularly held
elections and have duly elected people’s representatives at the helm of affairs in the
CCS. Still the CCS is inefficient and loss making and its deposits at risk. Other states
like Rajasthan have not had an election for over ten years and the state government
officers run the CCS with the same results as in West Bengal and Kerala.

Andhra Pradesh integrated its long term and short term structures many years ago but
within the organization, individuals still behave as if they work for the separate
structures and no gains have been realized. NABARD and some states have developed
revitalization plans and signed MoUs, training plans have been instituted and
innumerable studies carried out. Yet the CCS performance appears to worsen each

So is the CCS beyond redemption? The study team believes that the CCS is perhaps
the only network with the physical outreach to address the financial services needs of
the rural households. However, this potential is unrealised due to a combination of
inadequate regulation, political interference, poor governance and administration, very
poor accounting, reporting and auditing systems and a lack of innovation in
development of viable products and channels to address the specific needs of the rural
clientele. This potential can only be realized through fundamental changes in the
regulation/supervision approach, governance, financial and institutional arrangements.
Restructuring the cooperative system should be a vital part of the rural finance sector
restructuring and development exercise. A healthy and vibrant cooperative sector with
its tremendous outreach could also be the ideal delivery mechanism for products like
SHG linkages, insurance, and commodity price derivative products which are critical for
risk mitigation for the rural household.

October 2005                                                                               Page 14
                                                             Technical Assistance (TA) No. 4247-IND
                                                 Rural Finance Sector Restructuring and Development
                                                                       Volume 1: Executive Summary
In the study team’s assessment, restructuring plans have not worked in the past
because these have addressed only a part of the problem (people’s representation,
systems, training). We suggest that if the CCS has to be revitalized all parts of the
problem will need to be addressed simultaneously. In particular, the control, supervision
and regulation issue are vital. The CCS is said to suffer the problem of dual control. We
believe it suffers from a surfeit of rules and no regulation. It suffers from too many
supervisors and no supervision. NABARD requires DCCBs & SCBs to follow prudential
norms in line with RBI’s norms (for Agricultural loans) for commercial banks. In the
summer of 2004, RBI followed by NABARD effected changes in norms in relation to
restructured loans that do not take cognizance of the riskiness of such loans. It has too
many owners and no ownership. Over a quarter of the DCCBs and SCBs do not meet S
(11) requirements. So in addition to the control, supervision and regulation issue,
systems and procedures, professional management (banking) that feels accountable to
owners, supervisors and regulators is vital.

Our study shows that India is unique among countries with a large CCS in that there is
no separate financial cooperative law with clearly identifiable accountability for
supervision and regulation. In most countries where financial cooperatives are doing
well, these cooperatives are subject to regulation by the single financial regulator even
though the law and rules for financial cooperatives may be different from those of
commercial banks.

We have accordingly suggested that India explore a separate financial cooperatives law
(which could be a part of the BR Act) with the RBI as the regulator for this law. We
understand that this is a centre-state relations issue and so perhaps not immediately
tractable. However, in the absence of appropriate control and supervision, no
revitalization and restructuring plan can succeed and accordingly, we suggest that those
states be prioritised for restructuring the CCS which are voluntarily willing to facilitate
professional management and appropriate control and supervision of financial
cooperatives. This should include allowing unviable institutions to be phased out.

October 2005                                                                              Page 15
                                                             Technical Assistance (TA) No. 4247-IND
                                                 Rural Finance Sector Restructuring and Development
                                                                       Volume 1: Executive Summary

                                               Regulation &




    Institutional                                                             Financial
    Development                                                              Restructuring

The thrust of the recommendations is then that restructuring the CCS should involve
short (immediate), medium (2 – 3 years) and long term (5 years) actions along the three
dimensions of regulations and supervision, institutional development and financial
restructuring with movement to the next phase only after achieving objectives
/performance benchmarks on all three dimensions in the preceding phase. So for
example financial restructuring without institutional revitalization activities will be
throwing good money after bad and both without appropriate actions on the regulating
and supervision front will lead the CCS to come back full circle to poor performance
sooner or later. The Rajasthan, West Bengal and Andhra Pradesh reports provide
detailed projects detailing key activities and outlining implementation frameworks, roles
and responsibilities. A summary of the approach on key issues is provided below.

4.1.3 Approach and Strategy

The following guiding principles have been adopted in developing the strategy for
revitalization of the CCS:

•   Reaffirmation that the basic idea of a rural credit cooperative system is good and
    continues to be relevant in the current context
•   The need for a bottom up approach – to ensure a strong CCS, we need to have
    strong member controlled PACS, which in turn, requires not only changes in the
    legal framework and systematic withdrawal of the State from ownership and control
    of the CCS but also educating the PACS members about their rights and obligations
    and inculcating within them a sense of ownership and responsibility
•   There is also need for internal control and regulatory supervision systems calibrated
    to the needs of the reforming CCS
•   The newly designed CCS should be able to offer wider range of financial services to
    the rural poor including innovative risk management solutions – “one stop shop”

October 2005                                                                              Page 16
                                                             Technical Assistance (TA) No. 4247-IND
                                                 Rural Finance Sector Restructuring and Development
                                                                       Volume 1: Executive Summary
•   Adoption of IT by the CCS at all levels, including for example biometric cards, WLL
    swipe machines and low cost ATMs
•   Leverage existing outreach of the CCS without expanding financial intermediation
•   Accurate measurement of the extent of capital erosion and required investment to
    ensure there is no under-funding of the reform project
•   No life support for unviable entities. Only those entities that are capable of being
    revived should be restructured.
•   Financial support at all levels should be contingent on actions conducive to the

The project implementation strategy is divided into several components, addressing the
following issues:

Laws and regulation

There is urgent need for a coherent financial cooperatives legislation that clearly defines
regulatory authority and responsibility besides the basic regulatory paradigm. As
cooperation is a state subject it appears that this law will need to be legislated by each
state unless the constitutional lists are clarified through a constitutional amendment.
This law and its rules have to ensure that it creates an enabling environment for the
CCS, and that the financial cooperatives while being registered under that law gain
freedom of management and action. The cooperative law and rules will also need to
ensure that in regard to cooperative banks, authorities and mechanisms are provided to
enable RBI and NABARD to perform regulatory and supervisory functions with minimal
overlap in role and functions with the RCS.

As an interim measure the stage government can issue executive orders to facilitate
early implementation of the changes. These orders should cover inter alia:

•   All members should have the same rights and that every individual borrowing or
    making deposits with the co-operatives is a member
•   Bye-laws should define clearly roles and responsibilities of Directors, and foster
    regular elections
•   Bye-laws and regulations should provide for professional presence at the governing
    and administrative level
•   Abolish Board positions for state Government and state government to exit from
    share capital of CCS
•   Define and restrict role of RCS, withdraw restrictive orders on CCS actions
•   Provide appropriate authority/ facilitation to RBI/NABARD for cooperative banks

GoI/RBI will also have to establish regulation allowing transformation to take place,

•   Establish prudential norms and changes in the BR Act, keeping in view the
    cooperative character of DCCBs & SCBs.

October 2005                                                                              Page 17
                                                            Technical Assistance (TA) No. 4247-IND
                                                Rural Finance Sector Restructuring and Development
                                                                      Volume 1: Executive Summary
•   Allowing DCCBs to have agents to raise deposits
•   Clarifying the role of NABARD as the supervisor with appropriate tools at its

Control and Supervision

The success of all financial institutions is primarily based on the trust its potential
customers place on the organisation. Many institutions around the world have risen and
fallen because of that. It is obvious from field reports that the CCS is suffering from a
lack of trust. This is also evident if one compares the tremendous outreach with the
small deposit base of the CCS Field Work confirms that if there are two financial
institutions in the same area, the depositor will not favour the CCS unit.

Trust is engendered not only because of security but also because the customer knows
that the institution is well managed. Currently this perception is negative mainly because
it is well known that control over CCs is almost not existent. Therefore, if regulations,
policies, and procedures are not strictly followed, units should not receive permission to
operate freely.

In context of the situation in India, an integrated supervision system is recommended. In
this system, two levels of control and supervision are required. Firstly, the internal
control system should be reinforced by implementing state of the art system through
which regular inspection (once a year for performing units and as required for non-
performing) cold be conducted. The SCB would supervise the DCCBs; and DCCBs, the
PACS. The SCB and DCCBs will have internal separate entities for this function
comprising professionals. These professionals will be granted with enough
independence to avoid interference and they will conduct on and off site inspection and

The supervision of the SCBs, DCCBs, the core of their activities being banking, is the
responsibility of the banking regulator. NABARD has been concurrent powers of
inspection, but without authority to use supervisory tools. It is critical that NABARD’s
supervisory role be clarified vis-à-vis that of RBI as a regulatory and that there is a
specialised set up for supervision of the cooperative banks with appropriate supervisory

Structure of the CCS

While drastic changes to the physical structure of the CCS are not recommended,
certain important ownership changes are suggested. These include conversion of PACS
into agents of DCCBs so as to enable them to provide comprehensive financial services
(or at least those services that a DCCB is able to provide) to the rural poor. Currently,
for example, PACS are, strictly speaking, not allowed to accept deposits from members,
although some PACS are doing so. Thus DCCBs, which are already carrying out
banking functions through their branches, would now be servicing a larger client base
through their agents (PACS). PACS would accept deposits on behalf of the DCCB and

October 2005                                                                             Page 18
                                                               Technical Assistance (TA) No. 4247-IND
                                                   Rural Finance Sector Restructuring and Development
                                                                         Volume 1: Executive Summary
the loans disbursed by the PACS would reflect on the balance sheet of the DCCB. It is
proposed that the SCB should serve as a service provider to the CCS and exit the retail
lending activities. In fact there are arguments in favour of curtailing the SCB’s refinance
role also, but that is not recommended at this stage.

The proposed strategy is that each unit of the CCS will develop a restructuring plan.
The immediately higher tier will review the restructuring plan and either take ownership
of the restructuring plan, or if found infeasible, prepare winding up plans for the entity.
Thus, where it is felt that a PACS is dormant or cannot be revived, the households it is
currently serving should be linked to the nearest “healthy” PACS or to an extension
counter or branch of the DCCB. Similarly, some DCCBs may also be unviable and may
have to be closed. In such a situation, the PACS being serviced by these DCCBs will
have to be linked to the nearby healthy DCCB.


In order to ensure good governance of CCS institutions, it is important to empower the
real owners (i.e., the members) of these institutions. For this to happen, besides the
regulatory and legal changes discussed above, immediate steps will need to be taken
for free and fair elections through out the CCS and reversion of State Government
nominees on the Boards of and as managers of these institutions. But before that
training programmes would need to be organized to sensitize members about their
rights and obligations. Further, voting right which are currently restricted to borrower
members should also be extended to depositor members. While at the PACS level, the
Boards should be member-centric, at higher levels (DCCBs and SCBs), greater
professional involvement is envisaged. Accordingly, it is proposed that at least one-third
of the DCCB/ SCB board should comprise professionals with relevant banking/ financial
services experience. Specific recommendations are made in regard to board
committees, etc.

Products and Risk Management

The recommended strategy in relation to products is to enhance the capability of the
CCS to develop and deliver a full array of financial services (including savings and
insurance services) with products and procedures specifically designed for the clientele
(for example, products suited to seasonal cash flow patterns of agricultural households).
This will require intensive capacity building inputs under the projects and will have to be
facilitated by regulatory changes in relation to what CCS entities can do as well as
development of linkages with insurance companies, commodity exchanges, etc.

 It is also critical that the CCS build inherent capacity to address the risk of its clientele
as well as risk to its own sustainability in context of the risk proneness of its clientele by:

•   Expanding outreach of savings and insurance services to its members. The project
    will focus on development of suitable products and linkages between insurance
    product providers and the CCS.

October 2005                                                                                Page 19
                                                              Technical Assistance (TA) No. 4247-IND
                                                  Rural Finance Sector Restructuring and Development
                                                                        Volume 1: Executive Summary
•   Mainstreaming micro finance best practices in the CCS: best practices are being
    incorporated in each of the section of this strategy. A full review of products,
    procedures and processes will be carried out to introduce MFI best practices to the
•   Hedging the portfolio risk through weather derivatives: hedging agricultural risk is
    very difficult, but there are derivative products available (such as rain fall insurance)
    which could serve to mitigate risk. The project will provide support for pilot activities
    in this area.
•   Disseminating commodity pricing and knowledge will enable the farmer to mitigate
    price risk. The project will implement pilots.

Creating Risk Fund: If the CCS is to sustainable without resorting to periodic loan
forbearance or worse, relaxation in prudential norms, it will be necessary to create a risk
fund which should be partially funded by members. The projects propose some ideas in
this regard.

Management and Human Resources

Managing a bank/ financial institution requires specific skills and managing a
cooperative bank/ financial institution requires the same skills and more. It is felt that
most managers in the CCS being government employees on deputation do not have the
necessary skills or orientation to manage a cooperative financial institution. There is a
need to professionalize the management of the CCS. This can be done partly through
training but also requires replacement of the employees on deputation with professional

The CCS also suffers from an aging employee profile which lacks motivation. Both
these issues need to be addressed on priority in order to revive the CCS.

While there are several cooperative training institutes at state and national levels, their
training programmes require review and modification in light of the proposed changes in
the CCS. Further, mobile training units would need to be organized in order to ensure
that the training reaches those people who are not able to attend training programmes
organized at distant training institutes. The recommended strategy suggests inclusion of
innovative teaching methods like street shows and puppet plays for sensitization of

Information Technology

Reliable information is extremely important for day to day operation and management of
a financial institution. A strong MIS supported by a strong IT backbone will not only
reduce transaction costs but also improve the speed of decision making. It is therefore
strongly recommended that the CCS be computerized as soon as possible. The process
should begin with the SCB and DCCBs and be implemented in the PACS in a phased
manner. The use of smart cards, hand held devices and low cost ATMs should be
explored at PACS level. A common, standardized MIS would need to be implemented

October 2005                                                                               Page 20
                                                              Technical Assistance (TA) No. 4247-IND
                                                  Rural Finance Sector Restructuring and Development
                                                                        Volume 1: Executive Summary
across the various levels of the CCS in order to make the IT implementation smooth
and more meaningful. There is also a need to adequately train the staff in using the IT
solutions implemented at the CCS and to address any concerns they might have
regarding redundancies and loss of jobs, etc.

In order to ensure consistency in the quality of the systems implemented, a few reputed
software development agencies should be short listed after thorough review of the
available options. The CCS should be allowed to source their IT solutions from only the
short listed agencies.

4.1.4 Financial Restructuring

Cleaning up the balance sheets of these organisations will be necessary. But before
that, a thorough audit/review will need to be carried out on to assess the portfolio quality
and draw up financial statements using generally accepted prudential norms.

The major issues that will have to be faced to estimate the full extent of requirement of
financial restructuring are:

•   There are accumulated losses at all levels
•   Basic accounting is unreliable and PACS do not follow prudential norms
•   There have been successive loan restructurings. RBI norms do not require
    provisioning on restructured agricultural assets. Cooperative Law requires interest to
    be recognized on accrual basis. While RBI norms require overdue interest to be
    provisioned, the treatment is not followed consistently.
•   Actual asset erosion is likely to be substantially higher than currently assessed in the
    system or what CCS books will show after the summer 2004 circulars on
    restructuring and provisioning for agricultural loans are implemented.

Therefore, it is suggested that no financial restructuring of the CCS be carried out
without taking steps to ensure the CCS’s sustainability. Principles guiding this action will
be followed:

•   The state will accept the policy and reform framework in toto. This includes issuing
    executive orders to give effect to changes in the regulations, governance and
    ownership of CCS entities pending legislative changes.
•   PACS will initiate changes to have a single class of members characterized by
    voting rights.
•   Steps will be taken to hold elections at all levels.
•   Financial restructuring will not involve infusion of funds in such a manner that the
    state or its agencies are left as shareholders in CCS entities.
•   No funds will be provided to individuals or entities so that they can infuse capital into
    the system
•   Only potentially viable entities must be financially restructured.
•   While GoI, State Governments, the CCS entities and CCS members must all share
    the cost of financial restructuring of CCS to the extent that proximate responsibility

October 2005                                                                               Page 21
                                                            Technical Assistance (TA) No. 4247-IND
                                                Rural Finance Sector Restructuring and Development
                                                                      Volume 1: Executive Summary
    can be assessed, it will be important that the amounts required are available from a
    single pool so that delays in release of funds from any entity do not jeopardize
    project implementation. It is accordingly proposed that contributions by CCS
    members and entities be limited to the extent of owned funds and that State
    Governments be provided a loan by GoI to the extent of its assessed contribution
    with the actual funds flowing to the CCS through NABARD without going through the
    State Government.

It is critical that financial restructuring is carried out only to support and incentivize
revitalization of the CCS as a whole and that it is preceded by stakeholder acceptance
of an institutional restructuring plan including governance and management. It is also
critical that any restructuring be contingent on achieving pre-agreed performance
benchmarks. Thus first the project will have to identify candidates for restructuring.
Many PACS are dormant. Many others are in very poor shape. Similarly, some DCCBs
may need to be wound up or merged with other DCCBs.

The major issues to be taken into consideration in working out the details of financial
restructuring include:

•   criteria for determining eligible institutions,
•   the quantum of assistance required,
•   the sharing pattern between centre and state government,
•   conditionalities and
•   phasing of the assistance over time.

The enclosed project reports recommend an approach to the above except in relation to
sharing between state and centre. At the same time, the financial position of State
Governments may not enable them to meet their commitments in a timely manner. To
ensure that the state government’s financial position does not jeopardize the reform
program, GOI may like to consider soft loans to be made available to the concerned
State Governments to enable them to meet their commitments to the reform program.

The CCS Projects

Based on discussions with ADB, GOI and NABARD, three projects for possible ADB
funding have been prepared in respect of Andhra Pradesh, Rajasthan and West Bengal.
These are attached at Volumes 1A to 1C of this Final Report.

4.2 Regional Rural Banks
4.2.1 Overview

Regional Rural Banks were set up consequent to the Banking Commission observation
in 1972 regarding the need for a specialised network of bank branches to cater to the
rural poor. The RRB Act was passed in 1976 and RRBs were set up so as to hybridise
commercial banking culture with rural ethos. The idea was to develop RRBs as state-

October 2005                                                                             Page 22
                                                           Technical Assistance (TA) No. 4247-IND
                                               Rural Finance Sector Restructuring and Development
                                                                     Volume 1: Executive Summary
sponsored, region-based, rural-oriented commercial banks having the low cost profile of
cooperatives and the professional discipline and modern outlook of commercial banks.
Between 1975 and 1987, 196 RRBs were established. A large number of RRB
branches were opened in the hitherto unbanked or underbanked areas providing
services to the interior and far flung areas of the country. RRBs were expected to cover
primarily the small and marginal farmers, landless labourers, rural artisans, small
traders and other weaker sections of the rural community.

RRBs have played a significant role in providing banking services in remote rural areas.
However, during the first 10 years of the setting up of RRBs, 152 out of 188 RRBs had
notched up accumulated losses of Rs 3.4 billion. The losses went up sharply in 1992 on
account of implementation of the National Industrial Tribunal award which brought parity
in the wage structure of RRBs with that of commercial banks.

Since then several committees have been set up to look into the problems and issues
faced by RRBs and suggest ways and means to address the same. Over the period
1994-2000, 187 RRBs have been provided with a total of Rs 22 billion for
recapitalization. However, their financial viability continues to be shaky on account of
policy rigidities coupled with a low capital base in an environment of inadequate
infrastructure and deep social and economic disparities.

The 196 RRBs, with 14,433 branches spread over 516 districts, vary widely in coverage
and size:

•   45 RRBs cover just one district each while another 109 cover 2-3 districts each; 29
    RRBs service 4-5 districts while 13 RRBs have a service range of 6-9 districts each
•   70 RRBs have up to 50 branches each; 109 RRBs have between 51 – 150 branches
    each while 17 RRBs have over 150 branches each
•   82 RRBs have assets up to Rs. 2 billion, another 82 RRBs have assets between Rs.
    2 billion – Rs. 5 billion while 32 RRBs have assets over Rs. 5 billion.

Further, although RRB branch presence is remarkable in the rural areas, their
performance in the provision of financial services is not commensurate. At present,
RRBs’ share in agriculture credit is 8% while that of commercial banks is about 50%
and that of CCS is 42%. Such low market share coupled with poor financial
performance raises serious issues about the RRB model. Studies have also pointed out
that in an effort to meet financial performance expectations of shareholders, RRBs
appear to be drifting from their mission to serve the underserved and unreached in a
cost effective way.

4.2.2 Key Issues

Misalignment of Ownership and Management

The most pressing issue for RRBs is the misalignment of ownership and management.
While the largest owner, GoI (50%) is too distant to manage, the nearest, the state

October 2005                                                                            Page 23
                                                                    Technical Assistance (TA) No. 4247-IND
                                                        Rural Finance Sector Restructuring and Development
                                                                              Volume 1: Executive Summary
government (15%) has too little a shareholding. The Sponsor Bank plays the key
management role but has a minority shareholding (35%). Though government
shareholding to the extent of 65% (50% + 15%) adds to the confidence of the
depositors, it impedes any restructuring exercise due to lack of consensus among

Risk Aversion and Mission Drift

In the decade and a half since banking sector liberalization and ensuing focus on
financial performance, RRBs have drifted away from their mission. The Credit – Deposit
(CD) ratio during FY2003 stood at 44% as against the RBI stipulation of 60%. This has
serious implications for provision of credit to meet the needs of the rural borrowers. The
Investment – Deposit (ID) ratio has been at around 66%-72% during these years
indicating the relative preference of RRBs towards investment rather than the main
business of lending.

High Cost Operations

As on 31 March 2003, the liabilities of RRBs on a consolidated basis comprised owned
funds19 (Rs 47 billion), deposits (Rs 501 billion) and borrowings (Rs 48 billion). Deposits
grew at a CARG of 17% during the last 5 years. Though the RRBs are helping in
mobilization of savings in the rural areas, it is at a higher cost as a large proportion of
deposits are term rather than demand deposits. Commercial bank branches in rural
areas offer competition for lower cost current accounts from traders etc., and
government funds, as they can service such customers better.

     Share capital + share capital deposit + reserves

October 2005                                                                                     Page 24
                                                                     Technical Assistance (TA) No. 4247-IND
                                                         Rural Finance Sector Restructuring and Development
                                                                               Volume 1: Executive Summary

Inadequate Loan Loss Provisioning

RRBs have shown improvements in loan management over the last five years and
NPAs have come down from a high of 27.8% during 1999 to 14.4% as on March 31,
2003. This has also been coupled with an increase in recovery rates to around 72% in
FY2003. While standard assets have increased from 56% to 72%, substandard and
doubtful assets have declined from 9% and 28% to 8% and 17% respectively. Loss
assets came down to 3% from 6% between 1995 and 1999. Even though asset quality
appears to be improving with a decline in NPA levels and increase in recovery, RRBs
have relatively low provisioning levels (as compared to commercial banks20) with 162
RRBs having provisioning at less than 50% of Gross NPAs.

Low Capital Adequacy

Despite recapitalization, the Net Capital to Assets ratio (proxy for capital adequacy ratio)
of RRBs is low with 98 RRBs at less than 4%. Thus, significant proportion of the deposit
base can be considered at risk. Though risk is mitigated to some extent on account of
the ownership structure of RRBs, the low capital base of RRBs has also led to low
performance across different financial indicators. Capital infusion required to achieve a
minimum 12% net capital to asset ratio works out to over Rs. 55 billion based on the
consolidated picture as on 31st March, 2003. If this level of capital adequacy were to be
achieved for individual RRBs, the amount required would be larger. In spite of the
growth witnessed by RRBs, the share capital is pegged at Rs 10 million and additional
capital infused has been kept as ‘share capital deposit’ pending amendment in the RRB
Act 1976.

Low Profitability, High Accumulated Losses

Inadequate capitalization of RRBs is further compounded by continuing losses. RRBs
experience intense pressure on margins due to high costs and setting of lending rates
without taking full costs into account. The number of RRBs in profit had gone up to 170
in FY2001 but declined again to 156 by FY2003. Of the 196 RRBs, 40 (increased from
29 in FY2002) recorded losses in FY2003 and 97 (decreased from a high of 153 in
FY1999) had accumulated losses, aggregating Rs. 27.5 billion. Accumulated losses
have resulted in 55 RRBs having negative net worth and 52 RRBs having deposit
erosion greater than 10%. Overall, profitability was adversely affected in FY2003 with
net margins declining from 1.24% in FY2002 to 0.92% in FY2003. Net margins are likely
to be under pressure with interest rates easing out and yield on investments declining.

Competition with Sponsor Banks

The RRBs do not have adequate integration with the financial markets of the country
and for every financial/business initiative they are heavily dependent on Sponsor Banks.
Often Sponsor Banks themselves have a presence in the same rural areas and, at the
field level, the RRBs are perceived as potential competitors.
     Provisioning levels are over 50% of NPA for most commercial banks

October 2005                                                                                      Page 25
                                                                       Technical Assistance (TA) No. 4247-IND
                                                           Rural Finance Sector Restructuring and Development
                                                                                 Volume 1: Executive Summary

Need for Capacity Building

RRBs have high cost resources with inadequate training, low productivity and
insufficient systems and technology support. These issues will need to be addressed on
priority if RRBs are to be revitalized.

4.2.3 Approach and Strategy for Reform and Restructuring of RRBs

The Consultants visited identified RRBs in three states, namely Rajasthan, West Bengal
and Andhra Pradesh. While the operations and financial performance of the RRBs
visited were vastly different, most of the key issues identified above were starkly
apparent. It was felt that restructuring and consolidation of RRBs might be a plausible
way to deal with ownership issues, shore up their balance sheet and improve
operational performance.

The considered opinion of most committees converges on the need for unity of
ownership and accountability. In other words, for effective functioning and viability of
RRBs, majority ownership and management control should be with a single stakeholder.
Of the four stakeholders (Central Government, State Government, Sponsor Banks and
NABARD), complete ownership and accountability with either the Central Government
or State Government is unlikely to lend the required business focus while NABARD is
well entrenched in its refinance and supervisory role and a triple role may not be
prudent. Sponsor Banks, being engaged in similar business activity, are synergistically
well positioned to take a lead role in ownership and management of RRBs. This opinion
was also voiced by the Finance Minister in his budget speech in June, 2004 and
reiterated by the Ministry of Finance in a press statement on 30 November, 2004.21 We
would go a step further and suggest that substantial synergies will be realised if the
sponsor banks manage their entire rural portfolio (including their own branches) as
single a strategic business unit.

We have developed a project that focuses on consolidation of RRBs within a state and
institutional revitalization of the consolidated entities keeping in view current legal
constraints. The project proposes that RRBs in the state of Andhra Pradesh be
consolidated under three banks which have significant operations in the state. The
project will assist in this consolidation through TA support for change management
encompassing structural, governance, human resources, policies, systems and
products initiatives as also soft loan support for reaching a specified capital adequacy
level at each consolidated entity level within 5 years. Changes are required in the legal
framework, in particular in relation to the RRB Act. However, recognizing that legislative
changes will take time, the project proposes to work through agreement among the
stakeholders on key issues. The Components of the strategy are outlined below:

  The public sector banks have been asked to merge RRBs with themselves keeping in mind the specific
region of their operations. The urge to merge RRBs with the sponsor bank comes from two drivers. The
MoF feels that with the merger the public sector banks would reach out to the rural areas and help in
pushing up the rural credit take off…. The second reason is the scarcity of fresh capital...” Times of India,
1 December, 2004.

October 2005                                                                                        Page 26
                                                             Technical Assistance (TA) No. 4247-IND
                                                 Rural Finance Sector Restructuring and Development
                                                                       Volume 1: Executive Summary


In Andhra Pradesh, State Bank of India (SBI) has sponsored five RRBs operating in
eight districts and State Bank of Hyderabad (SBH) has sponsored four RRBs operating
in four districts. Syndicate Bank has sponsored three RRBs operating in five districts.
Andhra Bank and Indian Bank have sponsored two RRBs each both of which operate in
one district.

It is proposed that, as a first step, all RRBs owned by SBI be merged. No legal changes
are required for this amalgamation as the stakeholders are the same across the RRBs.
Similarly, RRBs owned by Syndicate Bank could be merged together and those owned
by Andhra Bank could be merged together.

In the second step, the RRBs sponsored by SBH could be merged with the SBI RRBs
(assuming cultural similarities between SBI and SBH sponsored RRBs). Further, given
Indian Bank’s limited presence in the state (as a commercial bank), the two RRBs
sponsored by it could be merged with the Syndicate Bank and Andhra Bank owned
RRBs (taking into account locational synergies).

The above exercise will result in three RRBs in AP state instead of the current 16. The
balance sheet of these three RRBs will be significantly stronger than that of the merging

Laws and Regulations

It is proposed that the three Sponsor Banks (SBI, Syndicate Bank and Andhra Bank) be
given operational control of the respective consolidated RRBs through Memoranda of
Understanding between GoI, GoAP and the respective Sponsor Banks. Eventually, the
RRB Act would have to be suitably amended or repealed (to facilitate divestment of
shareholding by GoI and GoAP in favor of the respective Sponsor Banks). Sponsor
Banks may then choose to merge RRB holding companies with themselves or realign
the RRB operations to synergize with their own rural branch network.

If the sponsor banks wish to retain their rural operations or the consolidated RRBs as
separate legal entities, such entities should receive licenses from the RBI to work as
scheduled commercial banks. The RBI should have a differentiated policy for regional
banks (as different from national banks) in matters relating to expansion, risk
management and other critical areas. However, at the minimum, for this project, certain
key constraints imposed by provisions of the RRB Act have to be addressed, initially
through MOUs/agreements among parties and eventually through amendments in the
Act. Some of the areas that need to be addressed include

 Issue                         Current Situation               Proposed Action
 Composition   of   Board   of 2 (GOI) + 1 (NABARD) + 1        Majority to be nominated by
 Directors                     (RBI) + 2 (Sponsor Bank) + 2    Sponsor Bank, none by
                               (State Government)              RBI/NABARD
 Appointment   of   Chair   & Approval required of GOI         Deemed       approval    for

October 2005                                                                              Page 27
                                                            Technical Assistance (TA) No. 4247-IND
                                                Rural Finance Sector Restructuring and Development
                                                                      Volume 1: Executive Summary

 Issue                        Current Situation               Proposed Action
 Salary of Chair              and NABARD              Sponsor     bank   nominee
                                                      within norms
 Salary Structure            To be determined by GOI  Deemed       approval   for
                                                      Sponsor bank action within
                                                      certain norms
 Board     Committees    and Approval required by GOI Deemed       approval   for
 Remuneration of Directors                            Sponsor bank action within
                                                      certain norms
 Rules                       GOI can make rules on GOI to desist other than
                             Board, Staff matters     rules to permit sponsor
                                                      banks/ RRBs to make rules.


At present RRB Board members function as interest groups for the particular
shareholder they represent. The Boards need to be reconstituted to give sponsor bank
a majority and to bring in required expertise through induction of independents. Pending
legislative changes, this will need to done through agreement among the shareholders.
The Boards have to be provided with adequate autonomy in decision-making and be
held accountable for the overall performance of the RRB. The project will work to
improve the role perceptions amongst the reconstituted Board of Directors and provide
intensive inputs to Board Committees in relation to their governance responsibilities in
general and technical issues of current relevance in particular.


In order to strengthen the consolidated RRBs to cater to the needs of the rural economy
for the entire range of financial services, diversification of their business has to be
encouraged without losing focus on fulfilling the financial needs of the rural poor. RRBs
will be encouraged to develop their own customer-segment specific products for
deposits, investments and loans depending upon the needs of the local rural economy.
They should also be allowed to enter into agency arrangements with Sponsor banks
and other financial institutions for extending services like remittances and collections,
cash management, foreign exchange services, crop and general insurance, trading in
Government and other securities, pension of government employees in rural areas etc.
Offering a complete array of services will improve the image of the RRBs as a
professional organisation, thus attracting more customers. The project proposes to help
develop institutional capacity in this area.

The outreach of the RRBs as well as their share in rural lending needs to be improved.
The project has built in specific support to each Consolidated RRB in sensitising and
training its Board Members and officers in developing products and schemes, building
linkages and undertaking a range of initiatives to extend the reach of the RRBs to
women and the unreached and underserved.

October 2005                                                                             Page 28
                                                             Technical Assistance (TA) No. 4247-IND
                                                 Rural Finance Sector Restructuring and Development
                                                                       Volume 1: Executive Summary
Another important problem plaguing the system is recovery of loans. The project will
aim to provide training and inputs to consolidated RRBs so that these organizations
intensively use micro-finance best practices in their lending methodology.

In tune with the changing environment and rising customer preference for technology
driven services in banks even in rural areas, consolidated RRBs will also be supported
to introduce automated services like multi-service credit/debit cards, smart cards,
automated teller machines, touch-screen services etc. at least on selective basis in
select major branches.

Human resources

The RRBs have, in general, good human resources. A well thought out and coordinated
strategy for rationalizing and energizing human resources and strengthening the
institutional frameworks at all levels is required. In particular the merger may result in
redundant HO staff. As the banking sector in India has developed a lot of rigidities in
terms of staff grade levels expected to be deployed in particular ways, this exercise will
require thoughtful planning and buy-in from affected staff members as well as staff and
officer unions.

The RRB Act has a lot of rigidities in relation to staff matters with powers resting with
the Central Government in relation to Wage structure etc. These will need to be diluted
initially through agreements and subsequently through legislative changes.

In addition, RRB staff will need to be provided appropriate training to enable them to
provide the full array of financial services. The Indian banking system has training
institutions in place, therefore participating commercial banks will be provided with
Project inputs to review their training modules, effectiveness and suitably of training and
remodel the same to meet the requirement. There may also a need to develop mobile
training units to ensure on the job training where the number of officers does not easily
allow for someone to leave his work place for an extended period. The restructuring
plan should include training plans for each target groups. With the help of training
facilities complemented by external resource persons and trainers, the participant banks
will elaborate adapted curriculum, and training schedule to reach a maximum of

Management Information System and Technology

The RRBs have good accounting systems in place although there are inconsistencies in
application. Similarly MIS reports are specified and are fairly clear as to what is
required. The key issue is that compilation of reports is generally manual and very
labour intensive. This coupled with substantial ad-hoc reporting requirement from the
multiple stakeholders puts a large burden on the branches which are generally tightly
staffed leading to inadvertent mistakes and sometimes ‘rule of thumb’ reporting. An
even more important issues is lack of action on reported trends, reducing the reporting
to a matter of record rather than a decision making tool. The project will work with the

October 2005                                                                              Page 29
                                                              Technical Assistance (TA) No. 4247-IND
                                                  Rural Finance Sector Restructuring and Development
                                                                        Volume 1: Executive Summary
consolidated RRBs to rationalize report generation and strengthen usage of reports for
decision making and for informing operating policy.

The management information systems in RRBs in AP are computerized partially. The
RRBs are in the process of automating their banking activities. Where computerization
effort is on, the staff at HO as well as Branches is fully involved in the process. There is
a systematic approach to the computerization; the plan and IT policy are in place. The
Computerization Plans of the Consolidated RRBs will need to build on these successes
and take into account new products and procedures. Communication is also nowadays
an intrinsic feature of a modern organisation. To accelerate processing of information
branches will be linked to HOs/Regional offices as required (based on business

The Project will support development of a Computerization Plan detailing the systems
and procedures required to be followed for successful computerization. Staff will be
identified, trained and motivated for faster and effective implementation of Information
Technology to streamline MIS compilation and reporting to the appropriate authorities.
The investments made for IT (hardware and software) would be monitored closely and
remedial action taken in case of delays or improper/ inadequate utilization of hardware
and software resources.

Control and Supervision

The need for a strong internal control system has to be recognized so as to improve
monitoring of adherence to the statutory and the regulatory requirements as also to
internal policy guidelines, operation of risk management and assets-liability
management systems, transparency and disclosures and various internal control
measures. With the strengthening of the computer-based data management system and
likely increase in number of branches as also their geographical span in view of
proposed consolidation, the emphasis should be more on off-branch surveillance of the
branches to be integrated with the regular branch inspection process. The internal
control system must be placed for overall guidance under an Audit Committee of the
Board. The Audit Committee should be empowered for taking decisions on various
aspects of an efficient internal control mechanism, review of the policies framed by the
Board and its implementation, compliance to the regulatory obligations of the bank and
ensuring integrity of information supplied to various regulatory or supervisory
authorities, decisions relating to finalization of annual balance sheets and profit and loss
accounts as also accounting policies related thereto, review of audit of annual accounts
and its compliance as also compliance of various inspections undertaken by the
supervisory authorities.

Financial Restructuring

The three consolidated RRBs would have a positive net worth as on 31.3.2004 if the
consolidation were carried as of that date. Two of these (Andhra Bank RRB and
Syndicate Bank RRB) would also meet the extant capital adequacy requirements of 9%.

October 2005                                                                               Page 30
                                                           Technical Assistance (TA) No. 4247-IND
                                               Rural Finance Sector Restructuring and Development
                                                                     Volume 1: Executive Summary
If provisioning is increased to 50% of NPA and the target capital adequacy is 12%, the
SBI Group RRBs require around Rs 1,600 million, as on March 31, 2004. The project
will support the restructuring effort by providing step up coupon bonds on soft terms to
enable the consolidated RRBs to absorb the additional provisioning requirements and to
build up adequate capital to weather risks inherent in the business.

October 2005                                                                            Page 31
                                                              Technical Assistance (TA) No. 4247-IND
                                                  Rural Finance Sector Restructuring and Development
                                                                        Volume 1: Executive Summary

Managing Risks

The rural/ poor households are vulnerable to a number of risks.

It is critical that the RRBs build inherent capacity to address the risk of its clientele as
well as risk to its own sustainability in context of the risk proneness of its clientele by:

•   Expanding outreach of savings and insurance services to its members. The project
    will focus on development of suitable products and linkages between insurance
    product providers and the RRBs.
•   Mainstreaming micro finance best practices in the RRBs: best practices are being
    incorporated in each of the section of this strategy. A full review of products,
    procedures and processes will be carried out to introduce MFI best practices to the
•   Hedging the portfolio risk through weather derivatives: hedging agricultural risk is
    very difficult, but there are derivative products available (such as rain fall insurance)
    which could serve to mitigate risk. The project will provide support for pilot activities
    in this area.
•   Disseminating commodity pricing and knowledge will enable the farmer to mitigate
    price risk. The project will implement pilots.
•   Creating Risk Fund: If the agricultural lending is to be sustainable, without resorting
    to changes in prudential norms, it will be necessary to make adequate provision for
    normal risk and to include this risk cost in pricing. The project will facilitate product
    costing and sensitisation of top management to pricing based on costing taking into
    account normal risk. Further, financial restructuring support is being provided to take
    capital adequacy to 12% of risk weighted assets (as against the current regulatory
    requirement of 9%). Over time RRBs and other commercial banks need to be
    encouraged to build a risk fund out of their profits in order to cope with abnormal

4.2.4 The Project

A project for revitalization of RRBs for possible ADB funding is attached at Volume 2 of
this report.

4.3 Micro finance institutions
4.3.1 Introduction

Microfinance has been an important tool of poverty alleviation in many countries across
the world for almost three decades. It has been fairly well established that microfinance
smoothens consumption, reduces the vulnerability of the poor, and leads to increase in
their income. Community banks, NGOs and savings and credit groups around the world

October 2005                                                                               Page 32
                                                              Technical Assistance (TA) No. 4247-IND
                                                  Rural Finance Sector Restructuring and Development
                                                                        Volume 1: Executive Summary
have shown that this can be profitable for borrowers and for lenders, having the
potential to be one of the effective poverty reducing strategies.

The TA reviewed the sector as it stands in India today focusing on the critical issues
that have emerged over time; issues that need wider attention and need to be resolved
in order to help the sector grow to its full potential.

The outputs included a framework for microfinance development that addresses issues
•   prevailing policy and laws;
•   financial infrastructure; and access to resources for outreach;
•   public-private and private sector participation;
•   institutional strengthening; institutional network and linkages;
•   delivery of social intermediation support;
•   five MFI appraisal reports.

4.3.2 Review and analysis of the microfinance sector

The microfinance providers can be divided into three segments:
•   Informal sector
•   Formal sector - banks and insurance companies and
•   Microfinance institutions (MFIs)

Informal Sector

The informal sector made up of moneylenders, pawnbrokers, traders and landlords
continue to be accessed by the poor for credit. Several micro case studies have shown
that the poor still obtain 60-80% of their credit from money lenders. It has been argued
that if the formal sector and MFIs continue to expand their services to the poor and the
availability of this cheaper source of credit forces money lenders to shift from being
‘exploitative’ to ‘competitive’ and lower their interest rates, then some part of the larger
objective has been met. Thus MFIs are supplementing rather than replacing the
informal sector.

The Formal Sector

Banks under the IRDP and SGSY programs

The Swarnajayanti Gram Swarozgar Yojana (SGSY) was launched by the government
in April 1999 to replace the Integrated Rural Development Program (IRDP) and its allied

October 2005                                                                               Page 33
                                                                     Technical Assistance (TA) No. 4247-IND
                                                         Rural Finance Sector Restructuring and Development
                                                                               Volume 1: Executive Summary
schemes. The SGSY is a holistic program covering various aspects of self-employment,
including organizing the poor into self-help groups, training, credit, technology and
marketing. The program provides financial assistance to individuals or self-help groups
in the form of a subsidy by the government and credit by banks. SGSY has achieved
significant numbers. However, it is driven by targets and has raised concern that it may
weaken the SHG movement.

NABARD SHG-Bank Linkage Program

The SHG-Bank linkage program is currently the predominant methodology through
which micro credit is delivered. A variety of agencies including NGOs, commercial
banks, regional rural banks and cooperative banks are involved in forming SHGs and
subsequently linking them to the nearest bank branches. By 1998, over 150,000 SHGs
were linked with banks and a number of microfinance institutions. In 2001 NABARD
adopted the goal of linking 1 million SHGs with banks by 2008. This goal has already
been achieved. Thus, with a reach of over 16 million poor households, the SHG-Bank
linkage program is one of the biggest microfinance programs in the world. To be
precise 1,079,091 self help groups have been financed by banking channels in the
country as on 31 March 2004 covering 16 million families and approximately 90 million
rural poor22.

But the program is not without its share of problems. The enthusiasm of banks to lend to
these SHGs and the increasing importance of quantitative ‘targets’ has led to a clear
decline in the quality of the groups that are being linked, most of the newer SHGs being
formed by government agencies or by the banks themselves in order to meet their

There is also the problem of cost. The cost of forming new SHGs by NGOs is estimated
to be in the region of Rs 10,00023 per group. So if an additional one million groups need
to be formed, the amount required is Rs 10 billion. Where is this money going to come
from? If the NGOs are not the ones to ensure quality and help the groups with their
bookkeeping and their management, then it is unlikely that the banks will take on this

     Norm established by the Ministry of Rural Development

October 2005                                                                                      Page 34
                                                              Technical Assistance (TA) No. 4247-IND
                                                  Rural Finance Sector Restructuring and Development
                                                                        Volume 1: Executive Summary

Microfinance Institutions

Microfinance Institutions (MFIs) fall in a sense between the formal and informal sectors,
offering flexible and tailor made products and simpler procedures (as in the informal
sector) but in a professional manner and with documentation and supervision akin to
formal institutions. The interest rates charged are higher than those of the formal sector
but much lower than those imposed by the informal sector.

Estimates of number of specialized Microfinance Institutions (MFIs) vary depending on
the definition adopted. There are about 2000 NGOs with substantial microfinance
activities. If we include Mutually Aided Cooperative Societies (MACS), which have
microfinance activities, then the number of MFIs would be about 3800. The total
outreach of these MFIs is estimated at about 3.8 million members. The loan outstanding
of members of Sa-dhan, the association of MFIs was Rs 400 crore in 2004. Many are
growing fast and doubling their size every year. But, there is still a long way to go before
MFIs meet the microfinance needs of the poor of India.

4.3.3 Various Forms of MFIs

MFIs in India belong to the following three broad categories:
•   Not for profit MFIs such as societies registered under the Societies Registration
    Act, 1860 or similar State Acts; and public trusts registered under the Public Trusts
    Act 1882; or Companies licensed under Sec 25 of the Companies Act, 1956
•   Mutual Benefit MFIs including cooperative societies registered under the
    Cooperative Societies Act of the state in question or the Multi-State Cooperative
    Societies Act (where activities extend beyond a single state), Mutual Benefit Trusts
    or Mutually Aided Cooperative Societies (MACS) formed under the progressive
    cooperative legislation pioneered in the state of AP and now also introduced in ten
    other states.
•   For Profit MFIs including Non Banking Financial Companies (NBFCs) registered
    with the Reserve Bank of India and incorporated under the Companies Act and
    Local Area Banks duly registered with the RBI.
The not for profit NGOs and the mutual benefit entities such as the MACS dominate in
terms of number with only a handful of MFIs registered as NBFCs with only one Urban
Cooperative Bank and one Local Area Bank in the sector today. The fact that a vast
majority of MFIs are either non-profit or mutual benefit entities has to do with the origin
of this work in the poverty alleviation work done by NGOs, but it has also become a
constraint in the growth of this sector and its ability to tap mainstream funds from the
capital markets.

October 2005                                                                               Page 35
                                                             Technical Assistance (TA) No. 4247-IND
                                                 Rural Finance Sector Restructuring and Development
                                                                       Volume 1: Executive Summary

Methodologies Used by MFIs

Microfinance Institutions (MFIs) in India follow a variety of methodologies in order to
service their clients. The SHG model (NGOs lending to SHGs) has been predominant
but there are MFIs that follow the Grameen Model (SHARE Microfin being the most
prominent example), the Individual lending model and MFIs that follow a mixed
methodology, like BASIX. Not all MFIs provide a composite set of services. Legal and
regulatory constraints do not allow them to do so. MFIs like SEWA Bank, KBSLAB (the
Local Area Bank in BASIX), Cashpor in UP and Spandana in AP are some of the few
that offer all three major microfinance services, namely credit, savings and insurance to
their clients.

The sector, as it grows and expands, is focusing on improving its product offerings and
finding better ways and means of serving its clients. Credit products span a wide range
now, even in the more regimented Grameen Bank inspired MFIs. Most MFIs offer some
form of loan-cum-life insurance to their borrowers, and those which are MACS or Banks
are offering a range of savings products.

Retailing through MFIs: Private sector banks and insurance companies

One welcome development in the sector has been the increase in the interest and
involvement of some of the larger private sector banks and insurance companies.
Supply of savings services

The poor have very little access to savings services despite their high inclination to save
and despite the huge network of bank branches all across rural India. The problem with
banks is that they do not have products suited to the poor and in their view the volume
of business that they would generate from the poor is simply not worth the effort and
would serve only to increase their transaction costs.

The Reserve Bank of India does not allow MFIs to offer savings services as this is
reserved for regulated banks. Only the SEWA Bank (Ahmedabad) and KBSLAB (3
districts in AP & Karnataka) offer savings as RBI regulated entities. All other savings are
through mutual benefit trusts, mutually aided cooperative societies (MACS) and SHGs.

Supply of Insurance Services

In response to the wide range of risks faced by the rural households, various risk
mitigation mechanisms have evolved. Some of these are mutual in nature, others are
dependent on the government, and some have moved from the government to public
insurance companies and eventually to private insurance companies. As the scope of
many of these schemes left out the poor, the government has initiated risk mitigation
schemes/mechanisms for the rural poor from time to time. These include life and asset
insurance schemes, health insurance schemes, disaster relief and social security

October 2005                                                                              Page 36
                                                            Technical Assistance (TA) No. 4247-IND
                                                Rural Finance Sector Restructuring and Development
                                                                      Volume 1: Executive Summary
Though insurance companies do little in terms of directly insuring the rural poor, in the
period since 2001 there has been a fair bit of activity in linking up with MFIs to provide
life as well non-life insurance cover to MFI clients. This has partly been due to the
social and rural outreach obligation imposed on insurance companies, as the wide and
existing outreach of MFIs to the target group was helpful them. In turn MFIs were able
to offer insurance products to their clients and reduce their own portfolio risks.

MFIs have thus started to offer insurance cover to their clients in the areas of life,
livestock, asset, health and more recently even weather. The leader among MFIs in
terms of volume is SEWA Bank in Ahmedabad, which provides insurance services
through its Vimo SEWA affiliate, a nodal agency of LIC and other general insurance
companies. BASIX, Cashpor and Spandana are the other large MFIs that offer
insurance services to their clients. But while there has been interest by private players,
in terms of demand estimates and people covered it is still very low.

4.3.4 Institutional Analysis

With a view to analyzing the issues confronting microfinance institutions in the context
of the above background, five MFIs were studied using a CGAP tool and methodology.
The five institutions studies were chosen based on their legal formation, size of
operations, methodology adopted and their outreach. The five institutions are:
•   SEWA Bank, an urban cooperative bank established in 1974 by the Self Employed
    Women’s Association (SEWA), a trade union in Ahmedabad.
•   Friends of Women’s World Banking, co-promoted by SEWA in 1982 to extend
    wholesale funds to NGOs extending micro-credit to their clients
•   Sanghamitra Rural Financial Services, established by MYRADA in 1998 to lend to
    SHGs, before the bank SHG-bank linkage program was mainstreamed
•   Cashpor Financial and Technical Services and its affiliate company Cashpor Micro
    Credit, which follows the Grameen Bank methodology and works in the poorer
    districts of eastern UP.
•   Nandipet Intideepam Mutually Aided Cooperative Society, established by GRAM, an
    NGO, in Nizamabad district in Andhra Pradesh, representing hundreds of such
    MACS that have been promoted in the state by NGOs and by government
    promotional agencies.

Institutional Development of MFIs

Many NGO and community based (NGO/ CB-MFIs) MFIs have learnt from their
experiences and developed appropriate systems for themselves. Many of these
organizations provide both financial (credit, savings and insurance) and non-financial
services like forward and backward linkages. However it was observed that often these
organizations, though strong on their social foundation, are not equipped to take up
financial activities. They need substantial strengthening in their operational models and

October 2005                                                                             Page 37
                                                              Technical Assistance (TA) No. 4247-IND
                                                  Rural Finance Sector Restructuring and Development
                                                                        Volume 1: Executive Summary
management information systems for increasing the scale and depth of outreach. The
key constraints for the successful growth of these institutions were as follows:

Design Constraint: Often the design of the microfinance operations of a NGOs/ CB-
MFIs is weak. This places more than necessary regulatory constraint on growth and
often makes it difficult to mobilize human and financial resources.
HR Constraint: Getting adequately trained personnel to manage the operations of
community-based organizations is difficult. In addition, deploying the people properly,
aligning their job responsibilities with financial discipline also needs refinement.

Information Constraint: As Microfinance activities are dispersed often for their effective
management, consolidation and processing of information plays a critical role. Absence
of appropriate systems is often is a major constraint.

Policy Constraint: Experience has shown that the potential of these organizations is
often constrained due to inadequate awareness of the policies by the NGOs/ CB-MFIs
and of the ground reality by the policy makers.

For enhancing the capacity of the NGO/CB-MFIs it is necessary to address all the three
constraints which are closely linked to each other. Unless these are addressed
simultaneously the desired outcome is not achieved.

4.3.5 Legal, Regulatory and Supervision Issues

The global experience in microfinance shows that there is no single methodology or
structure that works best in microfinance. Best practices across the sector are spread
over various institutional structures, following a fairly wide range of methodologies.
What are important are the organization’s mission and the ability to innovate and evolve
constantly in order to best serve its clients and achieve and maintain sustainability in the

What the sector needs from the policy makers in order to be able to do this, is a
supportive legal and regulatory framework, one that allows MFIs to grow and improve
their outreach without being bogged down by constraints related to regulation. There
are several examples across the world where governments have either modified
legislation or even passed new laws that allow MFIs to function in a supportive
environment. The first step in this is for the policy makers to realize the impact that
regulation has on the development of the microfinance sector.

India has its own share of regulatory hurdles that make it difficult for MFIs to expand
their operations and outreach. The TA report has categorized these as Problems of the
majority - NGO-MFIs, Issues of Cooperative MFIs, Issues of NBFC and Bank MFIs.

October 2005                                                                               Page 38
                                                            Technical Assistance (TA) No. 4247-IND
                                                Rural Finance Sector Restructuring and Development
                                                                      Volume 1: Executive Summary

4.3.6 Critical Issues & Recommendations for Microfinance Development

Amendments to Multiple Laws or a New Microfinance Act?

The TA study concludes that there is a need for amending the existing legal and
regulatory framework to facilitate the growth of the microfinance sector in India.
Substantial changes to almost all legislations affecting MFIs will be required for making
it possible for the microfinance sector to develop further. This can be a difficult
proposition. However, it has the advantage of respecting the diversity of the sector and
imposing differential regulatory requirements on different types of entities, based on
their size as well as types of activities undertaken (credit, savings, insurance).

An alternative in the form of an enabling legislation can be considered – a new
Microfinance Act. The key features of a new Microfinance Act would be to require all
MFIs to be registered with a special institution under RBI, say a Microfinance
Development and Regulatory Authority (MFDRA). To register, a minimum capital
requirement would be imposed, and then capital adequacy maintained as the loan
assets grow. MFIs would be allowed to take deposits from members/borrowers, to the
extent of a percentage of their outstandings, with due safeguards such as liquidity and
cash reserves. They would be allowed to retail life and non-life insurance. They would
be allowed to undertake related non-financial services such as training and supply of
inputs, technical assistance and marketing of produce. Such legislation, which was
enacted in neighboring Pakistan in 2001, can provide a regulatory framework which
encourages the development of MFIs and allows them to operate as recognized
financial intermediaries subject to specified supervisory and reporting requirements.

Financial Resources and Infrastructure including public private partnership

Almost all microfinance institutions that cross their first stage of growth cite lack of
equity as the single largest constraint they face in scaling up. Many MFIs have high
debt-equity ratios despite the small scale of their operations and this is because the
social entrepreneurs who start these institutions have little access to financial capital.
Cashpor is a classic case where equity was a constraint on its growth, which was
nevertheless enabled by loans from sectoral promotional entities such as FWWB and

Domestic sources of equity are very few, as the sector is not yet perceived to be an
attractive proposition for equity investment. Foreign sources are interested and
available but legal and regulatory restrictions make this option a difficult one to carry
through. The inclusion by GoI of ‘micro credit’ as one of the areas in which Foreign
Direct Investment is allowed in NBFCs was a step forward. But the minimum capital
requirements and cap on shareholding ($500,000 from foreign sources for not more
than a 51% stake) cannot be met by most MFIs wishing to take this route.

October 2005                                                                             Page 39
                                                             Technical Assistance (TA) No. 4247-IND
                                                 Rural Finance Sector Restructuring and Development
                                                                       Volume 1: Executive Summary

The RBI Informal Group on Microfinance has suggested the constitution of a
Microfinance Fund, independently managed and run by professional fund managers
and microfinance professionals that would cater to the equity and debt needs of MFIs
that have the potential to grow substantially, given these resources. At present there
are at least two private funds that are at the design stage. Once they come in, the equity
constraint could be eased to some extent as SIDBI-SFMC and NABARD which hold
some funds for investment in MFIs (but who have not made much headway) may also
start to flow (as consortium investments or in the spirit of competition).

MFIs have found it relatively easier to raise loan funds in recent times. In June 2000, the
Reserve Bank of India allowed banks to lend to MFIs and treat such lending as part of
their priority sector lending obligation. A number of banks, especially private sector
banks have made use of this opportunity to lend to MFIs and have designed innovative
products in the process (such as the portfolio securitization actively pursued by ICICI
Bank). The private sector banks have also started to view the sector as a sound
business proposition, a view that is perhaps not fully shared by the public sector
scheduled commercial banks just yet.

One key constraint is the lack of focused credit appraisal resources with respect to MFIs
within Financial Institutions and Banks. Bankers need to improve their capability of
appraising MFIs and assessing their credit needs. The Nandipet MACTS has only 17%
of its clients borrowing from it as it is unable to get enough loans from the banking
system. While bankers are keen to lend to SHG, they are reluctant to lend to MACTS or
federations of SHGs perhaps because of concerns in relation to lack of supervision and
regulation of these entities.

Expanding Access to Savings Services through MFIs

The regulatory framework is restricting as far as mobilization of savings by MFIs is
concerned. The RBI has taken a conservative view of this matter, which is perhaps
understandable given the recent failures among small banks. The deposit taking ability
of microfinance providers has to be enhanced if the sector has to be able to provide a
composite set of services to the poor. Adequate savings facilities would meet the
demand for financial services while also fulfilling an important requirement for financial
sustainability of the lender. The two institutions (SEWA Bank and Nandipet MACTS),
which had access to savings had the least cost of funds and were the most financially
self-sufficient organizations. Our recommendations on the legal framework encompass
some ways to balance the concerns of improving access and managing regulatory risk.

Capacity Building Funds

Microfinance is still delivered mostly by NGOs, mutually aided co-operative thrifts
societies (MACTS), Societies, not for profit Companies, some of whom run their
programs with a fairly low level of understanding of the principles of microfinance.
October 2005                                                                              Page 40
                                                            Technical Assistance (TA) No. 4247-IND
                                                Rural Finance Sector Restructuring and Development
                                                                      Volume 1: Executive Summary
Regulated institutions adopting mainstream practices are still few and far between. In
most cases, these NGOs provide microfinance services in addition to services that they
traditionally provide, say in health or education. At the time when such institutions wish
to transform into regulated entities in order to expand their services, they find
themselves lacking certain capabilities that are critical for such a transformation be

The support that is typically needed by MFIs involves suggestions as to the appropriate
legal form, developing and /or strengthening various operating and financial systems,
information technology support, capacity building of human resources, facilitating
member education and strengthening governance, advice on various aspects of
financial transactions, exposure to alternate methods/ models of microfinance and
support for development of infrastructure.

Until recently, a few domestic and foreign donor agencies were the key providers of
grants for the capacity building needs of NGO-MFIs. There are now a few large sources
at the national level, including NABARD and SIDBI, which have substantial funds
earmarked for the capacity building of the sector while others such as RMK, HDFC,
ICICI Bank have smaller amounts available. While capacity building funds are available
with these institutions, the issue seems to be that funds from these organizations are
not flowing freely enough.

Expanding outreach while ensuring sustainability

The skewed nature of distribution of MF in the country is another major area of concern.
The outreach of the SHG-Bank linkage program has been a largely southern
phenomenon with the states of the south accounting for 65% of the SHGs linked. The
extremely poor eastern region was far behind with 12.6%.

Similarly, the region-wise distribution of microfinance by members of Sa-Dhan reveals
that at the end of March 2002, the South accounted for 61.65 of the share in the loan
outstanding of all Sa-Dhan members. The western region followed at 26% leaving the
northern, northeastern, eastern and central regions with single digit shares.
The reasons for this divide between the south and the north are several. The general
slowness of the economy in the central, northeastern and eastern regions of the country
means less demand for credit among the poor. The credit discipline in these regions is
questionable and MFIs generally are unwilling to assume the risk of working in these
regions unless they are extremely committed to the cause. Another reason is the
shortage of high quality NGOs (the good NGOs at present are too few to have an
impact) that can take microfinance forward in these regions.

Further, as MFIs attempt to increase their outreach to the poorer segments and expand
their operations in to the more remote regions of the country, especially further to the

October 2005                                                                             Page 41
                                                            Technical Assistance (TA) No. 4247-IND
                                                Rural Finance Sector Restructuring and Development
                                                                      Volume 1: Executive Summary
north and east, they find that this is a vastly different challenge when compared to
providing services to the comparatively more developed markets of the south.

4.3.7 Pro-poor innovations

The Gap

There has been little sustainable innovation by the formal financial sector in India in
meeting the needs of the poor. This may be explained by the lack of competition in the
sector until recently wherein the Government owned, controlled and /or funded
institutions providing a majority of the services. The informal sector is equally
monopolistic (in that close multifunctional relationships lead to strong bilateral bonds
with the providers). In any case, the informal sector is amorphous and dispersed. The
entry of MFIs in this scenario has changed the situation some what. There are several
examples of partially successful innovations and a few of truly successful ones (e.g. the
SHG methodology and methodologies developed for lending for milch animals which
are now prevalent in both the formal and the MFI sector).

Accelerating strategic use of Information Technology

This is critical to addressing the transaction cost problem. Some experiments in this
direction have been made, notably by BASIX to give out very small loans (below Rs
1000) and collect repayments, using smart cards readable devices placed in STD
PCOs. It established that there is a market for “nano-credit” (loans below Rs 5000 or
$100) which can be profitably and efficiently served using sophisticated IT. Similar
experiments have been made by a number of other MFIs in other countries, using smart
cards, biometrics, VSAT terminals and mobile phones, the results of which need to be
studied and used more widely.

Offering Composite Microfinance Services

As seen by the poor, the specialization developed by the financial sector is perhaps
dysfunctional. What they need is a composite service which provides them at least the
three main components, savings, credit and insurance, and perhaps add on a few
services such as money transfer, which is increasingly needed by the poor as part of
the family migrates in search of a livelihood. There are only a few examples of
composite financial services, mostly to be found among MFIs.

What is the logic for such composite services? As far as the poor are concerned, it
reduces their problem of having to deal with a number of agencies and thus reduces the
transactions costs. Moreover, if they are good savers in an agency’s record, but want to
borrow from another, this does not count in the absence of credit history registries. But
if the agency is a composite and has a good internal MIS, it can use the savings history
as“collateral” for loans. Similarly, if the same agency provides insurance for lives or
livelihoods, it will be more willing to give a loan.

October 2005                                                                             Page 42
                                                             Technical Assistance (TA) No. 4247-IND
                                                 Rural Finance Sector Restructuring and Development
                                                                       Volume 1: Executive Summary

From the MFIs’ point of view, transaction costs come down as the same delivery system
can be used, with the addition of training, software and some staff. There is need for
regulators to also look at this issue. It may even be time to think about a Microfinance
Services Act, which would recognize the composite and special needs of the poor and
of institutions serving them.

4.3.8 Conclusion : No Felt Need for a Project

Despite a large banking network and huge government sponsored poverty reduction
initiatives, rural producers, particularly the poor and women, continue to remain
dependant on the informal sector for their financial service needs. The microfinance
initiatives over the last decade have been promising but have met a small percentage of
the total demand. This is mainly due to a lack of enabling legal and regulatory
environment, lack of Institutional capacity of microfinance programs and shortage of
resources. While a substantial number of poor do benefit from the program, successful
programs are concentrated in the South and the poorest still remain substantially
excluded. The sector needs concerted and high level attention to improve its policy and
regulatory framework, financial resources and capacity building to strengthen its
institutional outreach and sustainability.

At the same time there are projects and funds in place with a mandate to address these
constraints. A number of funding agencies and donors are actively engaged in
supporting the development of microfinance. These include the World Bank, DFID,
SDC, GTZ & KfW. The Government of India and the Reserve Bank have set up various
Task Forces and informal groups to identify and address constraints. NABARD and
SIDBI have substantial funds available for investment and capacity building support to

The private sector banks like ICICI Bank and ABN Amro have also moved in to finance
MFIs in a large way and have some capacity building support available.

In view of the above, we do not find a critical need for an ADB funded project. A loan is
not required as commercial banks are increasingly providing resources to this sector in
a market oriented way. While unused TA funds are available with the apex institutions,
there could be a case for TA funding of a market oriented capacity building effort. But
we understand that the ADB, by itself does not have access to significant TA funds.
Accordingly, we do not recommend a stand alone project in this sector. We would
however suggest that the recommendations made by us above for development of the
sector be kept in view for inclusion in other financial sector projects in areas of overlap
e.g. the CCS and RRB projects where there should be both an effort at mainstreaming
microfinance best practices as well to expand outreach through MFIs.

A detailed report is provided at Volume 3 of this report.

October 2005                                                                              Page 43
                                                                Technical Assistance (TA) No. 4247-IND
                                                    Rural Finance Sector Restructuring and Development
                                                                          Volume 1: Executive Summary

4.4 Risk Mitigation
4.4.1 Key Issues

The predominant economic activities in rural India are agriculture and livestock rearing.
Traditionally, these activities are prone to a number of risks and the traditional way of
coping with these risks was self-insurance, a modern name for the proverbial belief in
“fate” by the Indian farmer.

As per the terms of reference, the Consultants have analyzed the current risk mitigation
options available for rural poor and low-income households, such as:
•   Farmers (Arable and livestock)
•   Landless laborers
•   Shopkeepers, artisans, traders, transporters etc.
The risks faced by rural poor and low income household can broadly be classified as
• Agricultural risks (dealt more specifically in the section on agricultural risks)
      o Yield volatility on account of climate, pests etc
      o Price volatility
      o Agricultural assets such as pump-sets/irrigation equipment damage/failure
      o Non availability of agricultural inputs/credit
      o Fire/theft risks to stored or in-transit commodities
      o Untimely Livestock deaths or health hazards
•   Death/illness/accident risks
•   Fire/theft/riot/fraud risks to property/assets of the rural poor
•   Natural calamities such as earthquake/floods
These risks affect all sections of rural poor in varying degrees directly or indirectly. The
consultants analyzed the impact of the above risks on the income/ consumption/
education pattern of various sections of rural poor; evaluated the effectiveness of the
current risk mitigation products/ mechanisms and designed measures for improvement
of current mechanisms or alternative solutions for increasing the outreach and
effectiveness of risk mitigation services (including agricultural insurance).

The poor adopt Self-insurance strategies include a) reduced consumption of food grains
b) taking children out of school c) temporary migration d) diversification of income
sources. Some of these strategies reduce the ability to withstand future shocks and thus
if there are successive droughts or bouts of illness, then the family becomes more and
more prone to risk.

As a result, the poor forgo potentially viable new technologies, production choices, and
income opportunities due to risk aversion. So far insurance services are not widespread
in rural areas for a variety of reasons including lack of an appropriate policy framework
and lack of innovation in addressing the rural market by insurance companies which
October 2005                                                                                 Page 44
                                                              Technical Assistance (TA) No. 4247-IND
                                                  Rural Finance Sector Restructuring and Development
                                                                        Volume 1: Executive Summary
were largely state owned and had a subsidized window for implementing Government

India liberalized the insurance sector with the enactment of a legislation and setting up
the Insurance Regulatory Development Authority (IRDA) in 1999. The IRDA has put in
place regulation that casts an obligation on every insurer to address the rural market.
This together with the entry of private sector insurers has focused welcome attention on
the rural market. This attention requires to be converted into sustained action on for
improving products, delivery channels and contracts suited to the rural markets.

4.4.2 Recommendations

The Consultants stressed on the need for sustained action for developing and improving
products, delivery channels and contracts suited to the rural markets. Key
recommendations of the Consultants relate to:
• Deepening life insurance coverage through group micro insurance
•   Improving health services through public private partnerships
•   Innovative products such as weather derivatives for crop insurance
•   Expanding livestock coverage through dairy cooperatives and lending institutions
•   Rationalizing pay-ins and pay-outs for disaster relief
•   Moving from subsidies to a contributory system for social security
•   Continuing the directions of regulatory reforms already underway
•   Activating and intimately involving peoples organizations, cooperatives, self help
    groups, community based organizations, trade unions etc. in developing and
    distributing insurance for members.

The consultants recommended a Technical Assistance Project aimed at achieving the
above objectives by
    a) Analyzing, recommending and implementing required changes in policies and
    b) building institutional capability and changing institutional orientation and practices
       among insurance companies, microfinance institutions and any other relevant
    c) developing products and channels to bridge the demand supply gap
    d) developing capability for research and analysis on rural risk mitigation issues
       among a select number of institutions and scholars, and
    e) supporting NGOs and consumer associations to play an advocacy role on behalf
       of the consumers/farmers, on issues of pricing, terms of service and outreach.

October 2005                                                                               Page 45
                                                             Technical Assistance (TA) No. 4247-IND
                                                 Rural Finance Sector Restructuring and Development
                                                                       Volume 1: Executive Summary

4.4.3 The Project
The TA project is attached at Volume 4 of this report.

4.5 Commodity Futures
4.5.1 Background

The Commodity Futures markets in India date back to 1875. The establishment of the
Forward Contract Regulations Act (FCRA) in 1952 and the Forward Markets
Commission (FMC), the regulator, in 1953 provided a major impetus to the Commodity
Futures markets in the country which witnessed a heightened level of activity in these
markets around this time. In 1960s, Government imposed several restrictions on types
of tradable commodities and market participants treating trading in Commodity Futures
at par with speculative activities. These restrictions drove a part of the futures trade
underground thereby creating a parallel unofficial market having reasonable integrity
and liquidity. However, the last two to three years have been a period of high activity for
the Commodity Futures markets with the following key developments:

♦   Paradigm shift in the Government’s approach of regulation to promotion of
    commodities markets
♦   Permitting Futures trading in all commodities
♦   Setting up of national level multi commodities exchanges such as NCDEX and MCX
    and NMCE and strong growth in trading on these exchanges.

The heightened level of trading activity on these commodity futures exchanges has led
to several recent initiatives being implemented on all fronts to strengthen the trading
practices in commodity futures exchanges in the country:

♦   Commodities for Future Trading – Futures in all commodities have been
    permitted to be traded except in those contained in the negative list under Section
    17 of FCRA
♦   Strengthening of Commodity Exchanges – Broad basing of the Exchange
    Boards to facilitate independence and flexibility in decision making process. Further,
    Government has been promoting setting up of online multi commodity exchanges.
♦   Risk Management and Market Surveillance – Enhancement of market
    surveillance by enforcement of various practices based on transparency and
    supported by controls, monitoring of activities of the exchange and its participants to
    protect the customers etc.
♦   Forwards Market Commission – Steps have been taken to strengthen the office of
    the FMC to ensure market integrity. These steps include the power to grant
    recognition/withdrawal to exchanges besides the powers to make amendments to
    the bye laws of the exchanges.
♦   Market Participants – Evolving minimum standards in terms of capital, expertise
    and experience. Further suitable capital adequacy level for members of the various
    exchanges and most importantly widening the list of market participants such as
    export houses.

October 2005                                                                              Page 46
                                                                        Technical Assistance (TA) No. 4247-IND
                                                            Rural Finance Sector Restructuring and Development
                                                                                  Volume 1: Executive Summary

4.5.2 The Benefit to Small Farmers

Price discovery, price hedging and increased access to bank lending are the key
benefits perceived from small farmers’ involvement in the commodity futures (CF)
markets. It is expected that knowledge of spot and future prices would enable the
farmers to take knowledgeable decisions on their cropping pattern, the timing of their decisions
to sell and price negotiations while selling their produce. Further, while farmers’ participation in
the commodity futures markets, say by forward selling of his produce would protect them from
any downside price movements, introduction of certainty in their sale proceeds is expected to
increase their access to pre and post production financing, at a lower cost, from various lending
organizations .

4.5.3 Key Findings and Recommendations

The study carried out under the ADB TA on Rural Finance Sector Restructuring and
Development Project reviewed the Indian regulatory, legal, institutional and market
environment for an integrated commodity futures market and participation in this market
specially for small farmers and made recommendations for its development. It noted
that similar recommendations have been made by earlier committees/ task forces .The
Government appears to be generally in agreement with these recommendations and is
taking actions on various fronts including policy, regulatory and institutional. The PwC
study recommended that the ADB project focus on creating an environment and
infrastructure to facilitate the participation of the small farmer in the benefits from
development the commodity futures markets.

Since submission of the TA interim report, CF exchanges have begun several initiatives
in the area of warehousing infrastructure as functioning of an effective and efficient
warehouse and warehouse receipt (WHR) mechanism is critical to the evolution of the
commodity futures markets. NCDEX, a leading online commodity futures exchange has
set up a separate company – National Collateral Management Services Limited
(NCMSL) – to promote development of quality warehousing infrastructure. NCMSL is
reviewing the existing warehousing infrastructure and aims at working towards
integrated model of warehousing system providing testing facilities, trading facilities,
information dissemination and financing facilities in addition to storage facilities at
accredited warehouses and to operate warehouses on management contract basis.
Similarly, MCX, the other online commodity futures exchanges are taking initiatives for
accreditation of existing warehouses.

The TA has thus recommended a project to co-ordinate, integrate , facilitate and
support initiatives in the orderly development of warehousing infrastructure and WHR

  In the long run, the overall volatility of prices a farmer receives is not reduced, nor is a farmer’s average
income with price risk management different in any significant manner from his average income without
price risk management. The predictability of prices to be received vastly improves enabling better
decision-making and better access to and use of resources.

October 2005                                                                                          Page 47
                                                            Technical Assistance (TA) No. 4247-IND
                                                Rural Finance Sector Restructuring and Development
                                                                      Volume 1: Executive Summary
mechanism in India and to ensure that the resulting environment is supportive for the
small farmer, providing him with reliable real time price data, more accessible market
outlets and reducing his cost of financing.

4.5.4 The Project

A project as described above is attached at Volume 5 of this report.

October 2005                                                                             Page 48
                                                              Technical Assistance (TA) No. 4247-IND
                                                  Rural Finance Sector Restructuring and Development
                                                                        Volume 1: Executive Summary


The relationship between a well-developed financial sector and economic growth and
poverty alleviation is well-established. The relationship is not merely one of correlation,
but causal. This is demonstrated by several studies, most recently by Beck, Demirguc-
Kunt and Levine of the World Bank. This cross-country study published by them in
2004 demonstrates the linkage between financial flows and poverty reduction. It finds
robust evidence that countries with better developed financial systems experience faster
reductions in income inequality and faster rates of poverty alleviation. Thus the
development of an efficient financial system should be at the center of a pro-poor
development strategy.

The Indian Tenth Five Year Plan posits an overall growth rate of 8% pa in the GDP and
a 4% growth in agricultural GDP. The only way this can be achieved is through
significant increase in productivity, since increase in area under agriculture is not
possible. Enhancing productivity requires investments, both in working capital in terms
of crop inputs, but also in longer-term private investments in land and water resource
development, crop diversification into horticulture and animal husbandry; and public
investments in agricultural research, extension, warehousing, rural roads, electrification,
telecom and marketing infrastructure.

In addition, both to relieve under-employment in agriculture (where elasticity of
employment to output is near zero for the last decade), as well as to create additional
job opportunities, it is necessary to develop a robust rural non-farm sector, which at
present accounts for only about 25% of the rural employment. This will require again,
both private investments in micro- and small enterprises, and public investments in rural
roads, electrification and telecom, and in systematic development of small towns which
can serve as clusters for agro-processing and other rural industries.

Finally, while stress is being laid on additional investment, it is also equally important to
address the issues related to risk mitigation and risk management. There is too much
un-managed risk in rural India, which affects the lives and livelihoods of rural people.
Disease, general ill-health, poor work conditions and accidents, all are risks to life and
health. Floods, droughts, and irregular weather phenomena, as well as pest attacks are
major risks for crop cultivation. Disease and ill-health are a cause of risk to livestock.
Significant number of natural and man-made hazards also lead to risk for productive
assets and property. Price fluctuations, which are becoming less predictable as
commodity markets open up to global markets add to the risk profile of a rural

Yet, as the study carried out by us shows, not only credit, but the provision of other
financial services is woefully inadequate. Savings, the primary and entry-level financial
service is available only from banks and post offices, the former both relatively
unfriendly to the rural populace, particularly the poor and women, and the latter rather
stodgy in its service and product offering. Longer term savings products, particularly

October 2005                                                                               Page 49
                                                             Technical Assistance (TA) No. 4247-IND
                                                 Rural Finance Sector Restructuring and Development
                                                                       Volume 1: Executive Summary
pension products are virtually missing from the market. Insurance is being offered by
both companies and the post office, but penetration rates are low. Money transfers,
very important as a large number of workers migrate for work within and outside the
country, are limited in reach and expensive. Commodity derivatives are now available,
and large volumes are being recorded, but the participation of farmers in these markets
will require a systematic effort .

It is evident that in its current forms the Indian rural financial system (RFS) will not be
able to adequately address these challenges. The RFS is inadequate even to address
the short-term credit needs of agriculture, leaves aside the longer-term private and
public investment needs and even less to offer a comprehensive suite of risk
management products – insurance and commodity derivatives. Yet, there are several
positive signs that are emerging. These are positive signs of change and most of them
are new generation, either led by the private sector or involving the government, but
only in the role of facilitator and not service provider or operator, a role in which
government-owned institutions have generally not performed well.

So the task is to build a vibrant, responsive and financially sustainable RFS, using the
lessons from the Indian success stories as also from other countries –

•   the Unit Desa village banking system of Bank Rakyat Indonesia, which has over 16
    million savers and about 3 million credit customers,

•   the Bank for Agriculture and Agricultural Cooperatives (BAAC), Thailand, which
    reaches 85% of all Thai farmers, and

•   the recently turned around Xas Bank in Mongolia, the example of an old-style state
    agricultural bank, turned around to become a dynamic, profitable institution, using
    microfinance principles.

To address this task, we need to address four aspects of the RFS. These are demand,
supply, distribution and regulation. Each of these aspects requires work, as follows:

Demand – Though there is an enormous amount of unmet need, it does not necessarily
constitute demand. Before it can be treated as effective demand, the need has to be
aggregated, where is it is too small and dispersed, as in the case of tiny consumption
loans or commodity trading needs of small and marginal farmers. In other cases, the
need has to be differentiated into financial product wise demand. For example, several
small contingencies which should actually be met through savings are currently seen as
a “need for credit”.

Likewise, other large contingencies, such as death of livestock or of an earning
member, have to be met through insurance, not credit as is done now. Finally, several
consumers express need without the willingness to pay full-costs, due to decades of
subsidies or controls by the government on interest rates (almost all rural bank loans),
principal ( as in IRDP loans)and on insurance premiums (as in crop loans). This would

October 2005                                                                              Page 50
                                                             Technical Assistance (TA) No. 4247-IND
                                                 Rural Finance Sector Restructuring and Development
                                                                       Volume 1: Executive Summary
have to convert into effective demand over a period of time, through a combination of
customer education and improved service provision. The pioneering institutions which
provide this transformational input are the ones who need support from the government,
not the individual customers.

Supply – The supply of financial services - credit, savings, pensions, insurance, money
transfers, and commodity derivatives – needs to be increased dramatically. This means
that the number of institutions which willingly, rather than mandatorily, offer these
services, needs to go up. For this, the RBI, IRDA and other regulators have to facilitate
rather than thwart the entrance of a larger number of players, as well ensure
competition among them, while removing pricing caps, so that profitable performance
becomes possible, but extra-ordinary profits will get curtailed over time through

Distribution – Though this is an aspect of supply, it needs separate attention as the
critical issue in financial services is the last mile access. The present system of using
branches is unsatisfactory as it is too far and distant from a majority of customers, while
opening new branches in smaller places is uneconomical for the service providers.
Thus, there is a need for innovative use of alternative distribution channels – agents
being the most well-tried of these, even by the state owned Life Insurance Company
and the government’s National Small Savings Organization. However, several incidents
of fraud and unionism have put off the RBI and banks from using agents for the most
important service – savings. This antipathy co-exists with the RBI simultaneously
allowing para-banking companies – such as Peerless and Sahara - to use agents to
collect small savings from millions of savers in the country, without significant reported

Recently, Brazil has significantly increased the availability of financial services to its
hinterland population, by the use of “banking correspondents” – which are grocery
stores, telephone kiosks, gas stations. This model has been studied and recommended
for adoption in India by the RBI appointed Khan Committee in 2005. Thus the regulator
has to be more open-minded about this issue and weigh the demerits of excluding
something like 80% of the population from formal savings services, versus the small
chance of frauds by agents at the local level. The use of IT and innovations like hand-
held devices and cell-phones to record transactions can significantly reduce the
chances of frauds even further, while cutting costs and dramatically improving
information availability on the customers and agents.

Regulation – Regulatory reform is the major unfinished agenda.

India’s financial sector is characterized by two very different genetic codes – the old
style regulations emanating from the RBI Act, 1934; the Banking Regulation Act, 1949;
the BR Act as applicable to Cooperative Societies, 1966; the Bank Nationalization Act,
1969; the Regional Rural Banks Act, 1976 and the NABARD Act, 1982, and institutions
under these Acts.

October 2005                                                                              Page 51
                                                           Technical Assistance (TA) No. 4247-IND
                                               Rural Finance Sector Restructuring and Development
                                                                     Volume 1: Executive Summary
In contrast, the post 1991 reforms period saw the enactment of modern, progressive
Securities and Exchange Board of India Act and the Insurance Regulatory and
Development Authority Act, and the formation of regulatory institutions such as SEBI
and its regulated modern sector players like the National Sock Exchange, depository
institutions, mutual funds, venture funds, and IRDA private insurance companies, and
most recently the NCDEX, MCX etc in commodities (though the Forward Markets
Commission, the commodities regulator has the older genetic code).

There is a need to reform the “base” of the financial system, the one which deals with
savings and credit, particularly for the mass of the rural population.

Who will usher in such change? Unfortunately, the slow pace of change in the RFS is
largely due to the fact that the very same institutions which can bring about change are
not incentivized or equipped to do this. This is most obvious in the cooperative credit
sector, as has been graphically brought in several reports, aptly summarized in the most
recent Vaidyanathan Committee report. Even NABARD, which could have been a
change agent for the RFS, is invested too much in its past all-in-one but mutually
contradictory roles as a refinancing, supervision and promotional apex institution. The
RBI is focused on other things that require attention viz, macroeconomic management,
money supply, exchange rate stabilization and overall health of the banking system and
the payments system. Moreover, the RFS has too many aspects – insurance,
derivatives, etc. which are beyond the RBI’s purview.

Thus the impetus for change has to come from a supra authority , perhaps the Ministry
of Finance. If we see how major positive change was brought about in the RFS of
Indonesia, of Malaysia, of Thailand, of Mongolia, we find that it was done by nominating
a high level team and taking a mission approach. It is this approach that we
recommend, which is necessarily high-powered, high profile and time bound. In other
words, it is time for a National Mission on Rural Financial Services with a membership
including high level representatives from relevant institutions like the RBI, NABARD,
IRDA, Post Office Board and FMC with the mission to facilitate relevant financial
services for all segments of the population in rural areas.

October 2005                                                                            Page 52

To top