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Bank reform and the rural sector

C. P. Chandrasekhar
Jayati Ghosh

Internal financial liberalisation has had adverse effects upon the availability of credit for farmers, adding to the various economic sources of agrarian distress. In this edition of Macroscan, C. P. Chandrasekhar and Jayati Ghosh< /B> consider the main elements of banking reform over the past decade and the implications for agricultural credit in particular.


The rural sector still remains parched of bank credit - serious attempts have been made in recent years to dilute the norms of whatever remains of priority sector bank lending. — Kamal Narang

IN THE period before the nationalisation of banks, key sectors of the economy, including agriculture, remained thoroughly neglected in terms of availability of institutional credit. Whereas the industrial sector at that time accounted for about 15 per cent of national output, it appropriated two-thirds of commercial bank credit, whereas the agricultural sector contributing about half of national output was almost completely neglected by the commercial banks.

One of the most important objectives of government policy since the nationalisation of 14 commercial banks in 1969 was to extend and expand credit not only to those sectors which were of crucial importance in terms of their contribution to national income and employment, but also to those sectors which had been severely neglected in terms of access to institutional credit. The sectors that were initially identified for this purpose were agriculture, small industry and self-employment. These sectors were to be accorded priority status in credit allocation by the banks.

As a consequence, policies such as interest rate controls and pre-emption of resources through directed credit programmes aimed at agriculture and the small-scale sector increased in magnitude during this period. There was also a concerted effort at substantially expanding the reach of the banking system, especially to the rural areas.

The success of policy in terms of branch expansion, mobilisation of household savings, diversification of lending targets and direction of credit to the priority sector was substantial.

Yet, by the late 1980s, the banking sector in India was faced with criticism of a completely different kind. The focus of that criticism was the low profitability, low capital base, high non-performing assets and the ostensible "inefficiency" of and lack of transparency in the banking system. Such criticism constituted the point of departure of the Committee on the Financial System (CFS) under the chairmanship of M. Narasimham established in 1991 to pave the way for the liberalisation of banking practices.

Among other things, this Committee recommended a reconsideration of the policy of directed investments and directed credit programmes, as well as the interest rate structure pertaining to these. Thus it suggested that priority sector credit as hitherto defined should be phased out.

It also recommended that the concept of priority sector itself be re-defined to target only the truly needy — the small farmer and the tiny sector in industry — and that the credit to this redefined priority sector should be only 10 per cent of total bank credit.

On interest rates, the Committee suggested that the complex system of administered interest rates be dismantled in a phased manner and that there should be greater reliance on the market mechanism so that interest rates could be allowed to perform, in a greater measure, their allocative function.

As the erosion of profitability was not only due to factors operating on the income side, but also on the side of expenditure of banks, the Committee wished that without prejudice to the availability of banking facilities especially in the rural areas there should be a reconsideration of the future of unremunerative branches.

In the Committee's view, judgment relating to future expansion of branches should primarily be left to banks themselves and accordingly branch licensing by the Reserve Bank should be abolished.

When recommending financial liberalisation as a solution to the "problem" of low profitability, there was the immediate problem of dealing with the existing large element of non-performing assets (NPAs) in banks' portfolio. Subjecting banks that had hitherto functioned under a completely different discipline to market-based competition and the threat of closure would have amounted to discrimination vis--vis new entrants with adequate resources.

The Narasimham Committee coined a new definition of NPAs that was in conformity with international practice. From 1991-92, banks had to classify their advances into four groups, such as i) standard assets; ii) sub-standard assets; iii) doubtful assets; and iv) loss assets, and indicated that the advances classified under the last three groups were to be considered as NPAs.

Chart 1 shows the NPAs of public sector banks (PSBs) between 1993 and 2001, as a proportion of total assets. It shows that the proportion of total NPAs to total advances declined from 23.2 per cent in March 1993 to 12.4 per cent in March 2001.

The sharp decline in NPAs of PSBs in 1996-97 was really due to a definitional change. The RBI introduced a new concept of `net NPAs' in 1996-97 in place of gross NPAs followed by it earlier. This was derived by deducting various items, including "total provisions held", the exclusion of which conceals the gross damage caused by the NPAs on the banks.

Chart 2 indicates that the share of the priority sector in total NPAs for PSBs decreased until 2000, even though the proportion of total NPAs accounted for by the priority sector was inflated by the new method of calculating net NPAs. Subsequent increases have been due to the broader scope of priority sector lending, as explained below.

Also, NPAs resulting from small advances (that is, where outstanding bank loans amount to Rs 25,000 or less) have been declining and that too quite sharply in relative terms. The recovery performance of direct agricultural advances had been improving, especially in the first half of the 1990s. According to the RBI, the recovery performance of direct agricultural advances had increased from 54.1 per cent in 1992 to 59.6 per cent in 1995.

The policies initiated by the RBI, which implicitly treat agricultural advances as prone to result in NPAs should be viewed against this backdrop.

An informal working group set up by the RBI in 1992-93 to consider any required relaxation in the implementation of new prudential norms had recommended that in the case of advances granted for agricultural purposes, banks should adopt the agricultural season as the basis for treatment of NPAs. Accordingly, it was decided that any agricultural advance should be treated as NPA only when interest/instalment is not paid continuously for two half-years, synchronising with the harvest.

This decision was reversed in April 1997 when the RBI advised the banks to reduce the interest overdue period of two half-years in the case of agricultural advances, to two quarters, that is, from 12 months to six months, from 1997-98 onwards. This was bound to accelerate the process of agricultural loans getting increasingly classified as NPAs and negate the effect of the continuous increase in the recovery performance of agricultural loans.

Priority sector lending

However, the argument of high NPAs was used to encourage banks to cut back on lending to the priority sector. Among the directed credit programmes followed by the banks, priority sector lending has been perhaps one of the most effective.

In 1969, banks provided only 14.6 per cent of their total credit to the priority sectors, with the percentage of credit disbursed to agriculture being a mere 5.4 per cent. In 1991, 40.9 per cent of net bank credit was advanced to priority sectors, and total credit to agriculture, even though remaining below the prescribed level of 18 per cent, was 16.4 per cent by 1991.

Unfortunately, since 1991, there has been a reversal of the trends in the ratio of directed credit to total bank credit and the proportion thereof going to the agricultural sector, even though there has been no known formal decision by the Government on this score. At the same time, serious attempts have been made in recent years to dilute the norms of whatever remains of priority sector bank lending.

As mentioned earlier, the Committee on the Financial System recommended phasing out of the bulk of priority sector targeting by the banks. The changes recommended by the Committee in the field of priority sector lending were as follows:

  • The directed credit programmes should cover a redefined priority sector consisting of small and marginal farmers, the tiny sector of industry, small business and transport operators, village and cottage industries, rural artisans and other weaker sections.

  • Credit targets for this redefined priority sector should be fixed at 10 per cent of aggregate bank credit.

  • Stipulations of concessional interest to the redefined priority sector should be reviewed with a view to its eventual elimination, in about three years.

  • A review should be undertaken at the end of three years to see whether the directed credit programmes need to be continued.

    While the recommendations of the Narasimham Committee on priority sector lending were not completely accepted, various policy measures, aimed at diluting the norms of priority sector lending were adopted, so as to ensure its gradual phase-out in the future.

    While the authorities have allowed the target for priority sector lending to remain untouched, they have widened its coverage. At the same time, shortfalls relative to targets have been overlooked. In agriculture, both direct and indirect advances to agriculture were clubbed together for meeting the agricultural sub-target of 18 per cent in 1993, subject to the stipulation however that `indirect' lending to agriculture must not exceed one-fourth of that lending sub-target or 4.5 per cent of net bank credit.

    It was also decided to include indirect agricultural advances exceeding 4.5 per cent of net bank credit into the overall target of 40 per cent. The definition of priority sector itself was also widened to include financing and distribution of inputs for agriculture and allied sectors (dairy, poultry, livestock rearing) with the ceiling raised to Rs 5 lakh initially and Rs 15 lakh subsequently.

    The scope of direct agricultural advances under priority sector lending was widened so as to include all short-term advances to traditional plantations including tea, coffee, rubber, and spices, irrespective of the size of the holdings.

    Apart from this, there were also totally new areas under the umbrella of priority sector for the purpose of bank lending. This meant that banks defaulting in meeting the priority sector sub-target of 18 per cent of net credit to agriculture, would make good the deficiency by contributing to various other institutions such as the Rural Infrastructure Development Fund of NABARD. They could also make investments in special bonds issued by institutions like State Financial Corporations and treat such investments as priority sector advances.

    The changes thus made in the policy guidelines on the subject of priority sector lending were obviously meant to enable the banks to move away from the responsibility of directly lending to the priority sectors of the economy. It is in the light of this that the trends in priority sector lending during the post-liberalisation period of 1991-2001 should be understood.

    Priority sector lending as a proportion of net bank credit, after reaching the target of 40 per cent in 1991, had been continuously falling short of target till 1996. It has subsequently been in excess of the target for the reasons specified above, and stood at 43 per cent in 2001, which was mainly due to the inclusion of funds provided to regional rural banks by their sponsoring banks, that were eligible to be treated as priority sector advances.

    Advances to agriculture also declined from 16.4 per cent in 1991 to 15.3 per cent in 2002, well below the target of 18 per cent of net bank credit. In the year ending March 2003, direct agricultural advances amounted to only 10.8 per cent of net PSB credit.

    The fall in the ratio of priority sector lending to deposits from 26.6 per cent in 1991 to 22.8 per cent in 2001 was partly due to the decline in the overall credit-deposit ratio of banks and partly due to the decline in the ratio of priority sector advances to total bank credit.

    Private banks in general and foreign banks in particular have been lax in meeting regulatory norms.

    The sector most affected was agriculture, in whose case private bank lending amounted to just 10.8 per cent of net credit, which was far short of the stipulated 18 per cent in the year ending March 2003. Direct agricultural advances were only 6.3 per cent of net private sector bank credit.

    Within the private sector, foreign banks were the major defaulters. According to the annual report of RBI, the advances of foreign banks to the priority sector were only 34 per cent of net credit in the year ending March 2003.

    Here again, agriculture was the prime area of neglect. Foreign banks' performance on credit to the small scale industries and export sectors was much better, with lending to these sectors accounting for 9 and 19 per cent, respectively, of the net bank credit against the sub-sectoral targets of 10 per cent and 12 per cent.

    Clearly, even to the extent that priority-sector lending targets had been met, the choice was in favour of the more cost effective and profitable sectors.

    Overall, nearly 60 per cent of the priority sector lending by foreign banks was directed towards export credit.

    The difficulty is that, faced with the demands made on them by the advocates of liberalisation and the effects of competition from the private sector banks, banks in the public sector are also being forced to change.

    They are trying to trim operating expenses, by reducing the wage bill by reducing employment through retrenchment under the VRS scheme and computerisation. They are also seeking to reduce costs by limiting branch expansion and reducing the number of bank branches.

    The latter, which affects the rural areas first, reduces access to credit in rural areas that were well-served by the post-nationalisation branch expansion drive, and worsens the tendency towards reduced provision of credit to the agricultural sector.

    In consequence of all this, the formal credit squeeze upon Indian agriculture is now acute. This has led to severe problems of accessing working capital for cultivators, and has also meant the revival of private money-lending in rural areas.

    Such retrogression has extremely disturbing implications for the future of Indian agriculture.

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