Deregulating rural credit


back to issue

MONEYLENDERS in India are as old as its villages, agricultural credit cooperatives go back a century, commercial banks have been involved in agricultural loans for nearly 50 years, the regional rural bank network is over 25 years old, and reforms in the banking system were triggered a decade back. Yet, credit flow to small farmers has remained far below needs, both for crop cultivation and for long term requirements such as land development, irrigation and farm equipment as compared to the potential demand. The widespread discontent among farmers has manifested itself in the form of mass voting against incumbent governments as also individual acts of despair such as farmers committing suicide, particularly in Andhra Pradesh.

Partly in response to this situation, the finance minister announced certain measures required to be implemented by all scheduled commercial banks in July 2004 for improving the flow of credit to agriculture. Accordingly, banks have been advised to reschedule the debts of farmers who have suffered losses on account of drought, flood or other calamities. The principal and interest outstanding in the accounts of such crop loan and agriculture term loan borrowers up to 31 March 2004 would now be repayable over a period of five years at current interest rates, including an initial moratorium of two years. On restructuring their existing loans, the farmers would become eligible for fresh loans.

Banks have also been advised to formulate guidelines on one-time settlement (OTS) for small and marginal farmers declared as defaulters as on 24 June 2004 and thus ineligible for fresh credit. Banks should complete the exercise of notifying defaulters of the OTS guidelines by 30 September 2004. Banks have been told that all applications for OTS received from defaulters should be processed within one month of their receipt. Further, in order to mitigate the acute distress that farmers might be facing due to debt from non-institutional lenders (e.g. moneylenders) and to provide them relief from such indebtedness, banks have been asked to advance loans to such farmers against appropriate collateral or group security.

In an effort to ameliorate the suffering of debt-ridden farmers, the Andhra Pradesh Legislative Assembly passed the A.P. Farmers Agricultural Debts (Moratorium) Act 2004 on 21 June 2004, which provides for declaring a six-month moratorium on repayment of loans from private moneylenders. The move comes in the backdrop of a continued spate of suicides by farmers even after the new Congress government unveiled a series of steps, including free power, to the agriculture sector and a comprehensive package for farmers.

In this article, we try to understand the problem of credit to small farmers and identify possible solutions.



Demand for Rural Credit: In a study carried out for the World Bank between 1994 and 1995, Mahajan and Ramola1 (1996) estimated the average annual credit usage by rural households in the survey area based on their credit usage for the previous three years. Accordingly, the annual average credit usage per household from all sources worked out to Rs 14,549. Of this, 65% was for productive purposes. Long term productive purpose, viz. purchase of livestock, farm machinery, etc. accounted for 16% of the total usage while the remaining 49% was for short term purposes like agricultural crop loan. Of the total usage, 35% was for consumption purposes – 15% being on account of long term purposes like house building, marriage, etc. and 20% was for short term purposes like household expenses, clothes, consumer durables, and so on.

We can try to estimate the annualised credit usage in rural India from the above data. The above-cited study was carried out in Raichur district of Karnataka, which though a dryland region, has a higher credit usage compared to the poverty belt in Bihar, Madhya Pradesh, Rajasthan, Uttar Pradesh, Orissa, and the North East. In view of the above, if we assume the average annual credit usage in 2004 to be only Rs 9000 per house-hold per annum, the total usage comes to Rs 117,000 crore by rural households. This is an extremely conservative estimate.

It should be noted that the demand for credit is not the same as credit usage, since the latter is constrained by supply. The Xth Five Year Plan Working Group on Agricultural Credit estimated the requirement of credit at Rs 720,000 crore in five years ending 2007, or Rs 144,000 crore per annum on an average. This has to be compared with Rs 60,000 crore that was actually disbursed in 2001, the terminal year of the IXth Plan. It is obvious therefore that if the proposed growth rate in agriculture is to be achieved, the agricultural credit system needs to be significantly re-engineered.

Before we describe what is wrong and how it can possibly be fixed, let us look at the basic architecture of the system as it exists now.



Supply of Rural Credit: The present structure of the rural credit system has emerged after a series of interventions by the government and Reserve Bank of India. In the formal sector, a multi-agency approach has been followed to provide the necessary financial services in the rural areas. The various institutions are the commercial banks, regional rural banks and the cooperative credit structure (CCS).

CCS: The Cooperative Credit Structure caters to both the short term and long term credit need of the rural consumers. The short term credit need of the rural consumers is fulfilled by three institutions, namely, the State Cooperative Banks (SCBs), District Central Cooperative Banks (DCCBs) and the large network of the Primary Agricultural Credit Societies (PACS) in the villages. On the other hand, the State Cooperative Agriculture and Rural Development Banks (SCARDBs) provide long term credit in the rural economy through Primary Land Development Banks, now renamed Primary Cooperative Agriculture and Rural Development Banks (PCARDBs). In Andhra Pradesh and Jharkhand the long term structure has been merged with the short term structure.



The CCS is refinanced by the National Bank of Agricultural and Rural Development (NABARD). These institutions are, however, beset with problems like low recovery percentage (40-60%), inefficient management systems and politicization of the cooperatives due to inadequate laws prevalent in the system. In 2001-02, there were over 98,000 primary agricultural cooperatives and the loan outstanding was Rs 32712 crore. In addition, the cooperative sector also had Rs 14,172 crore of long term loans given for land and water development, tractors, etc.

In the last few years, several committees were set up to propose a solution to the growing problem. Partly based on this, the NDA government had in February 2004 announced that it will earmark Rs 15,000 crore to revive the cooperative credit system, with 60% of the contribution coming from the Centre and the rest from the states. Though the UPA government has not explicitly repeated the pledge, it has instead broadened its commitment by promising to double the flow of rural credit in three years. It is obvious that this cannot be done without reviving the CCS.

However, simply recapitalising the same old structure will amount to putting water in a bucket with a big hole. Plugging that hole, however, is more an issue of grappling with the political economy of cooperatives and less an issue of improving management systems and installing prudential norms, although that is also necessary. In a recent study of the CCS in A.P. by the Rama Rao Committee, only 36 of the 4469 PACS in A.P. were considered healthy, and the system was estimated to need nearly Rs 2350 crore of recapitalisation. This is to be seen in the light of outstanding credit to the order of Rs 5900 crore.

The fact that new progressive cooperative acts have been enacted in nine states behoves well for the future, but we must also remember that Andhra Pradesh, which led this movement with the A.P. Mutually Aided Cooperative Societies (MACS) Act, 1995, has not been able to make a dent in its older credit cooperative system with the new law. Though over 3000 new MACS have come up, their collective credit outstanding is a small fraction of the older system. It is to be seen when and how the older system will give way altogether or transform itself into the newer generation cooperatives, which are built on the principle of member control and no government interference.



Commercial Banks: The involvement of commercial banks in credit to agriculture began after the Gorawala Committee Report in 1954. The State Bank of India was asked to open 400 branches in semi-urban areas and start agricultural lending. The issue became urgent with the onset of the Green Revolution, as the package of high yielding variety seeds and fertilisers required access to credit. The government responded by first directing banks to lend to agriculture, then imposing ‘social control’ and eventually nationalising the major banks in 1971. This was followed by a major expansion in rural branches and introduction of the Lead Bank scheme and district credit plans. Within the overall quota of 40% priority sector lending, banks were asked to lend 18% of their total advances to agriculture. The number of commercial bank branches as also the share of commercial banks in agricultural credit kept rising, particularly as cooperative credit structure in many states was not working well. This trend remained till the late 1980s, when the Agriculture and Rural Debt Relief Scheme, 1989 was announced by the then government resulting in a waiving of all loans below Rs 10,000. This created repayment problems for banks and generally discouraged them from further lending.



The circle turned completely with the Narasimhan Committee report in 1993 recommending that banks should focus on profitability and adopt prudential norms. This meant much more stringent provisioning for non-performing loans than earlier and de-recognition of interest on overdue loans. Expectedly, banks became even more averse to lending to smaller, rural and agricultural borrowers. The proportion of bank credit to small borrowers (below Rs 25,000) came down steadily from 18.3% of total commercial scheduled bank credit in 1994 to 5.3% by March 2002. The declining trend by commercial banks is continuing.

The new generation private sector banks hardly have any branches in district towns, leave alone rural areas and are generally averse to agricultural lending, even through they have an obligation that 18% of their total lending will be to agriculture. Some of them are trying to meet this by offering bulk credit to corporates in agriculture such as sugar mills and plantations, while most others simply deposit the shortfall with NABARD at low interest rates, from where it goes into the Rural Infrastructure Development Fund. To incentivise banks to lend to small farmers, interest rates must be deregulated and use of traditional (such as arhatiyas or commission agents in market yards) and innovative channels (such as e-kiosks) must be permitted, indeed encouraged.



Regional Rural Banks (RRBs): In 1972, the Banking Commission observed that despite massive expansion of the network of commercial banks consequent to nationalisation, there was still a need for having a specialised network of bank branches to cater to the needs of the rural poor. With this premise, RRBs were established in India under the RRB Act, 1976. The thinking was to set up RRBs as rural-oriented commercial banks with the low cost profile of cooperatives but the professional discipline and modern outlook of commercial banks.

Between 1975 and 1987, 196 RRBs were established with over 14,000 branches. A large number of branches of RRBs were opened in the hitherto un-banked or under-banked areas providing services to the interior and far-flung areas of the country. RRBs were expected to primarily cover small and marginal farmers, landless labourers, rural artisans, small traders and other weaker sections of the rural community. However, even after so many years, the market share of RRBs in rural credit remains low. At present, the RRBs share in agriculture credit is 8% while that of commercial banks is about 50% and that of CCS is 42%.

In the very first decade of the setting up of RRBs, 152 out of 188 RRBs had accumulated losses of Rs 340 crore. The losses went up sharply in 1992 on account of implementation of the National Industrial Tribunal Award bringing parity in wage structure of RRBs with that of commercial banks. This negated the low cost structure of RRBs and more losses were accumulated. The government took note of the grim situation of RRBs and several committees were set up to look into various problems and issues faced by RRBs. Over the period 1994-2000, 187 RRBs were provided with a total of Rs 2188 crore for recapitalisation. However, their financial viability continues to be overstretched by policy rigidities coupled with a lower capital base in an environment of inadequate infrastructure and deep social and economic disparities. The accompanying table throws light upon the movement in the key indicators on RRBs for the last four years.

To ensure that RRBs serve the credit needs of small farmers, they must first be healthy themselves. This demands policy autonomy and strategic attention, not micro-management by a plethora of actors. They must also be allowed to charge higher interest rates to small farmers in turn for timely credit.



Micro Finance Institutions (MFIs): Even as banks are physically present in rural areas and offer concessional interest rates, small farmers are unable to access them because of borrower-unfriendly products and procedures, inflexibility and delay, and high transaction costs, both legitimate and illegal. It was in this context that NGOs began to examine alternative ways to enhance access to credit by the poor since the mid-1970s. After pioneering efforts by organisations like SEWA, MYRADA, PRADAN and CDF, in 1992 the RBI and NABARD encouraged commercial banks to link up with NGOs to establish and finance self-help groups of the poor.



From small beginnings in 1992, with a pilot project to link only 500 SHGs all over India, the programme expanded dramatically and by March 2004, over one million SHGs were linked to banks with a cumulative credit disbursement of Rs 4500 crore. These reached nearly 16 million borrowers. In addition, there are over 3000 micro-finance institutions (MFIs) – comprising nearly 1000 NGOs, over 2000 mutually aided cooperative societies (MACS) and a handful of commercial MFIs, such as BASIX, SHARE and CASHPOR – which together reach over one million borrowers directly.








Deposits (Rs Crore)





Investments (Rs Crore)





Loans and Advances (Rs Crore)





No. of RRBs With Accumulated Losses





Accumulated Losses





Credit Deposit Ratio (%)





Recovery (%)





NPA (%)





Source: Regional Rural Banks - Key Statistics 2003, NABARD.


Despite this impressive growth, there are still a number of problems with micro-credit. For a start, the average loan size through SHGs is only about Rs 1600. This is too little to even alleviate poverty, leave alone lift a family out of poverty. Second, the distribution of the SHG loans is highly skewed regionally, with nearly 75% coming to the four southern states, while less than 0.6% went to all the eight northeastern states. The geographical distribution of MFIs is not much better. There are also problems of banks and MFIs being forced by vote-seeking political leaders to lend at unrealistically low interest rates, which does not cover costs, and thus eventually makes the whole effort financially unsustainable.

There are a number of concerns with using the SHG model for extending credit to small farmers. The most important is that SHGs work well with women and not as well with men. Men do not like to come together in larger groups and save regularly. Instead, smaller joint liability groups, exclusively for borrowing by male farmers, have been tried successfully by BASIX and seem to work well enough. This idea has been picked up by NABARD and the Government of Andhra Pradesh and they are now encouraging the formation of Rythu Mitra Groups (RMGs) through which credit will be extended to farmers. Over 200,000 such RMGs have already been formed in A.P. Another problem with MFIs is that a vast majority focus on micro loans for the landless in which repayments are made weekly or monthly, and do not have the experience or confidence of working with agriculture where repayments can be made only upon harvesting. However, this constraint can be overcome with some training and exposure.



Informal Sources: RBI data reveals that informal sources provide a significant part of the total credit needs of the rural population. The magnitude of the dependence of the rural poor on informal sources of credit can be seen from the findings of the successive All India Debt and Investment Surveys (AIDIS). These show that the share of non-institutional agencies (informal sector) in the outstanding cash dues of rural households has reduced from 83.7% in 1961 to 36% in 1991. As per the latest AIDIS, 1992, formal institutional sources, banks and cooperatives provided credit support to almost 64% of the rural households, while professional and agricultural moneylenders extend credit to about one sixth of the rural households.



From the point of view of a small farmer, the important informal sources of credit are large farmers, input suppliers (seed, fertiliser and pesticide dealers), commission agents or arhatiyas who arrange the sale of a farmer’s produce in a mandi or market yard, and occasionally professional moneylenders. The interest rates from these sources vary from 3% per month in the southern states to over 10% per month in the eastern states. Moreover, such credit is often tied – such as the obligation to work in the large farmers’ land as needed, and selling their produce through the same arhatiya who advanced a loan for the sowing season. The relationship varies from being mildly unfavourable to the farmer to being highly exploitative, depending on the place.

To increase access to credit for small farmers, use must be made of the informal sector players and the best way is to make them compete with each other. Thus in locations where there are only few input dealers or arhatiyas, an effort should be made to help set up others in the same business. Bank loans, for instance, should be provided to set up seed/fertiliser shops and licenses given to more arahtiyas in regulated market yards. Once they are forced to compete, they will end up serving the small farmer better and on more reasonable terms.



Interest Rates: One of the abiding questions related to extension of credit to small farmers revolves around interest rates. Both emotive as well as intellectual arguments tend to suggest that smaller borrowers, including farmers, should be charged a lower rate of interest than larger borrowers. Policies and directives based on this thinking have been dominant in India since over a hundred years. This was partly justified on the grounds of the usurious practices of traditional moneylenders, often aimed at dispossessing borrowers of their main collateral security – land. This led to the enactment of anti-usury laws, known in most states as the Moneylenders’ Acts. However, the result has been perverse, reducing the supply of credit and increasing the interest rate of the little that is given.

The discomfiting fact is that interest rates of informal lenders are difficult to control, whereas formal institutions which are under public scrutiny have to keep their interest rates low. Thus formal institutions tend to ration credit to small farmers since they are not able to meet their full costs. Transaction costs on small loans are necessarily higher than for large loans, when expressed as a percentage of the loan amount. The pricing should cover the cost of funds, the transaction costs and the risk costs (likelihood of bad debts). Most arguments in favour of lower interest rates for small farmers do not take this into account. As a result, banks find it unprofitable to lend to small farmers and effectively cut their losses by lending as little as they can get by without incurring regulatory wrath.

In India, though interest rates on small loans by RRBs and cooperative banks were deregulated in 1996, the amount of credit by these banks has not gone up significantly. This is because the regulatory cap was never removed for the largest channel of rural credit, the commercial banks, thus ensuring that RRBs and cooperatives could never significantly increase their interest rates. More recently, the government has been asking (though it has refrained from getting the RBI to direct) banks to reduce interest rates to farmers to 9%, on the grounds that interest rates on housing loans to the urban middle class were down to 7-8%. Though it is acceptable to compare these rates, what is not discussed is that the transaction cost of an urban housing loan is much lower because of high volumes per branch and much lower risk levels. Bad debts for housing loans are a fraction of one percent while those for agricultural loans are anywhere from 3-5%, even without the risk of politically motivated loan waivers, and with those included, the bad debt costs are much too high to be built into any reasonable interest rates.



Politicians, intellectuals and farmers all need to accept that small loans are more expensive and must be priced accordingly. Thus an answer to the credit needs of small farmers in India is to free up interest rates, not just in terms of regulation but in terms of acceptability. At the same time, the government should permit a whole spectrum of credit providers, formal and informal, to enter the field and compete with each other so that they can enhance the total credit flow and eventually bring down costs. No regulation can control supply and price simultaneously. So if more credit has to flow to farmers, the price (interest rate) must be deregulated. Initially it may go up, attract more players and then they will compete and bring down the rates. Ironically, this lesson from the housing and consumer finance market has been missed by our policy-makers.


* The BASIX Group has cumulatively loaned Rs 250 crore to over 100,000 rural farmers and non-farm producers since 1996 and has a long term repayment rate of 97.5%.



1. Vijay Mahajan and Bharti Gupta Ramola. ‘Financial Services for the Rural Poor and Women in India: Access and Sustainability,’ Journal of International Development 8(2), 1996, 211-24.