Question

write a short paper to introduce the rural financial system in your country. (300-400 words)

Answer 1

Rural Financial System

Access to financial services or financial inclusion will not have success if there does not exist a conducive rural financial system. From the history of literature it is found that while there was improved access to finance for certain sections of the rural

population over the years of social banking in India, it still left out of its ambit a large

section of the rural population, particularly the poor. Pallavi (2005) found from her

study that social banking in India did not deliver the required platform for building an

inclusive financial system because of the need for a more liberalized and competitive

rural financial systems, in which banks are given greater operational freedom and provide

better incentives for banks to deal with rural borrowers.

Robin, Rohini and Grace (2005) found from their study that for the period 1961–

2000 rural branch expansion in India significantly lowered rural poverty and rural labor

households, especially SC/ST households and these households were much less likely

to obtain bank loans once the emphasis on social banking was reduced. Poor access to

finance has led to a heavy reliance by rural household on informal finance, from

moneylenders, friends and relatives, etc. and this has been highlighted by Priya (2005)

and others in their studies. As per the authors, policies, institutions and markets need to

be transformed in India for improving the efficiency of the formal rural finance sector.

In the short-term, much can be achieved by introducing more appropriate products and

services, simplifying procedures and re-thinking staffing policies. Over the longer-term,

building a more inclusive banking system will require more fundamental changes to

improve the incentive regime, promote competition and enhance the efficiency of rural

financial institutions and markets.

Financial Literacy

Studies done by various authors on financial literacy conclude that small and

micro-entrepreneurs often lack the basic financial literacy skill required to take complex

financial decisions to effectively run and manage their enterprises. Shawn, Thomas and

Bilal (2011) have pointed out that financial literacy is an important predictor of financial

behavior in emerging market countries and it may improve risk-sharing by households

through increased demand for financial services, reduce economic volatility, improve

intermediation, and speed overall financial development. Sukanya and Arvind (2014)

have pointed out that financial literacy is seen as an instrument to raise demand for

banking services. As per them, the effects of financial literacy, however, will not accrue

if it is not accompanied by adequate outreach of banking services, particularly affordable

and timely credit, through credible public institutions.

The Importance of Rural Finance

The study done by FAO (2007) observes that under-provision of financial

services, inappropriate products and absence of competitive savings instruments in rural

areas cut further into households’ scarce liquidity and dampen local growth prospects.

Expansion of rural financial services can create a win-win scenario that will promote

growth while also helping reduce poverty. As per World Bank report (2001), access to

financial services is important for poor people. Low-income households and

microenterprises can benefit from credit, savings, and insurance services.

India has one of the world’s most extensive formal rural credit systems, with
nearly 1, 25,000 bank branches and more than 1,00,000 cooperative credit outlets in
rural areas. India’s roughly 45,000 rural bank branches (38.7% of total branches,
Economic survey of India 2015) are severely constrained in serving around 6,50,000
villages where more than 60% of Indian population reside and who are mostly poor. As
per NAFSCOB (a journal of rural cooperative credit and banking, 2014) report, the
share of long term credit in total agriculture credit declined to 37.8% in 2012 from
74.3% in 1991.
Rural finance encompasses the range of financial services offered and used in
rural areas by people of all income levels and access to financial services is important
for poor people for their income enhancement and enabling them to come out of poverty.
This fact has been supplemented by various studies done by different researchers and
key players like Reserve Bank of India (RBI), the World Bank, Asian Development
Bank (ADB), Food and Agriculture Organization (FAO), etc. There has been robust
evidence that opening branches in rural unbanked locations in India was associated
with reduction in rural poverty. Robin and Rohini (2005) found that the reductions in
rural poverty were linked to increased savings mobilization and credit provision in
rural areas.

Indian Banking system in pre-independence era

The history of Indian Banking shows that banking in India was started back in

the 18th century when efforts were made to establish the General Bank of India in 1786

and Bank of Hindustan in 1790. With the recommendation of the Board of Directors of

the East India Company the establishment of the first bank of India; the Presidency

Banks, the Bank of Bengal happened in 1809, under the charter of British East India

Company. The first Bank of Bombay, set up in 1840, collapsed and the new Bank of

Bombay was born in early 1868. The Bank of Madras came last, in 1843. Since all these

three presidency banks had the right to issue notes, and the government held a part of

their equity and participated in management, they had to have a proper Charter, fully

approved by the Court of Directors during the days of the East India Company, i.e., up

to 1858, and thereafter by the Secretary of State for India. Authors like Mohan (2006),

Howard (1921), Bagchi (1985), Banerji and Bagchi (1988) and others have done a detailed

study on establishment of Indian banking system in pre-independence era.

Establishment of RBI (Central bank of India)

The period between 1906 and 1911 witnessed the establishment of many banks

in India which have survived to the present namely Bank of India, Bank of Baroda,

Canara Bank, Corporation Bank, Indian Bank and Central Bank of India. In 1926, the

Royal Commission on Indian Currency and Finance (Hilton Young Commission)

recommended that the dichotomy of functions and divisions of responsibilities for control

of currency and credit should be ended. The Commission suggested the establishment

of a central bank to be called the Reserve Bank of India, whose separate existence was

considered necessary for augmenting banking facilities throughout the country. The

Bill to establish the RBI was introduced in January 1927 in the Legislative Assembly,

but it was dropped due to differences in views regarding ownership, constitution and

composition of its Board of Directors. Finally, a fresh Bill was introduced in 1933 and

passed in 1934. The RBI Act came into force on January 1, 1935. The RBI was inaugurated

on April 1, 1935 as a shareholders’ institution and the Act provided for the appointment

by the Central Government of the Governor and two Deputy Governors. The RBI was

nationalized on January 1, 1949 in terms of the Reserve Bank of India (Transfer to

Public Ownership) Act, 1948 (RBI, 2005b).

Indian banking system was not sound at the time of independence and there

were hundreds of private banks under unprincipled managements. Post-independence,

in the year 1949, government of India took two major steps towards bringing structural

reforms in banking sector; first, the banking regulation act and nationalization of RBI.

Evolution of Indian Rural Banking System

The post-independence era witnessed a gradual change in the banking sector. In

the area of rural finance two broad categories of banking gradually evolved in the Indian

Financial System; a) Social Banking and b) Priority Sector Banking (Lending). Each of

these categories developed gradually with some specific objectives to achieve. The broad

objectives of these sectors are a) increasing bank presence in rural areas and to equalizing

population per bank branch across Indian states, b) directed bank lending towards priority

sectors which included agriculture and small scale industries and within these sectors to

individuals belonging to “weaker sections” of society, which included scheduled castes

and scheduled tribes.

Rural Finance Service Providers:

1. Cooperative Banking
2. RRB'S
3. NABARD
4. SIDBI
5. SBLP
6. Microfinance

Rural Finance Institutions

Such institutions generally have only low operative and innovative capacities. For this reason, the Government of India has charged the National Bank for Agriculture and Rural Development (NABARD) with the implementation of programmes to promote rural finance and financial inclusion

The majority of people in rural India have no access to demand-oriented banking services which might help them to improve their economic situation. This is especially true of poorer households, smallholder farmers and women. Cooperative banks and other regionally active banks, as well as credit cooperatives and self-help groups would be able to provide financial services for these population groups. However, such institutions generally have only low operative and innovative capacities. For this reason, the Government of India has charged the National Bank for Agriculture and Rural Development (NABARD) with the implementation of programmes to promote rural finance and financial inclusion.

Approach

Partner in the programme is the development bank NABARD, which is responsible for the supervision, refinancing and promotion of the rural finance system. The partners promote the rural credit cooperatives, microfinance provided by banks through self-help groups, and the financial inclusion of poorer households by banks.

The programme experts advise state governments, banks and non-government organisations, and they arrange training for employees of NABARD, the credit cooperatives and self-help groups. This, and the application of new model solutions and technologies, contributes to the financial inclusion of the rural population.

NABARD disposes over funds which it uses for training, technological innovation and the expansion of the programme activities (EUR 190 million from 2009 to 2013). These measures have so far reached 488 rural banks and about 200 million members of credit cooperatives and self-help groups. The programme cooperates with the German Association of Cooperative Banks (DGRV) and the German Academy for Cooperatives (ADG).

Results

Rural cooperative credit system: Since 2008 the rural cooperative credit system, which consists of 92,000 institutions with 120 million members, has been able to improve its performance, by standardising its systems for accounting, auditing, training and counselling. One particular success has been the creation of a national institute with currently 4,360 institutional members, which now controls the quality of training in the sector and certifies the professional competences of employees. By establishing advisory units in cooperative banks (114 to date), the programme has helped to improve the business development of the primary cooperatives. The proportion of cooperative banks achieving a rating of at least ‘sufficiently sound’ has increased from 66 to 97%. Many cooperatives have increased the range of services for their members. The value of loans disbursed has doubled and the share of members borrowing has increased from 37 to 45%.

Microfinance through self-help groups and financial inclusion: Since 2008 the number of members of self-help groups holding deposits in banks has increased from 50 to 90 million. 82% of the members are women and 56% of the groups have outstanding bank loans. The range and quality of banking services for self-help groups has been improved though the development of demand-oriented products and the employment of their members as banking agents at village level. On behalf of two banks, about 70 women now provide banking services to 18,600 clients in 286 villages. New technologies enable the women to provide previously unavailable services such as money transfers.

Nine further banks now plan to replicate this approach. Membership in self-help groups and their role as bank intermediaries strengthen the position of women in households and village communities. Studies show that 92% of the women feel empowered by joining a self-help group. Meanwhile, 70% of the group members are satisfied with the banking services, 25% of them have increased their incomes, and the expenditure on education and health has increased by 34%.

Objective

Rural financial institutions offer demand-oriented financial services for smallholder farmers, women and poorer households.