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A Review of Bank Lending to Priority and Retail Sectors

The surge in bank credit in the last couple of years has been an encouraging phenomenon in Indiaâ??s banking sector. This reflects as much the turnaround in the economy as the improved balance sheets of the banks themselves. However, though overall credit growth has been of a high order, the expansion of agricultural credit and credit to small-scale industries sector has not kept pace with it. Retail credit, which is growing from a very low base, has expanded rapidly during this period. While consumption-led growth can help improve the growth rates in the economy, it would also result in increasing risks.

A Review of Bank Lending to Priority and Retail Sectors

The surge in bank credit in the last couple of years has been an encouraging phenomenon in India’s banking sector. This reflects as much the turnaround in the economy as the improved balance sheets of the banks themselves. However, though overall credit growth has been of a high order, the expansion of agricultural credit and credit to small-scale industries sector has not kept pace with it. Retail credit, which is growing from a very low base, has expanded rapidly during this period. While consumption-led growth can help improve the growth rates in the economy, it would also result in increasing risks.


I Introduction

ndian banking has witnessed several positive changes in the recent years making it progressively sound and stable. Bank stocks have witnessed sustained demand from investors in the equity market, reflecting the vast improvement in the sector’s fundamentals. The buoyancy in banking stock prices has been used by many banks to boost their capital by tapping the capital markets. Internally, banks have constructively used the trading gains arising out of profits from the sale of government securities to strengthen their balance sheets. Externally, a number of policies have been of crucial help in considerably reducing the nonperforming assets (NPAs) – these include the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act for foreclosure, the Corporate Debt Restructuring (CDR) mechanism, the debt recovery tribunals (DRTs) and the policy initiatives towards one-time settlements. These factors have given a boost to banks’ ability to readjust assets and significantly extend their advances portfolio.

At the same time, helped by benign interest rates, corporates have improved their inventory and working capital management besides diversifying their liabilities portfolio. Their internal resources have strengthened in recent years and debt-equity ratios have improved. This has provided an opportunity to banks for expanding into new and alternative avenues for deploying their funds. In response, banks, of late, have been lending to the retail sector in a big way and the days of “lazy banking” seem to be nearing an end.

Retail lending is conventionally defined as lending to individuals, as opposed to institutions. It is meant for very small entrepreneurs or individuals who are engaged in gainful commercial activity as also those who have demand for durable consumption or investment goods (such as, houses) with long streams of utility or income flows and have bankable proposals in terms of repayment capacity. The latter is judged through the cash streams (income) available with the borrower for repayment of the loan. The typical products offered in the Indian retail banking segment are housing loans, consumption loans for purchase of consumerdurables, auto loans, credit cards and educational loans in addition to loans to individuals against shares, debentures, bonds and fixed deposits. The quantum of bank loans to this sector has been increasing substantially in the recent years and, given the low base, the scope for further growth in this segment continues to be significant.

In India, apart from lending purely on commercial considerations, banks have to fulfil the prescribed directed credit to meet certain socio-economic obligations. Directed credit in the Indian banking system takes the form of priority sector credit wherein the Reserve Bank of India (RBI) mandates a certain type of lending on the banks operating in India, including foreign banks. RBI sets targets in terms of percentages (of net bank credit lent by the banks) to be lent to certain sectors, which would not have had access to organised credit market in the normal course, without regulatory intervention and purely on commercial considerations. This type of lending constitutes priority sector lending. The trend towards increased retail lending, as mentioned above, has been accompanied by some reorientation of lending to the priority sectors.

Specifically, the present study is built around the changing face of bank lending in India. In this quest, the annual data on sectoral deployment of credit (SDC), published in the Annual Reports of Reserve Bank of India, have been analysed. These data relate to 47 select scheduled commercial banks, which account for about 90-95 per cent of bank credit of all scheduled commercial banks. In this data-set, priority sector credit is categorised into credit to agriculture, small-scale industries and other priority sector lending. The data-set also contains a sub-sector of retail credit which includes credit to housing, consumer durables, loans to individuals against shares and debentures/bonds, advances against fixed deposits and other non-priority sector personal loans. The time series available on SDC is relatively short, covering the period from 1996-97 to 2004-05, and has been used to study the inter-sectoral movement of credit and its growth over the period.

The rest of the study is organised as follows: while Section II discusses the trend in sectoral distribution of bank lending, Section III focuses on trends in priority sector lending in recent years. Section IV is devoted to the discussion of the trends in lending to retail sector. Section V concludes with an analysis of the policy implications of the observed changes in bank lending.

II Trends in Bank Lending in Recent Years

After displaying a decelerating tendency for several quarters, growth in bank credit picked up pace in the third quarter of 2003 and grew at the rate of 15.3 per cent in 2003-04. In 2004-05, annual growth of bank credit in India more than doubled to about

Economic and Political Weekly March 18, 2006 31 per cent. In contrast, total deposits of the banking system grew only by 13.0 per cent over the same period. As a result, the credit-to-deposit ratio reached a record 65 per cent in March 2005, and the incremental credit-deposit ratio exceeded 100 per cent. A similar trend has continued in 2005-06.

There are several explanations for the present phase of rapid credit growth in India. According to IMF (2004) and Hilbers et al (2005), theoretically, there are three main reasons for rapid credit growth. First, credit tends to grow more quickly than output during the development phase of an economy due to the occurrence of financial deepening. Secondly, credit expands more rapidly than output at the beginning of a cyclical upturn due to firms’ investment and working capital needs. Third, excessive credit expansion may result from inappropriate responses by financial market participants to changes in risks over time. For example, highly positive expectations about future earnings may increase asset valuations, lead to a surge in capital inflows, increase collateral values, and allow firms and households to sharply increase borrowing and spending. However, it may be hard to distinguish between these three reasons of fast credit growth, since all three may be present in various degrees at the same time in an economy. Financial deepening can coincide with the cyclical growth in lending, which, in turn, can be accompanied by an asset price bubble.

In India, credit expansion is taking place against the backdrop of relatively smaller financial markets, suggesting that financial deepening may be an important driver behind this rapid credit growth, which should be seen as a positive development, since a number of recent studies indicate that financial development is one of the determinants of economic growth [King and Levine 1992 and 1993; Levine 1997; Benhabib and Spiegel 2000; Favara 2003; Khan and Senhadji 2003]. In India, the ratio of bank credit to GDP grew from 20.35 per cent in 1996-97 to over 35.4 per cent in 2004-05. This is still relatively low compared to the credit-GDP ratios in major developed countries such as UK (158.5 per cent) and the Euro area (143.1).

During the last eight years, the average growth in gross bank credit (GBC), in the sectoral deployment of credit (SDC) database, has been 17.9 per cent per annum. The growth in credit was sharp in 2003-04 and 2004-05 in most sectors. Priority sector credit has grown by about 30 per cent during both the years, with credit to agriculture recording growth rates of 26.4 per cent and

35.2 per cent, respectively, while credit to SSI grew by 8.9 per cent and 15.6 per cent, respectively (Table 1). Credit to medium and large industry has grown by over 23.4 per cent and 17.4 per cent whereas retail credit has grown by about 34.4 per cent and

40.8 per cent in the last two years. Not only has the growth rate of retail credit been higher than of the other sectors, but it has also overtaken the share of other sectors in gross bank credit. The average annual growth of credit to sectors other than agriculture and industry has been 23.6 per cent, with the annual growth rate consistently ruling above 20 per cent in the recent years and touching 36.3 per cent in 2004-05. Moreover, during the last five years, the growth in credit to this sector has been generally higher than that to agriculture or industry.

Recent trends in credit deployment show that there has been a structural shift in credit delivery towards sectors other than agriculture and industry – mostly towards services and retail. The share of priority sector that had hovered around 32-33 per cent upto 2002-03 has increased to 35.5 per cent in 2004-05 (Table 2). However, the share of agriculture has remained almost stagnant around 12 per cent during the period under review, with some improvement in 2004-05. The share of credit to small-scale industries has fallen from 14.0 per cent in 1994-95 to 7.8 per cent in 2004-05. Clearly, the increase in share of priority sector loans has been led by the increase in housing credit. Housing loans to individuals up to Rs 15 lakh, irrespective of location, count as priority sector loans leading to an incentive to supply such credit. On the demand side, the fiscal incentives given to housing loans have given rise to an increasing demand for such loans from individuals.

Over the last eight years, the share of industry in the total loan portfolio of commercial banks has declined. This share fell from

53.5 per cent in 1996-97 to 37.7 per cent in 2004-05. Over the same period, Indian corporations have reduced their reliance on bank loans as a source of financing, and have used retained profits, the capital market and external borrowings more actively for raising the finances needed for growth and expansion. The decline in share has been marked in the case of SSI sector – from 13.9 per cent to 7.8 per cent in 2004-05. The share of industry (medium and large) also declined sizeably from 39.6 per cent to 29.8 per cent. Also, within industrial credit, the growth in credit offtake has been driven largely by the infrastructure sector. Infrastructure, which barely accounted for 2 per cent of credit to industry (small, medium and large) in 1997-98, accounted for about 16 per cent of gross bank credit in 2004-05.

The share of the credit to sectors other than agriculture and industry in outstanding gross bank credit, which was 31.4 per cent in 1996-97, now accounts for almost 45.5 per cent of the total gross bank credit, and has exceeded the share of industry since 2002-03. The share of sectors other than agriculture and industry has gone up secularly, indicating a structural change

Table 1: Variations in Sectoral Deployment of Credit

(in Per cent)

Year Ending March 21, March 19, March 18, 2003 2004 2005

Non-food gross bank credit 17.5 28.4 27.9

a) Priority sectors 16.3 29.5 31.0 i) Agriculture 17.9 26.4 35.2 ii) Small-scale industries 5.8 8.9 15.6 iii) Other priority sectors 25.1 49.8 37.0

b) Industry (medium and large) 16.3 23.4 17.4 c) Wholesale trade 9.5 11.0 36.0 d) Other sectors 22.8 36.6 36.0

of which, retail 22.0 34.4 40.8 Memo credit to sectors other than agriculture and industry 22.1 38.2 36.32

Note: Data relate to 47 select scheduled commercial banks, which account for about 90-95 per cent of bank credit of all scheduled commercial banks.

Table 2: Share of Various Sectors in Gross Bank Credit

(in Per cent)

Year Ending March 21, March 19, March 18,
2003 2004 2005
Non-food gross bank credit 92.0 95.3 95.8
a) Priority sectors 33.04 34.5 35.5
i) Agriculture 11.61 11.8 12.6
ii) Small-scale industries 9.8 8.6 7.8
iii) Other priority sectors 11.6 14.1 15.1
b) Industry (medium and large) 32.5 32.3 29.8
c) Wholesale trade 3.6 3.3 3.5
d) Other sectors 22.8 25.2 26.9
of which, retail 14.9 16.2 17.9
Memo credit to sectors other
than agriculture and industry 38.1 42.5 45.5

Note: Data relate to 47 select scheduled commercial banks, which account for about 90-95 per cent of bank credit of all scheduled commercial banks.

Economic and Political Weekly March 18, 2006

in the deployment of credit that is diversifying from the industrial sector. Among the sectors other than agriculture and industry, credit offtake by the retail sector has increased at a faster pace. Housing loans are the fastest-growing class of advances on banks’ balance sheets, having increased by over 47 per cent annually between 2003-04 and 2004-05.

It may be noted that during the period under review (1996-97 to 2004-05), the share of agriculture, industry and services sector in GDP averaged around 24.2 per cent, 22.0 per cent and 53.7 per cent, respectively. The average annual growth of value added at constant prices in agriculture, industry and services was 1.6 per cent, 5.2 per cent and 8.2 per cent, respectively. Industrial demand for credit has remained subdued during this period. Given the faster growth of the services sector, the share of services and retail sector in credit absorption is expected to remain high, both in the priority as well as other sectors.

III Trends in Priority Sector Lending

Directed credit programmes involving loans on relatively preferential terms and conditions to priority sectors have been major tools of development policy in both developed and developing countries. Prior to the nationalisation of banks in 1969, banks’ lending was confined primarily to big business and trading, with operations predominantly confined to the metropolitan and urban centres. After nationalisation, the government of India undertook corrective measures for such lop-sided lending by the banks. Indian banks were expected to contribute towards economic development of the country by extending credit for the activities undertaken in the areas, which were considered to be “priority sectors”. The obligation to provide widespread coverage to these types of advances was also accompanied by changes in branch licencing policy, necessitating banks to move to rural and semiurban centres and to hitherto unbanked/underbanked areas in order to fulfil their new responsibility.

Under the prescriptions for priority sector lending in India a target of 40 per cent of net bank credit has been stipulated for lending by domestic commercial banks. Within this, sub-targets of 18 per cent and 10 per cent of net bank credit, respectively, have been stipulated for lending to agriculture and weaker sections. A target of 32 per cent of net bank credit has been stipulated for lending to the priority sector by foreign banks. Of this, aggregate credit to the small-scale industries sector should not be less than 10 per cent of net bank credit and that to the export sector should not be less than 12 per cent of net bank credit. Domestic scheduled commercial banks that have a shortfall in priority sector lending contribute to the Rural Infrastructure Development Fund (RIDF), and in the event of failure to attain the stipulated targets and subtargets, foreign banks are required to contribute to the Small Industries Development Bank of India (SIDBI).

The scope and extent of the priority sector has undergone several changes since 1972 with several new areas and sectors being brought within its purview. At present, financing of agricultural activities, small-scale industry, small business, export activities, professional and self-employed persons, weaker sections, education, housing, consumption loans, micro-credit, food and agro-based processing sector, software industry, venture capital, leasing and hire purchase, loans to urban poor indebted to non-institutional lenders, etc, fall under this category. Financing priority sectors in the economy is perceived to be not strictly or purely on a commercial basis, as it is expected that the general approach should be flexible and liberal and also the rate of interest charged on such loans should be modest. For example, export finance is available at a discount on the normal rate of interest to Indian corporates. Part of the cost of this concession is borne by the RBI by means of its refinancing facility. As per the current interest rate policy, in the case of loans upto Rs 2 lakh, the interest rate should not exceed the benchmark prime lending rate (BPLR) of the bank, while in case of loans above Rs 2 lakh, banks are free to determine the interest rate.

Over the past eight years, the share of the priority sector has hovered at around 32-33 per cent of gross bank credit. Within the priority sectors, the share of credit to SSI sector has declined secularly during the period under review while that of agriculture has been almost stagnant. The share of credit to “other priority sectors”, on the other hand, has shown a sharp and secular increase during the same period, offsetting the decline in credit to the SSI sector. The average growth in credit to “other priority sectors” has been 25.5 per cent in the last eight years, with over 50 per cent annual growth recorded in 2003-04 and 37 per cent in 2004-05, mainly on account of a sharp growth in credit to priority sector housing. In 2004-05, within the priority sector, agriculture loans have also been a major driver of growth with a 35 per cent increase.

In view of the stagnant share of agricultural credit and declining share of credit to SSI, there is concern over the composition of priority sector credit as well as its pricing [Shajahan 1999; Puhazhendhi and Jayaraman 1999]. An area of concern, in terms of public perception, is that there is under-pricing of credit risk for private sector corporates while there could be overpricing of risks in lending to agriculture as well as small and medium enterprises [Reddy 2005]. The BPLR is the risk-adjusted rate for the best corporates. Yet, banks lend to the best corporates at sub-BPLR rates. Banks are said to compensate themselves by earning a better return on the overall relationship with corporates. The return includes not just loan income but fee income as well. Besides, big corporates bring to banks large volumes of low-cost deposits that lower the cost of funds. So far as the risk capital is concerned, the denominator, capital allocated, is lower for feebased services than for loans. As a result, banks can perhaps afford to price loans below the risk-adjusted rate insofar as large corporates are concerned. In contrast, small businesses do not generate much fee income and are charged a higher rate for loans. Estimates of risk based on past data of small businesses are biased upwards due to lack of reliable data on small businesses, and poor track record of lending to small businesses in the 1990s. Also, loan rates for the priority sector could be higher than dictated by risk as, of late, banks have found lending opportunities in the retail sector to be more profitable than priority sector areas such as agriculture and SSI.

Future of Priority Sector Lending

The Committee on Financial Sector Reforms (chairman M Narasimham 1991) had recommended that directed credit programmes should be phased out. It proposed that the priority sector should be redefined to comprise the small and marginal farmer, the tiny sector of industry, small business and transport operators, village and cottage industries, rural artisans and other weaker sections. It also suggested that the target for this redefined priority sector should be 10 per cent of aggregate credit; but this recommendation was not accepted. In 1998, the Committee on Banking Sector Reforms (chairman M Narasimham) recognised that small and marginal farmers and the tiny sector of industry

Economic and Political Weekly March 18, 2006 and small businesses have problems in obtaining credit and some earmarking may be necessary for this sector. However, it recommended inter alia a phased move away from overall priority sector targets and sub-sector targets.

While there has been continuous demand to include new areas such as infrastructure within the ambit of the priority sector, there have also been suggestions that the focus on the original sectors included under the priority sector such as agriculture and smallscale industries is getting lost because of such inclusions. In the Annual Policy Statement of the Reserve Bank of India for the year 2005-06, it was stated that “…credit growth in housing, venture capital and infrastructure has been strong while it has been sluggish in agriculture and small industries. Further, it is argued that only sectors that impact large population, weaker sections and are employment-intensive such as agriculture, tiny and small industry should be eligible for priority sector. Since there are several issues that need to be considered in this regard, it is appropriate that these are debated and examined in-depth.”

In response to this felt need to review the concept and the segments of priority sector, an internal working group of the RBI has prepared a ‘Draft Technical Paper on Priority Sector Lending’ [RBI 2005] which has been put in the public domain. This paper has recommended that only the financing of small-scale industry, small business, education, agricultural activities and export activities should fall under the priority sector category, which is aimed at undoing the dilution that the priority lending sector concept has suffered over the years on account of the inclusion of a wide range of activities in the list of qualifying advances. The group has cited, in support of its conclusion, the fact that agriculture continues to account for the largest segment of the workforce, disproportionate to the sector’s contribution to the gross domestic product, as well as the large contribution of SSIs to production, employment and exports. Its recommendation to exclude advances to a range of institutions – from electricity boards and state-level corporations to professionals – from the eligibility list should, if implemented, induce banks to focus once again on funding the farmer, the small entrepreneur and small manufacturing enterprises. This would result in a larger focusing of lending to priority sectors, as originally envisaged and would reorient priority sector lending activity in a marked fashion.

In addition to this possible reorientation of priority sector lending, the face of bank lending in India has started changing in other ways during the last few years, with banks veering towards sectors like retail lending, which earlier did not enjoy significant credit support from banks.

IV Trends in Retail Lending in Recent Years

Retail lending or lending to the individual as against business enterprises became popular in the western countries nearly two decades back. But, banks in India traditionally lent to the “productive” sectors of the economy, such as wholesale traders, industries and service providers like transporters. Since, capital was scarce it was felt that available resources had to be channelled to the most deserving segment. Also, loans were preferred to be of selfliquidating nature, i e, it was felt to be desirable that the use of the credit should automatically generate the cash flow for its repayment.

Given this scenario, the plausible reasons for banks not financing the retail segment in a large way in the earlier years could be:

– Lending to large corporate clients was a preferred option given extensive pre-emptions.

  • Low current income of households.
  • Lack of effective regulatory and legal background.
  • High costs of entering the retail market segment.
  • Asymmetric information and adverse selection problems were more serious in retail lending markets.
  • A general emphasis upon lending to “productive” sectors with implicit discouragement of consumption loans.
  • After nationalisation, banks did start financing consumer durables. But, the range of credit offered was limited and most loans of this type were generally absorbed by banks’ own employees; this was extended to the general public in a very limited extent. In India, some foreign banks started financing this segment from the late 1980s. Slowly, the lending to this sector increased on the strength of the realisation that retail lending could be a very profitable avenue. Defaults in personal loans have been comparatively negligible so far. Also, the slackening of demand for industrial credit made banks turn to the retail business for improving credit volumes. Further, supporting consumer spending in a rapidly developing economy was considered necessary for correcting recessionary trends and creating accelerated demand to market the increasing supplies of goods. Retail lending since 1999-2000 has witnessed fast growth combined with easing of lending standards by banks and retail banking has been described in recent literature as “hotter than vindaloo” [DiVanna 2004].

    First, economic prosperity and the consequent increase in purchasing power has given a fillip to a consumer boom. During the last decade, India’s GDP has grown at a compound rate of 6.2 per cent and in the last three years – 2003-04 to 2005-06 – the growth rate averaged a little below 8.0 per cent. The expansion of the retail banking segment can be attributed to a growing middle class with high disposable income. As stated recently,

    The rise of the Indian middle class is an important contributory factor in this regard. The percentage of middle to high income Indian households is expected to continue rising. The younger population not only wields increasing purchasing power, but as far as acquiring personal debt is concerned, they are perhaps more comfortable than previous generations. Improving consumer purchasing power, coupled with more liberal attitudes toward personal debt, is contributing to India’s retail banking segment [Gopinath 2005].

    Second, there is a wider choice of consumer durables, increased acceptance of credit cards and increased demand for housing loans, encouraged by attractive tax breaks. Third, changing consumer demographics indicate a vast potential for growth in consumption, both qualitatively and quantitatively. India is one of the countries with a highest proportion (70 per cent) of the population below 35 years of age. The BRIC report of the Goldman-Sachs [Goldman Sachs 2003], which predicted an optimistic economic future for Brazil, Russia, India and China, mentioned the Indian demographic advantage as an important positive factor for India. Fourth, technological factors have played a major role. Convenience banking in the form of debit cards, internet and phone-banking has attracted many new customers into the banking field and has contributed to the growth of retail banking in India. Fifth, the treasury income of banks, which had strengthened their bottom lines for the past few years, has been on the decline during the last two years. In such a scenario, the retail business has provided a good vehicle for profit maximisation for banks. Considering the fact that the share of retail lending in impaired assets is far lower than on the overall bank loans and advances, retail loans have put a comparatively lower provisioning burden on banks apart from diversifying their income

    Economic and Political Weekly March 18, 2006

    streams. Sixth, the decline in interest rates has also contributed to the growth of retail credit by generating the demand for such credit. In addition, the RBI has taken a number of initiatives to increase transparency and competition in the credit market, including the dissemination of information on lending rates of banks since 2002, and the creation of a credit information bureau.

    Bank loans as a ratio of GDP have grown steadily since 19992000. According to the sectoral deployment of credit data, credit flow to retail sectors has accelerated from 12.9 per cent in March 2002 to 40.8 per cent in March 2005 (Table 3). Retail lending has grown in importance significantly as its weight in banks’ balance sheet has doubled in the last three years. Credit to the housing sector has recorded the sharpest average growth at 50.0 per cent in 2003-04 and 44.6 per cent in 2004-05. Also, the most popular retail lending product has been changing from time to time. For example, credit for consumer durables grew by 44.4 per cent during 2000-01 but has decelerated in subsequent years. It is notable that loans to individuals against shares and debentures/bonds and against fixed deposits have picked up markedly in the last two to three years after declining/stagnating in the initial years of this decade. Other personal loans which include, ‘inter alia’, education loans, credit cards, etc, have also recorded a sharp increase.

    As a result of this boom in retail lending, the share of bank advances to households in GDP has increased from 1.5 per cent in 1999-2000 to 3.52 per cent in 2004-05. The growing share of bank credit in households’ financing modes has added to the macroeconomic importance of retail lending with concomitant policy implications.

    V Policy Implications of Pattern of Credit Growth

    The surge in commercial credit in the last couple of years has been an encouraging phenomenon in India’s banking sector. Banks are no longer engaged in parking funds heavily in government securities. They are eager to lend. This reflects as much the turnaround in the economy as the improved balance sheets of the banks themselves. However, though overall credit growth has been of a high order, the expansion of agricultural credit and credit to smallscale industries sector has not kept pace with it. Current fiscal and monetary and credit policy interventions have attempted to address this vital issue to ensure that both the sectors can grow

    – especially as they provide employment and both backward and forward linkages to other sectors leading to equitable and balanced development across sectors and regions in the country.

    For agriculture, banks have exhibited a lag in responding to monetary policy changes signalling the easing of interest rates and interest rates on credit to the agricultural sector have not been reduced as expected. Further dialogues with banks in this area to sensitise them towards the need for reducing interest rates for agriculture are necessary. Second, agricultural productivity hinges critically on investment in agriculture and findings of certain studies such as Rao (1994) and Shetty (1990) suggest that the decline in public capital formation in agriculture since the 1980s had an impact on private sector capital formation on account of its complementarity. In view of this, it is felt that an added emphasis on pubic investment in agriculture may be required for crowding in private investment including bank credit in this sector. Third, in the recent years, Kisan Credit Cards and micro-finance are the two innovations in the field of rural banking. Government policies should be aimed at bringing out more such innovative products and service in rural banking. Fourth, the present system and procedure of recovery of agricultural NPAs is cumbersome, time consuming and costly. At times the wilful defaulters welcome legal action to get more leeway in repayment and relief from interest charges. In spite of valid decrees or awards, recovery is not effected due to difficulties in auctioning of collateral securities. In view of this, it is suggested that efforts have to be made to streamline the legal infrastructure for administering agricultural credit.

    Credit offtake by the small-scale industries’ sector has not responded very strongly to the initiatives taken by policy-makers and stagnating growth and declining share in overall credit continue to dominate this sector. Banks still do not find it profitable to lend to this sector as its record of NPAs has been very discouraging. To counter the slow growth in credit offtake by SSI, several committees have made a number of valuable suggestions which need to be implemented by the authorities in a timely manner. The rating of SMEs, developing cluster-based SSIs, offering incentives to banks to lend to this sector may lead to credit expansion.

    Retail credit, which is growing from a very low base, has expanded rapidly during this period. Although growing rapidly, retail loans are still small as a proportion of GDP. Though the buoyancy in retail lending is expected to continue in the coming years, it is undeniable that the phenomenon poses certain challenges. Given the short span over which the boom in retail credit has occurred in India, it is difficult to separate the trend and cyclical element. The choice of precautions to be taken against risks becomes difficult in such a scenario. Though lending to retail sector has positive welfare effects, but it also increases macroeconomic and financial stability risks.

    Theoretically, macroeconomic risks include balance of payment problems if a large proportion of retail purchases are sourced through imports with concomitant effect on the current account and the exchange rate. At present, macroeconomic risks from fast credit growth appear to be low in India. Although credit growth has led to a reduction of banks’ holdings of government securities, this has so far led to only a modest pressure on interest rates. Moreover, while imports and the trade and current account deficits are rising, forex reserves with the central bank continue to remain comfortable.

    Theoretically, financial stability risks arise from (a) higher credit risks and deterioration of the quality of the portfolio in the long run, (b) fiercer competition, decreasing margins and possible mispricing, easing in lending criteria, (c) increasing external exposure of the economy (d) higher volatility of rupee exchange rate could hurt the banks’ position through credit risk

    Table 3: Variation in Segments of Retail Credit

    (in Per cent)

    Year Ending March 23, March 22, March 21, March 19, March 18, 2001 2002 2003 2004 2005

    Non-food gross bank credit 14.31 12.5 17.5 28.4 27.9 Retail credit 12.9 23.0 22.0 34.4 40.8

  • (i) Housing 14.5 38.43 55.1 50.0 44.6
  • (ii) Consumer durables 44.4 26.03 -1.6 19.8 4.6
  • (iii) Loans to individuals against shares and debentures/bonds -20.9 -10.43 15.9 14.6 18.3

  • (iv) Advances against fixed deposits 5.7 6.5 6.9 16.1 11.3
  • (v) Other personal loans 17.1 29.6 11.5 34.8 67.3
  • Note: Data relate to 47 select scheduled commercial banks, which account for about 90-95 per cent of bank credit of all scheduled commercial banks.

    Economic and Political Weekly March 18, 2006 exposure. In the current juncture, it would appear that the main risk would emanate from credit risk due to a failure by banks to maintain asset quality, properly accounting for risks, and to ensure that adequate buffers were built in anticipation of a possible downturn. Some banks that are experiencing high rates of credit growth have very high loans-to-deposits ratios, and may encounter liquidity problems. While the aggregate loans-todeposits ratio is 65 per cent, it is not evenly distributed. The current rapid credit growth is also accompanied by considerable buoyancy in asset markets such as housing, equity, gold, etc, suggesting that asset overvaluation could possibly become a concern.

    Globally, as retail lending has evolved, so too has the risk profile for retail lending. At the present state, retail lending in India has plain vanilla products, and the focus is on expanding credit with limited efforts to segment the market and design products that meet specific customer needs. The present state of affairs needs to change from the customer as well as the bank perspective. From the bank’s viewpoint, there is a need to look at strengthening credit analysis and collection processes and from customer’s perspective there is a need to make the customer aware of the cost of unsecured credit. At the same time, at present in the retail lending business the banker knows the borrower and used traditional underwriting policies. But once this evolves into a business that uses risk-based pricing, off-balance-sheet transactions (like securitisation), and new products to maximise loan production, concerns about risk would surface.

    For example, while expansion of credit to a large section of borrowers has allowed more people to own housing stock, it also has meant that banks need to focus more on appropriate pricing and risk management. Banks’ credit risk management practices for housing loan should keep pace with the product’s rapid growth. Credit risk would arise out of changes in economic conditions in the country. The Indian banking sector is yet to go through a complete cycle in the retail lending industry in the country and the level of default risk is still unknown if the economy decelerates. Banks should be strongly urged to manage risk and compliance on an enterprise-wide basis and they should develop broader, more discriminating, and more forward-looking management information systems for retail lending.

    Retail lending is a new trend in developing countries but most of the developed markets have well-established processes evolved over the years. Developed countries have sophisticated methods for risk analysis as compared to the developing markets. Thus, historical data are available with banks and credit bureaus to firm up the risk policies based on behavioural patterns. Developing countries are in the process of assimilating data and need to rely on the verification process for information reliability. Most of the developed countries have evolved credit scoring models which has still not been possible for banks in other countries due to lack of historical data.

    While consumption-led growth can help improve growth rates in the economy, it would also result in increasing the risks in economy. In a slow-down, bank and consumer behaviour could lead to increasing the variability of economic performance. In a low-growth period, the banks would have a pressure on their capital (in view of increasing NPAs) and may cut credit growth in order to retain their ratings resulting in lower credit available for consumption, thereby, hurting growth.

    The Reserve Bank has already taken several steps to respond to potential risks. It has increased the risk weights on consumer and housing loans, and on commercial real estate and capital market exposures. It has also tightened loan classification rules in line with the international best practices, by requiring that a loan be classified as non-performing after it has not been serviced for 90 days, instead of the previous 180 days. More recently, general provisioning for non-priority sector loans was increased from 0.25 to 0.4 per cent.

    Some additional steps which could be considered, especially if the rapid credit growth continues, may include stricter asset classification and loan loss provisioning, reduction in exposure limits to groups, reduction in connected lending limits, encouraging the use of stress tests by banks themselves as well as by the central bank, intensify surveillance and onsite-offsite inspection of potentially problematic banks and accelerate the operation of Credit Information Bureau of India (CIBIL). This general approach would ensure that the necessary safeguards against excessively risky lending are in place, while at the same time allowing the financial deepening to continue.



    [This paper expresses the personal views of the author and does not necessarily reflect those of the institution to which she belongs. The author wishes to thank K Kanagasabapathy for his guidance and suggestions in organising this paper.]


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    Economic and Political Weekly March 18, 2006

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