Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 5 Bank Credit

Introduction

Availability of adequate and timely finance is an important pre-requisite for growth. Monetary policy affects economic activity not only through the conventional interest rate channel but also through supply of bank credit. In most developing economies and in some advanced regions such as Europe, banks have traditionally been the main source of finance for various sectors of the economy. In contrast, in many advanced economies such as the US, market-based finance systems predominate. In either case, adequate and timely provision of finance is necessary to fund investment in the economy. Moreover, a well-developed domestic financial system can help to mobilise domestic savings and channel these funds to local borrowers in local currency, and thereby mitigate the potential for externally induced crises that may arise from various sources such as currency mismatches.

A particular characteristic of developing economies, often justified by the need to conserve scarce resources for socially productive uses, has been the prevalence of a wide range of credit controls and directed credit programmes often at concessional prices. Such programmes, usually accompanied by extension of the financial system, played an important role in the process of financial deepening in the 1950s and 1960s. At the same time, the resultant segmentation of markets blunted the process of price discovery and limited the allocative efficiency of financial systems. In consonance with the increasing market orientation of monetary policy, most central banks in developing countries have been phasing out direct instruments of monetary control. A key challenge for central banks in emerging market economies (EMEs) is their ability to channel credit to the relatively disadvantaged sections of society.

Apart from financing growth, variations in bank credit are an important channel of monetary policy transmission mechanism even for central banks that rely on interest rates to convey their policy stance. Modulations in policy interest rates by the central bank influence credit market conditions which reinforce the effects of the traditional interest rate channel of monetary transmission. For the interest rate channel to be effective, however, it is critical that monetary policy signals are transmitted by banks onto their lending rates. This, in turn, requires banks to be able to assess various risks adequately and incorporate them in their lending rates. While such risk assessment techniques are in place in advanced economies, they remain underdeveloped in many EMEs. Given the large information and transaction costs, banks are not fully able to take into account the risk profile while pricing their loans to various borrowers. For monetary policy signals to work effectively, effor ts to reduce information and transaction costs through promotion of agencies such as credit information bureaus assume importance. Better information does not mean that banks will necessarily reduce credit availability for riskier borrowers. Rather, banks can more knowingly choose their risk profiles and price risk accordingly. While facilitating an efficient allocation of resources, it also enhances the efficacy of monetary policy signals. In other words, improvements in the credit delivery mechanism are necessary for monetary policy signals to have the expected effect on output and prices.

In India, a key objective of monetary policy since Independence has been the provision of adequate credit to support investment demand in the economy while keeping a vigil on inflation. Given the existence of large fiscal deficits in the past two decades, banks have been required not only to finance the credit requirements of private sector but also that of the Government. Coupled with the administered interest rate mechanism that was in place till the early 1990s, this necessitated regulation of credit by the Reser ve Bank to meet the requirements of both the Government and the private sector and those of the underprivileged segments within the private sector. In consonance with the overall reform process, the arrangements in regard to provision of credit have undergone a significant shift from micro-regulation of the 1970s to macro-management during the 1990s. Interest rates have been deregulated while statutory preemptions have been almost halved between 1990 and 2004. However, while making this shift from a planned and administrated interest rate system to a market-oriented financial system, the importance of credit has not been undermined. A key issue is to maintain balance between deregulation that brings about medium to long-run efficiency gains on the one hand and the required credit flow to various sectors on the other hand.

The actual experience indicates that notwithstanding the deregulation of interest rates and the significant reduction in the statutory pre-emptions during the 1990s, banks continued to show a marked preference for investments in Government securities vis-à-vis extending credit to the commercial sector. Thus, policies of liberalisation, deregulation and the enabling environment of comfortable liquidity at a reasonable price have not automatically translated into increased credit flows to various sectors. The banking system continues to charge interest rates to various categories of borrowers by their category per se - whether agriculture or small scale industry -consistent with the legacy of the old administered interest rate regime rather than actual assessment of risks for each borrower. Moreover, significant divergence in lending rates between formal and informal markets still exists. Consequently, issues relating to information asymmetries that keep lending rates high for a large category of borrowers/sectors have come to the forefront. The Reserve Bank's endeavour has, therefore, been to reduce transaction and information costs so that adequate credit to such sectors is available at reasonable interest rates.

Against this backdrop, Section I of this Chapter addresses the role of finance in contributing to investment and growth. The section begins with a brief overview of the theoretical literature and empirical studies on the interlinkages between finance and growth. This is followed by a discussion of the role of bank credit in the conduct of monetary policy. Section II dwells upon the Indian experience in regard to bank credit. Key measures taken by the Reserve Bank to improve the credit delivery mechanism in the country in the recent years are highlighted. Trends in the flow of credit to various sectors of the economy in the post-reforms period are critically examined. With the gradual waning of the development finance institutions, the ability of banks to cater to the needs of long-term finance is assessed. Despite reductions in statutory liquidity ratio (SLR), banks' investment in Government securities remains significantly above the statutory requirements and reasons for this are explored. Concluding observations are presented in Section III.

This Module addressed issues related to the role of finance in growth. Empirical evidence confirms a positive relationship between finance and growth, notwithstanding the debate on the causality. In developing economies like India, with bank-based financial system, bank credit plays a critical role in the growth process. At the same time, the banking system has the responsibility of not only financing the credit requirements of the private sector, it is also often required to finance the fiscal authority.

In recent decades, there has been a renewed interest in the role of bank credit in economy activity. This is essentially for two reasons. First, it is believed that monetary policy impulses affect economic activity not only through the interest rate channel but also through the credit channel. The credit channel, especially in view of balance sheet effects, through the financial accelerator mechanism augments the conventional interest rate channel of monetary transmission. The second reason for interest in credit aggregates emerges from the view that excessive increases in credit are a precursor to a probable future financial instability. Monitoring of credit behaviour may thus be a reliable leading indicator for monetary and financial stability.

In India, the banking system has been financing both the Government and the private sector. With the initiation of structural reforms in the early 1990s, the focus has shifted from micro-regulation of credit to macro-management. Interest rates on loans have been deregulated, except for small loans (loans up to Rs. 2 lakh). Banks have been provided the flexibility to lend to various sectors of the economy, based on their risk-return assessment. While the requirement of priority sector lending has been retained at 40 per cent of bank credit, the categories of advances eligible for priority sector have been expanded to provide banks increased opportunities to lend to these sectors. In the recent years, the efforts of the Reserve Bank have mainly concentrated on improving the credit delivery mechanism. The policy endeavour has been to reduce various information and transaction costs associated with lending so that increased flow of credit takes place at reasonable rate of interest.

Analysis presented in this Module indicates that these efforts to improve credit delivery have had a positive effect. There is evidence that credit flow to the agricultural sector has recovered significantly in the last 3-4 years. The declining trend in the share of agricultural credit to total bank credit as well as its share to overall GDP has been reversed since 2000. Credit to agriculture in relation to its sectoral GDP - a more relevant metric - maintained its upward trend. This is remarkable since the share of foodgrains in total agricultural output has been declining. It is critical that the flow of credit to agriculture is maintained. In order to sustain the flow of credit to the agricultural sector, there is a need for legal and institutional changes relating to governance, regulation and functioning of rural cooperative structure and Regional Rural Banks(RRBs). The changes warranted in cooperatives as well as RRBs involve deep commitment of state-governments and have significant bearing on political economy. Second, in view of overhang problems of non-performing loans and erosion of deposits in both cooperatives and the RRBs, restructuring and recapitalisation by the Government becomes important. The current acceleration in credit-delivery can be sustained in the medium term, if such fiscal support from States and Centre is firmly put in place soon to revive or reorganise rural cooperative structure and the RRBs. Third, there is a need to foster an appropriate credit culture to make enhanced rural credit a lasting phenomenon. Fourth, a comprehensive public policy on risk-management in agriculture is required as not only a means of relief for distressed farmers but as an ingredient for more efficient commercialised agriculture. Furthermore, banks in India - so far geared to financing of traditional crops like cereals - will have to be prepared to meet the changing requirements of commercialising agriculture.

Credit flow to industrial sector by banks has also been maintained. However, in the context of the waning of the DFIs, the issue of meeting long-term funding needs of corporates has attracted attention. The ability of commercial banks to meet the long-term fund requirements is hampered by the relatively shorter maturity of their deposits. The limited flexibility available to banks is further compounded by the fact that banks are already holding large volumes of Government paper, usually of long tenors. This stresses the need to develop an active corporate bond market in the country. Although several pre-conditions for the evolution of a successful corporate debt market are now in place, other requirements such as enhanced public disclosure and effective bankruptcy laws are still awaited. Funding from equity markets hinges upon the expansion of the mutual fund industry and channelling of a part of contractual savings to equity markets.

The increase in disbursement of housing finance is heartening as housing construction has strong backward and forward linkages. This large increase in housing loans to potential home-seekers in India is fundamentally different from the speculative activity in real estate in other countries. Although the housing sector provides a relatively safe destination for bank credit on account of relatively low default rates, banks need to be on alert against an unbridled growth of housing finance and should take due precaution in the matter of interest rates, margin, reset period and documentation.

Given the growth and employment potential of small-scale units, there is a need to increase credit availability to this sector at reasonable costs. Banking institutions must improve their credit assessment capabilities with regard to small-scale enterprises so that they can distinguish adequately between good and bad credit. Small-scale must not be equated with high risk. If the interest rates charged to SSIs are much higher than normal good credit risk to large-sized industries, there is an implicit adverse selection in the credit appraisal process. Thus, there is a need for realignment of interest rates among various segments of the financial market. As the financial market develops, ideally the interest rates on all types of debt instruments, both in the Government and private sectors, and in the credit market should align in a relatively narrow band, reflecting realistic risk premia.

The flow of credit to the various sectors of the economy could be increased further if banks can contain their operating costs and improve the loan recovery. Operating costs of banks in India remain higher than major economies. Recovery management is a key to the stability of the banking sector. Indian banks have done a remarkable job in containment of non-performing loans considering the overhang issues and overall difficult environment. These efforts need to be pursued further. This will help banks to reduce their lending rates which will provide a further impetus to investment demand in the economy.

The structural reforms during the 1990s, inter alia, attempted to enhance the credit flow to the private sector through reductions in statutory preemptions. However, despite this reduction, banks continue to prefer to invest in government securities for a variety of reasons like weak demand, excess capital flows and risk aversion. The banks' preference for gilts runs a danger of the link between liquidity, credit, money and economic activity being severed in the long-run. Furthermore, with the upturn of the interest rate cycle, there could be an adverse impact on banks' profitability. Fiscal consolidation as envisaged in the Fiscal Responsibility and Budget Management Act is expected to reduce the Government's draft on the banking system. A reduction in banks' holding of long-term Government securities will permit greater flexibility in providing long-term loans for infrastructure projects and this will, therefore, help to bridge the gap created by the DFIs. Overall, lower Government borrowings are expected to increase the flow of credit to the commercial sector with beneficial effects on investment demand, output and employment in the economy.