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

Module: 5 Bank Credit

Banks versus Market Based Systems

Adequate availability of credit to support investment demand in the economy has been an important objective of monetary policy in India. At the same time, monetary policy had to contend with widening fiscal deficits. The higher borrowing requirements of the Centre as well as the State Governments in an environment of administered interest rate mechanism were essentially met through a phased increase in statutory pre-emptions of banks' deposits. Not only were the banks' lendable resources to be shared between the private sector and the government, the social concerns of society had also to be taken into account. This took the shape of directed lending in the form of priority sector lending targets. Thus, by the early 1980s, an elaborate and arduous system of credit planning was in place. With food credit for procurement operations as the first charge on credit demand, credit planning involved sectoral limits for credit deployment. The broad objective of the credit policy was to meet genuine credit needs for productive purposes without stoking inflation expectations. The focus on credit aggregates implied a reduced role for the interest rate as the equilibrating mechanism between demand and supply although interest rate was used as an instrument of cross-subsidisation (RBI, 1999). Increasingly, it came to be realised that such a system hindered efficient allocation of resources [Chakravarty Committee (RBI, 1985); Narasimham Committee (RBI, 1991)]. First, a combination of an administered interest rate regime and directed credit controls prevented proper pricing of resources. Second, most financial intermediaries remained confined to markets relating to their area of operations because of balance sheet restrictions, leading to market segmentation. Finally, there was the problem of missing markets, especially at the shorter end, with caps even on the inter-bank rate.

From the mid-1980s onwards, steps were, therefore, taken to liberalise the credit delivery system but these gathered momentum only in the 1990s. Selective credit controls have been dispensed with and micro-regulation of credit delivery has been discontinued providing greater freedom to both banks and borrowers. Although directed lending in the form of 'priority sector' remains at 40 per cent of total bank lending, banks have been provided greater flexibility in the changed milieu to meet the priority sector requirements. Notably, advances eligible for priority sector lending have been enlarged and interest rates deregulated, thus making the system far more flexible for priority sector lending. Arrangements requiring banks to form consortia for loans beyond specified credit limits were phased out by 1997.

Consequent upon the deregulation of interest rates and the significant reduction in the statutory preemptions, there was an expectation that enhanced credit flow to the needy would be facilitated. In contrast to these expectations, banks continued to show a marked preference for investments in Government securities. Even as the SLR was brought down from 38.5 per cent in 1992 to 25 per cent by 1997, the credit-deposit ratio of scheduled commercial banks did not witness any increase at all. In fact, the ratio at 53.6 per cent at end-March 2000 was lower than that of 54.4 per cent at end-March 1992. As discussed later, a number of factors such as weak demand and risk aversion by banks explain this phenomenon.

The micro-management of credit through various regulations during the 1970s and 1980s had eroded the risk appraisal techniques of the banks. Notwithstanding the shift in approach from lending based on credit allocation targets and administered interest rates to a risk-based system of lending and market-determined interest rates, banks continue to charge interest rates to borrowers by their category - whether agriculture or small scale industry - rather than actual assessment of risks for each borrower. Thus, the need for the banks to improve their credit risk assessment skills has gained importance.

Development of appropriate credit risk assessment techniques is critical also for the efficacy of monetary transmission. With the shift to indirect instruments of monetary management, monetary policy signals are increasingly transmitted through modulations in short-term interest rates. The monetary transmission mechanism is, thus, now crucially dependent on the impact of changes in policy interest rates, such as the Bank Rate or the reverse repo rate, on banks' deposit and lending rates. An improvement in banks' credit risk assessment techniques will help not only to increase the flow of credit to the commercial sector but should also enhance the efficacy of the transmission mechanism in the economy.

It is against this backdrop that various measures by the Reserve Bank aimed at reducing the information and transaction costs of lending in order to improve the credit delivery mechanism (issues related to interest rate deregulation are covered in Module: 6). This analytical discussion is followed by an analysis of recent movements in credit availability to various sectors of the economy in order to assess the efficacy of the policy measures. Finally, the section addresses reasons for banks' continued preference for Government securities, well above the statutory requirements.

It is against this backdrop that various measures by the Reserve Bank aimed at reducing the information and transaction costs of lending in order to improve the credit delivery mechanism (issues related to interest rate deregulation are covered in Module: 6). This analytical discussion is followed by an analysis of recent movements in credit availability to various sectors of the economy in order to assess the efficacy of the policy measures. Finally, the section addresses reasons for banks' continued preference for Government securities, well above the statutory requirements.