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

Module: 7 Monetary Transmission Mechanism

Financial Stability: The Indian Approach
Regional Rural Banks, Cooperative Banking Sector, DFI & NBFC

Regional Rural Banks & Urban Cooperative Banks

Notwithstanding their low profitability and relatively high non-performing assets, the regional rural banks (RRBs) and cooperative banking segment appears to present minimal risk, owing to their small size. The Government had recapitalised 187 RRBs to the tune of Rs.2,188 crore to shore up their capital base. Several constraints, both at the institutional level (inappropriate implementation of policy programmes, governance structures) as well as at the field level (inadequate infrastructure, staff motivation) have acted as impediments on the financial performance of the RRBs. The Union Budget 2004-05 has made the sponsor banks 'squarely accountable' for the performance of RRBs under their control (Government of India, 2004). As regards the scheduled urban cooperative banks (UCBs), which account for a major portion of the cooperative sector, the Reserve Bank undertook a series of policy initiatives, including subjecting these banks to CRAR discipline (the same CRAR as applicable for commercial banks for scheduled UCBs and nine per cent for non-scheduled UCBs, effective March 31, 2004), introducing a system of gradation of UCBs based on financial/prudential parameters for initiating prompt corrective action, 90-day norm for loan impairment (excluding gold loans and small loans) and enhanced disclosures in their balance sheets (effective March 31, 2003) for UCBs with at least Rs.100 crore of deposits. The rural cooperative banking is also plagued by low profitability and high non-performing loans. As regards the long-term rural cooperative credit structure, which makes a major contribution to the capital formation in agriculture through investment credit, it lacks a sound appraisal system, effective monitoring mechanism and proper loan policies and procedures (NABARD, 2004). The Union Budget 2004-05 proposed the appointment of a Task Force to examine the reforms required in the cooperative banking segment including the appropriate regulatory regime. Additionally, the Budget also provided an amount of Rs.800 crore as grants through NABARD for providing incentives to States and cooperative institutions to adopt reform measures for strengthening the cooperative credit structure (Government of India, 2004).

Development Finance Institutions (DFIs) were established in the 1950s with the objective of providing medium to long-term project finance to industry. The absence of a long-term debt market to provide risk capital to industry coupled with the short-term asset liability profile of banks meant that DFIs emerged as an ideal vehicle to fund long-term industrial projects. On the supply side, DFIs had recourse to cheap credit from the Reserve Bank and with limited competition from banks on project finance on the demand side, this ensured them a comfortable spread. Post-reforms, DFIs have been significantly impacted upon on both the supply and demand sides. The drying up of long-term concessional resources has meant that they had to access the market for resources at competitive rates, putting pressure on their margins. On the supply side likewise, the entry of banks into project financing has intensified the competition for DFIs. Over the past several years, DFIs have accumulated substantial NPLs. A rapid expansion of loans has been accompanied by a commensurate increase in net NPLs (Table 8.23). Additionally, since DFIs raise resources with short maturities to fund long gestation projects, their loan portfolio might also entail a term mismatch.

The concentrated portfolio of DFIs also exposes them to sector-specific vulnerabilities. In view of the slowdown in industrial performance during the last few years and the restructuring and repositioning of several industries, which weigh heavily in the portfolio of DFIs, their asset quality could come under pressure.

Another important segment of the financial segment is the NBFCs. After a period of rapid growth in the 1990s, the growth in this sector has slowed down, consequent upon the introduction of strict entry and prudential norms, rationalisation of interest rates offered by these entities and the process of providing a Cer tificate of Registration (CoR) to NBFCs accepting public deposits. As many as 584 NBFCs were authorised to accept/hold public deposits at end-June 2004. The number of NBFCs has stabilised since the introduction of CoR process and at end-March 2003, the total number of reporting NBFCs was 870 with total asset of Rs.37,709 crore and public deposits of Rs.5,035 crore. The RNBC segment accounts for a disproportionately high quantum of public deposits (over 60 per cent) with high public deposit to net owned funds (NOF) ratios. The Mid-term Review of Annual Policy 2004-05 announced several measures to focus on improvements in the functioning of RNBCs in order to ensure that the depositors are served appropriately and systemic risks are avoided. Additionally, the interest rate paid by NBFCs on their public deposits is high with a quarter of these deposits being of short (less than one year) maturity. This raises twin concerns: the risk-premium on NBFC deposits vis-à-vis banks and their long-term commercial viability.