case study apa paper – Rural Credit Cooperatives in India

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This case was written by Bidhan Parmar (MBA/PhD ’09) under the supervision of Wei Li, Associate Professor of
Business Administration. It was written as a basis for class discussion rather than to illustrate effective or ineffective
handling of an administrative situation. Copyright © 2007 by the University of Virginia Darden School Foundation,
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RURAL CREDIT COOPERATIVES IN INDIA

One Sunday morning in July 2006, Mohan R. Narayan was keeping his eye on the
weather. Lately the seasons were unpredictable. During the usual monsoon season the clouds had
refused to rain, and now during peak harvesting time, temperatures were flaring. Like a child
throwing a temper tantrum, sometimes the weather just refused to do what it was supposed to.
Narayan knew that erratic weather was an ominous sign.

Narayan was a leading economist at a prestigious Indian university outside New Delhi.

Recognized for his work on banking-sector development, he had developed a reputation for
being strong-willed through his staunch advocacy of financial discipline and free market
competition. Recently, the Indian Congress had asked him to be a member of a distinguished
committee whose goal was to analyze and make policy recommendations about India’s
Cooperative Financial Institutions (CFIs), which included organizations such as credit unions
and cooperative banks. On one hand, Narayan was enthusiastic about the job; it was an
opportunity to help millions of rural poor and to have a positive effect on the country. On the
other hand, he knew the system had a long history of overregulation, financial laxity, and
corruption. Creating an actionable and clear strategy would be no easy task.

Narayan flipped past the weather report in the newspaper, and on page five saw a story

that shocked him. In villages in the western state of Gujarat, 100 farmers had committed suicide
in the last week by drinking pesticides.1 The farmers reportedly had been heavily in debt to
money-lenders. Because the recent drought had yielded little harvest, they had no money to get
out of debt, and the poor farmers found themselves with no hope for the future or reason to
continue living.

Six hundred miles away, Puja Mehta was in crisis mode. She was the director of the

credit cooperatives in the 15th district in the state of Gujarat. Seven farmers had committed
suicide in the last week in her district alone and she did not know what to do. How could she

1 This fictitious example is based on real events reported in the New York Times on September 9, 2006, in an

article entitled “On India’s Farms, a Plague of Suicide.” http://www.nytimes.com/2006/09/19/world/asia/19india.
html?ex=1316318400&en=5b14a09e800d407c&ei=5088&partner=rssnyt&emc=rss, (accessed 12 March 2007).

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console their families? What would she tell the other members of the cooperative? When she was
appointed to this job by her uncle, a local politician, she never thought it would be so gruesome.
Over the past 15 years, Mehta had seen a lot of things. She saw firsthand that access to credit
could empower the rural poor. Credit cooperatives were a way to get aid to those who needed it
most without resorting to the usury of money-lenders. Since the country had liberalized its
markets to international trade in agriculture in the early 1990s, she noticed that farmers were hit
the hardest. They had seen the prices of their produce fall, and in order to compete, they had to
use genetically modified seeds marketed by Monsanto that were substantially more expensive.
With unpredictable weather, crop yield was also volatile. Every now and again, the government
would try to encourage the cooperatives to be more profitable, but in time, they would reverse
course. Mehta understood the cooperatives to be a social institution, which would crumble
without government support. If the cooperative were able to get more money to the poor, it could
make a bigger impact. She wondered if this latest round of suicides would spark the government
to appropriate more funds to CFIs. She was certain that something had to be done.

Cooperative Financial Institutions (CFIs)

CFIs comprised a broad category of institutions where members pooled their own
resources to create a bank where they could deposit their savings and get credit. Governments
around the world from Argentina to India had supported and encouraged the growth of various
credit unions and credit cooperatives as a way for the poor to help themselves out of poverty.
CFIs were distinct from microfinance institutions because they generally served clients with
some savings or property and did not rely as much on donor support.2

Cooperatives were started simultaneously in Britain and Germany in 1844 during the

Industrial Revolution. The first cooperative in Britain was a group of 28 weavers, called the
Rochdale Society of Equitable Pioneers, who pooled their resources to create a cooperative store
that sold flour, oatmeal, sugar, butter, and candles. The members pledged to better their lives by
pooling capital to acquire land for food production and provide housing and work for members.
In Germany, the first credit union was created as a response to crop failures and the usury of
money-lenders. These “people’s banks” mainly helped skilled workers borrow for business
purposes. Both these movements laid the foundations for cooperatives in other countries.3

The cooperative institutions in India had a three-tiered structure (see Exhibit 1). At the

grass-roots level were village banks called Primary Agricultural Credit Societies (PACS). There
were 112,000 PACS, roughly one for every six villages. They had the largest rural penetration
with membership estimated at 120 million people, but only 50% of these members actually

2 Carlos E. Cuevas, Klaus P. Fischer, “Cooperative Financial Institutions Issues in Governance, Regulation,

and Supervision.” World Bank Working Paper No. 82, 2006. The International Bank for Reconstruction and
Development, The World Bank.

3 “The Story of Credit Unions,” http://googolplex.cuna.org/20988/cnote/story.html?doc_id=460#1844 (accessed
12 March 07).

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borrowed from the PACS (see Exhibit 2).4 For the PACS to be regulated and properly funded,
the government created two additional levels of cooperative banks. The second-tier banks were
the 367 District Central Cooperative Banks (DCCB), and at the top tier, there were 30 State
Cooperative Banks (SCB). The SCB did most of the regulation and monitoring of the CFI sector;
therefore, rules, regulations, and norms varied from state to state. The Reserve Bank of India
(RBI) and the National Bank for Agricultural and Rural Development (NABARD) made policy
recommendations and kept records of government spending in the CFI sector.

By the early 1990s, CFI accounted for more than 60% of total agricultural credit in India;
by 2007, that share had fallen to 34%, despite a 10% annual increase in the amount of absolute
disbursement.5 The loss in market share had been made up by commercial banks that took the
more financially secure clients out of the CFI system (see Exhibit 3). The farmers left in the
system had fewer assets to serve as collateral for loans and less savings to deposit in the
cooperative banks.

The Indian government had long appreciated the link between improving access to

financing and the reduction of poverty. Of the 26% of the population (260 million people) who
were classified as living below the poverty line, 74% lived in rural areas. According to the World
Bank’s National Council of Applied Economic Research, “rural banks serve primarily the needs
of the richer rural borrowers: Some 66% of large farmers have a deposit account; 44% have
access to credit.”6

Given the concentration of poverty in rural areas, the expansion and success of rural

banking had become a focal point in the fight against poverty. Since the early 1980s, the volume
of credit flowing through CFI in India had increased, but the financial health of these
organizations had also declined(see Exhibits 4 and 5).7 As of 2003, the accumulated losses of
PACS were estimated at $10.4 billion.

History of the Cooperative Movement in India8

The Indian government had been heavily involved in the development and regulation of
CFI since their inception in the early 1900s. Witnessed cycles of regulation and laxity, Indian
CFI evolved through four distinct phases.

In the 1900s, officers of the British Indian Empire recognized that high lending rates for

the poor increased poverty. They imported a European (German) model of credit cooperatives
and were convinced that by breaking the cycle of indebtedness moneylenders create, the poor

4 A. Vaidyanathan, “Report of the Task Force on Revival of Rural Cooperative Credit Institutions,” Department
for Cooperative Revival and Reforms (DCRR), 04 February 2005, Section 3.09 http://www.nabard.org/departments/
departmentforrivalsreforms_task_force.asp (accessed 12 March 2007).

5 Vaidyanathan, Section 3.17.
6 Priya Basu, Improving Access to Finance for India’s Rural Poor (World Bank, 2006), xv.
7 Vaidyanathan, Section 3.29.
8 Vaidyanathan, Chapter 2.

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would be freed from poverty. In 1904 and again in 1912, the British colonial government passed
legislation encouraging and promoting cooperatives. The state began its protection of
cooperatives in this period. In 1915, the Maclagan Committee advocated that “there should be
one cooperative for every village and every village should be covered by a cooperative.” As
interest and momentum began to build around the idea of CFIs, the activities of actual CFI
diversified well beyond agricultural credit—which led to debates about whether there should be
single (financial) or multipurpose cooperatives in a single village.

The second phase beginning in 1930 was marked by the increased role of the Reserve
Bank of India (RBI). The RBI emphasized the creation and fortification of CFIs and encouraged
them to be financially viable. The RBI also began lending credit to provincial cooperatives for
seasonal agricultural operations and fluctuations. In this period, there was less promotion and
growth of CFIs than in the first phase. A majority of CFIs were found to have frozen assets due
to low repayment rates. The government liquidated these frozen assets and adjusted
cooperatives’ claims to the payment abilities of their members. Having considered the CFIs too
small to have the scale economies needed to withstand market competition and to fulfill their
social obligations, the government offered CFIs protection from their main rivals—commercial
banks—and simultaneously sought to increase their scales of operation by pooling resources
among grassroots CFIs through bureaucratic intervention. For some, this was the beginning of
state interference in the management of CFIs and “the consequent erosion in the credit discipline
of the members.”

After Indian independence from Britain in 1947, CFIs received renewed attention as the

state sought rapid and equitable development for the poor. The state took on a larger partnership
in not only equity but governance and management of CFIs. During this third period, state policy
and institutional design was based on the premise that CFIs were vehicles for low-cost credit to
be extended to rural areas. In 1981, the National Bank of Agricultural and Rural Development
(NABARD) was created to further monitor and support the cooperatives. “The focus was on
expanding and reorganizing the state-supported structures, without addressing the tasks of
restoring and strengthening autonomy, mutual help and self-governance that are the cornerstones
of genuine cooperatives.”9 Large amounts of state funds were injected into cooperatives, but it
had little effect on repayment rates. As a potential solution, the state requested that commercial
banks get involved in the management of CFIs. Although this greatly increased commercial bank
penetration in rural areas, it brought with it rigid directives on the cost of credit, and the profile
of acceptable borrowers.

When the state nationalized the commercial banks in 1969, it had even more control over

the sector. This time, state intervention meant a loosening of criteria and ultimately began to
affect the quality of the lending portfolio. In response to the drop in repayment rates, the state
infused more capital and required a “professional work force” to manage the activities of CFIs.
Political expediency also became a problem in this period. The widespread practice of writing
off loans to secure votes further aggravated the weak financial discipline of the sector.
Cooperatives also became vehicles for distributing political patronage because the financial and

9 Vaidyanathan, 13.

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political power inherent in management positions at CFIs became ideal “gifts” for party
supporters.

Beginning in the 1990s there was wider acknowledgement of the destructive potential of

too much state interference in CFIs. Several committees had made policy recommendations that
sought to offer government support to viable and financially sound CFIs. States had been slow to
concede regulatory powers to the RBI.

The history of CFIs illustrates the difficulties in striking a balance between self-

sufficiency and state support for CFIs. It left many questions open for debate. What were the
goals of the CFI sector (financial self-sufficiency or social welfare)? How could both of these
seemingly conflicting goals be brought together in a sustainable way? What set of metrics best
captured the goals?

Getting Credit in Rural India

India had a wide spectrum of financial service providers ranging from formal financial
institutions (e.g., commercial banks and government-regulated cooperative banks) to informal
arrangements (e.g., moneylenders and shopkeepers). Formal institutions were regulated by the
Reserve Bank of India (RBI) and the National Bank for Agriculture and Rural Development
(NABARD). Those two entities provided funding and administrative guidance to banks that
interacted with the rural poor. India also had a growing semiformal financial sector that consisted
mainly of microfinance institutions. These innovative lending practices typically reached 5% to
6% of the country’s poor rural households. Finally, survey data showed an active informal
financial sector, where 44% of poor rural households reported borrowing from a moneylender or
landlord in 2003, at an average annual borrowing interest rate of 48%.10 The informal financial
sector represented a dominant source of funding for the poorest farmers and tradesmen.

The rural poor had borrowing needs that did not match well with the lending practices of

traditional banking institutions (see Exhibit 6). A majority of rural poor people were farmers,
most of whose households relied on a mixture of agriculture and seasonal labor to earn a
subsistent living. Most of the labor income (e.g., from harvesting and plowing) depended on
agricultural cycles and rhythms, which in turn depended on the caprice of nature. For farmers
with small plots of land, there was great uncertainty in crop yield, annual expenditures, and
income. Typically a farming household had small regular expenses throughout the month. But a
majority of households reported having to cope with at least one unforeseen expense each year,
which they typically financed through savings or informal borrowing. The financial services
most urgently needed in rural areas were those that enabled saving for the future, taking
advances on future income, and building precautionary cash reserves for unexpected events.

Rural borrowers typically found formal institutions unattractive for a variety of reasons.

First, the typical product profile of formal institutions did not match their needs for flexible

10 Basu, xvi.

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products and services to meet their seasonal and volatile income and expense profiles. They
tended to borrow frequently in amounts that were tiny compared with the typical credit offered
by a commercial bank, and they tended to repay in small increments. They were also interested
in insurance products as well as savings and lending products, which were not offered by
commercial banks. Rural clients often had to walk several kilometers to get to a commercial
bank branch, only to encounter cumbersome and lengthy procedures for opening an account or
getting a loan (average loan approvals could take 33 weeks), as well as corruption (clients
sometimes had to pay bank officials bribes of 10% to 20% of the loan).11 Finally, formal banking
institutions required a form of collateral that the rural poor generally lacked. Typically that
collateral is land, which most rural poor do not own.

Large commercial banks also were reluctant to lend to the rural poor for several reasons.

The rural population’s volatile income stream meant banks had to be concerned about repayment
and default risk. This uncertainty was exacerbated by lack of a formal credit reporting system—
without relevant credit history, the risk profile of a loan could not be easily ascertained. In the
rural market, commercial banks incurred high transaction costs due to small loan sizes, more
frequent transactions, travel expenses, linguistic differences and high illiteracy rates among
borrowers, and more intense customer interactions (to educate customers about the system).
India’s weak legal framework made it difficult to enforce contracts, which only added to the
culture of distrusting poor farmers.

Current Challenges in the CFI sector

The cooperative system was aimed at providing credit to those who could not meet their
credit needs or could not afford to pay for credit in the commercial credit market. Due to
information asymmetry, lack of sufficient collateral, high transaction costs, and small loan
amounts, the net private-sector benefit of extending credit to the rural poor was much less than
the net social benefit (see Exhibit 7). This gave rise to the argument for government intervention
in this sector.

The government had competing and conflicting goals for the CFI sector. If the CFI sector

served those who could not be served by the market, how could market-based metrics be applied
to CFIs in an equitable way? Should CFIs be required to be financially self-sufficient? Should
they be protected from commercial banks? In addition, political patronage (trading credit for
votes), inefficient allocation of funds, and corruption plagued the CFI system.

In a cooperative structure, the ratio of net lenders to net borrowers was important. The

more net lenders there were, the more money there was to lend. If net lenders started to leave the
cooperative by depositing their savings in commercial banks, there would be less money to lend
and fewer lower-risk borrowers in the pool, reducing the size of the cooperative’s loan portfolio
and at the same time increasing the portfolio’s risk. The ratio of net lenders to net borrowers at
the PACS level was tipping toward net borrowers as a result of increased competition from

11 Twenty-seven percent of patrons of commercial banks reported paying bribes; see Basu, 39.

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commercial banks (see Exhibit 8). There was an eroding stake in the cooperatives from the
relatively well-off members who could afford to leave.

There were also significant issues related to governance. The two upper tiers of the credit

system (DCCBs and SCBs) were created to make sure that the PACS level received the
necessary refinancing and support. The upper tiers managed the lower tiers in varying degrees
across the country and within each state. The state government was responsible for conducting
management elections as well as financial auditing, but in a few states, no elections at the PACS
level had been held for 10 years. Although cooperatives were supposed to be run for the
members and by the members, recommendations by member boards were typically overridden.
Unnecessary intervention and political entrenchment of power could erode member confidence
and responsibility.

In 2007, the state government played the role of dominant shareholder, manager,

regulator, and auditor—which created various conflicts of interests. The state intervened on the
level of interest rates—setting a floor and a ceiling (which did not include the costs of bribes,
typically paid by borrowers). It also set lower regulatory requirements for credit cooperatives
than for commercial banks. For example, rural credit cooperatives faced a lower minimum
capital requirement and a lower cash reserve ratio. Clarifying the role of government in funding
and monitoring would be a key challenge for reformers.

Government intervention also affected the governance and functioning of grass-roots

cooperatives. PACS members felt they received insufficient financial mediation services from
their cooperatives. They believed their voices and votes did not count as much as those of the
directors and government officials. Most PACS managers were nonmembers appointed by local
politicians whose compensation was not directly tied to any relevant performance metric. There
was also concern about the level of training managers received. Some of these managers also
used the cooperatives as vehicles to secure their political careers by promising loans to
supporters. In these situations, what was best for the members fell by the wayside. Many PACS
did not keep up-to-date records of their transactions, and because each state had its own reporting
conventions, there was no central reporting system that made financial information easily
comparable. In addition, the frequency and quality of audits needed improvement.

Given the wide variety of issues that the CFI sector faced, ranging from conceptual and

structural problems to individual motivation and responsibility, charting a path toward
sustainable reforms of this sector would be no small challenge for the government, the CFI
sector, and the rural communities.

Finding a New Way Forward

Mohan Narayan knew something had to be done quickly to re-energize the cooperative
sector. With a general election approaching in two years, there was not much time to study the
situation, assemble recommendations, and get the necessary buy-in from commercial banks,

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CFIs, nongovernmental organizations, various levels of government, and the rural communities,
to make effective and sustainable change. The next government might not make the CFI sector as
high a priority as the current one did. Narayan finished his morning chai and began to think
deeply about how he and his fellow committee members should tackle the major reform issues.

Across the country, Puja Mehta had heard the Indian government was assembling a

distinguished committee to make recommendations on the CFI sector. She hoped the committee
would break the cycle of over-regulation and over-reliance on market mechanisms that the CFI
sector had been caught in for the last 100 years. Would this next round of reforms further cut the
sources of funds for the 15th district? She wondered how the credit cooperative would run
without the necessary government aid. She had enough trouble keeping enough capital in the
collective as it was. Due to recent competition with commercial banks, many of the net lenders
and lower-risk borrowers in her cooperative were leaving. The cooperative was left with less
capital to serve a higher-risk clientele. She was beginning to entertain the idea of extending
credit to nonmembers, but she didn’t know if this was best for the cooperative or even at what
rate to price those loans. Worse yet, she was being pressured by her uncle, who had hired her and
was now running for political office, to extend loans to some high-risk clients.

In addition to all her troublesome financial concerns, Mehta wondered how she could

best help the poor out of poverty. What would another round of suicides do to the little remaining
confidence the farmers had in the cooperative structure? What could she do differently on the
ground to make their lives better and how could she do it in a way that was sustainable? Was
there a way for the cooperative to put more power and responsibility in the hands of its
members? As she walked to a village to speak with one of the families who had lost a family
member in the recent suicides, she hoped the winds of change were in the air.

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Exhibit 1

RURAL CREDIT COOPERATIVES IN INDIA

Breakdown of Loans Outstanding
(in billions of U.S. dollars)

Agricultural

Loans
Nonagricultural

Loans
Other
Loans Total

%
Agricultural

State Cooperative Banks $2.82 $3.70 $1.40 $7.93 36%

District Cooperative Banks $7.00 $4.96 $2.15 $14.11 50%
Primary Agricultural

Credit Societies $5.24 $1.73 $2.62 $9.59 55%

Source: NABARD REPORT, http://www.nabard.org/pdf/rcci_task_report.pdf, (accessed 6 December 2007).
Converted to U.S. dollars using March 2007 exchange rates.

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Exhibit 2

RURAL CREDIT COOPERATIVES IN INDIA

Flow of Ground-Level Credit to Agriculture through Various Agencies
(in billions of U.S. dollars)

Agency 1992–93 1997–98 2000–01 2001–02 2002–03

Cooperative banks $2.12 $3.16 $4.68 $5.32 $5.34
% 62% 44% 39% 38% 34%

Regional rural banks $0.19 $0.46 $0.95 $1.10 $1.37
% 5% 6% 8% 8% 9%

Commercial banks $1.12 $3.58 $6.29 $7.59 $8.99
% 33% 50% 53% 54% 57%

Total $3.43 $7.20 $11.93 $14.01 $15.71

Source: NABARD REPORT, http://www.nabard.org/pdf/rcci_task_report.pdf, (accessed 6 December 2007).
Converted to U.S. dollars using March 2007 exchange rates.

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Exhibit 3

RURAL CREDIT COOPERATIVES IN INDIA

Average Loan Size of Public-Sector Banks in Relation to PACS

# Accounts $ Outstanding Average Loan Size

Public-sector banks 164,000 $11.71 billion $714

PACS 639,000 $9.59 billion $150

Source: NABARD REPORT, http://www.nabard.org/pdf/rcci_task_report.pdf, (accessed 6 December 2007).
Converted to U.S. dollars using March 2007 exchange rates.

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