Rural Finance in World Perspective
(A Contempary Scenario)


N. Kavitha
MBA, M.PhiL, (Ph.D)
Lecturer-MBA Department
SSM College of Engineering
Komarapalayam-638 183, Namakkal-Dist.
Dr. A. Ramachandran, M.Phil, Grad CWA, Ph.D
Reader in Commerce
SNR Sons College

Rural Financial Trends: How Are Lenders and Interest Rates Changing?

In recent history, it looked to many as if rural financial markets would become dominated by large banks that offered relatively expensive credit to agricultural firms. However, the 1990's have seen resurgence in smaller banks with a focus on smaller, agricultural producer loans. Moreover, small banks may be more competitive than ever with respect to interest rates. This report outlines some of the important trends in rural credit markets including the types of lenders, volume of loans, interest rate trends and some discussion of specific types and sizes of loans. It is our hope that such information will allow agricultural firms and organizations to make more informed decisions with respect to securing capital, as well as choosing an appropriate lending institution.


Rural Finance

Rural finance comprises credit, savings and insurance (or insurance substitutes) in rural areas, whether provided through formal or informal mechanisms. The word 'credit' tends to be associated with enterprise development, whereas rural finance also includes savings and insurance mechanisms used by the poor to protect and stabilize their families and livelihoods (not just their businesses).

An understanding of rural finance helps explain the livelihood strategies and priorities of the rural poor. Rural finance is important to the poor. The poorest groups spend the highest proportion of their income on food typically more than 60% and sometimes as much as 90%. Under these circumstances, any drop in earnings, or any additional expenditure (health or funeral costs, for instance) has immediate consequences for family welfare unless savings or loans can be accessed. Financial transactions are therefore an integral part of the livelihood system of the poor.

Rural finance consists of informal and formal sectors. Examples of formal sources of credit include: banks; projects; and contract farmer schemes. Reference is often made to micro-credit. Micro underlines the small loan size normally associated with the borrowing requirements of poor rural populations, and micro-credit schemes use specially developed pro-poor lending methodologies. Rural populations, however, are much more dependent on informal sources of finance (including loans from family and friends, the local moneylender, and rotating or accumulating savings and credit associations).

Rural Finance is a set of financial services that are not limited to credit only. Financial services in rural finance include: loans, savings, investment, guarantee funds, remittance services, inventory credit, trader finance and insurance.


The Consultative Group to Assist the Poor (CGAP) defines rural finance as 'financial services offered and used in rural areas by people of all income levels', and agricultural finance as 'a sub-set of rural finance dedicated to financing agriculture-related activities, such as input, supply, production, distribution and wholesaling, and marketing' (Pearce, 2003).

Schmidt and Kropp (1987), rural finance is treated in this paper as encompassing all the savings, lending, financing and risk minimising opportunities (formal and informal) and related norms and institutions in rural areas.

This definition recognises that rural financial markets are part of the domestic financial system and are therefore affected by government and central bank policies. Rural financial markets tend to be fragmented (Germidis, 1990; Besley, 1994) and consist of formal, semi-formal and informal financial intermediaries. The definition also acknowledges that the rural population requires a range of financial services, including the following:

Intermediation, which involves mobilising and transferring savings from surplus to deficit units and provides safe, liquid and convenient savings (deposit) facilities and access to credit facilities tailored to the needs of the rural population (World Bank, 2004);

Savings facilities, which allow wealth to be kept in a form that preserves its value and is liquid and readily accessible;

Credit for consumption smoothing and investment in agricultural production, marketing, processing and input supplies (Gonzalez-Vega, 2003); systems for effecting payments and transfer of remittances (Orozco, 2003; Sanders, 2003); and

General insurance and cover against variability in output (especially as agriculture is largely weather-dependent), price and marketing uncertainty (Skees, 2003; Von Pischke, 2003).

Rural finance comes in three major forms:

1. Informal financial institutions which are not regulated by banking sector such as rotating and savings groups, church groups or similar groupings of people

2. Semi formal institutions which are not regulated by banking sector but are usually licensed and supervised by another government agency such as self help groups, NGOs involved in provision of financial services and microfinance organizations (in some instances).

3. Formal institutions which are subject to banking regulations and supervision such as microfinance institutions, banks. In order to enhance the quality of rural livelihoods a more holistic approach to development is needed. Governments need to design and implement agriculture friendly polices that will encourage the development of financial sector and market oriented enterprises. Governments and donors need to invest into human and institutional development in rural areas.

Microfinance: financial services (savings, credit, payment transfers, insurance) for the poor and low-income people.

Agricultural finance: sub-set of rural finance dedicated to financing agriculture-related activities, such as input supply, production, distribution and wholesaling, and marketing.

Rural finance: financial services offered and used in rural areas by farm and non-farm population of all income levels trough a variety of formal, informal and semiformal institutional arrangements and diverse type of products and services, such as loans, deposits, insurance, and remittances. Rural finance includes agriculture finance and microfinance and is a sub sector of the larger financial sector..

Financial services for the rural poor are represented by the shaded overlap of microfinance with rural and agricultural finance. It includes financial services for all purposes and from diverse sources tailored to the needs of poor people in rural areas. Providers include both financial institutions, such as banks, credit unions and non-financial mechanisms. State-owned banks include agricultural development banks, regional development banks, savings banks, and postal banks. Often they have extensive rural networks of branches or outlets. Privatized state banks may also have significant rural outreach, although in many cases the privatization process has reduced rural branch coverage.

Statement of the Problem

In general there are many differences between rural and urban settings. The following Problems in rural settings:

Dispersed demand - due to low levels of economic activity and population density; on the other hand paralleled by larger family sizes and higher population growth rates;High information and transaction costs - linked to poor infrastructure (roads, institutional, telecommunications) and lack of client information (no personal identification or functioning asset registries);Weak institutional capacity - related to the limited availability of educated and well trained people in smaller rural communities; Crowding-out effect - due to subsidized and/or directed credit from state-owned banks or donor projects; Low economy: the range of income-generating activities and the degree of economic diversification is lower, agriculture predominates, low profitability of economic activities; Seasonality because of agricultural activities and long maturation periods for others, resulting in variable demand for savings and credit, uneven cash flow and, lags between loan disbursal and repayments; Farming risks - such as variable rainfall, pests and diseases, price fluctuations, and small farmers' poor access to inputs, advice and (national) markets; Lack of usable collateral - due to ill-defined property and land-use rights, costly or lengthy registration procedures, and poorly functioning judicial systems. It should be noted that these features can vary greatly from one or the other rural area. In some countries absolute poverty may even be more severe in cities.As a result of the above mention constraints, most MFIs have their working area mostly in urban areas. In this situation, the researcher probes further to find the possible avenues for rural finance to develop the people who are residing in rural and around Erode district.

Sustainable financial institutions requires:

- Mobilization of own resources through savings,
- Working through savings based member-owned SHGs operating at low costs
- Serving rural clients engaged in both farm and non-farm activities
- High repayment rates
- Covering costs from operational income
- Earning enough profits to offset effects of inflation
- Financing expansion from profits and savings mobilized.

SWOT of rural finance


- high level of social capital and collateral substitutes
- informal mechanisms used to enforce contracts


- assumption that credit is a binding constraint; rural finance is often treated as an equivalent for agricultural credit, which is used as 'input' for agricultural production

Objectives: supply-driven basis

- subsidized interest rates creates market distortions and unsustainable financial services
- lack of analysis of true market demand
- lack of cross-sectoral collaboration: specialists of financial sector and rural/agricultural sector often do not work together: rural development projects are often designed without financial sector expertise
- lack of alternative models to replace the discredited approach in agricultural credit; agricultural finance is therefore often ignored in many agencies


- increasing demand for agricultural development because of population growth
- high demand for financial services in rural areas


- Vulnerability: systemic, market, credit risks, etc.
- Operational: low investment returns, low investment, low asset levels, geographical dispersion
- Capacity: infrastructural capacity, technical capacity and training, social exclusion and institutional capacity, etc.
- Political and regulatory: political and social interference and regulatory framework, export market protection, etc.

The World Bank has held various policies of the Government responsible for a highly inadequate supply of finance to the rural poor.

In a report titled `Scaling-up access to finance for India's rural poor,' the World Bank has pointed out that a combination of various factors has affected both banks and their clients. This has driven up costs and hampered access to the poor.

The study has observed that the Government policy has created a `financial climate' that is not conducive to lending in general, and to rural banking in particular.

"High fiscal deficits, the Government's domination of rural finance institutions, persisting weaknesses in the regulatory and legal framework, and a set of policies towards the sector that have been designed to gain political patronage, have resulted in the distortion of risk/return signals and inefficiencies in the delivery of rural finance services. An outcome of these realities has been a dilution of the credit creating role of rural banks," the World Bank report said.

According to the World Bank, the high fiscal deficits have led to the Government's appropriation of a large share of financial savings for itself, pre-empting credit to the private sector. However, the Government's deficit financing policies have provided bankers with opportunities to deploy bank resources in Government securities, which are not only safe, but also yield high profits for banks in a declining interest rate environment.

The World Bank report has pointed out that the directed lending norms that require commercial banks to allocate 40 per cent of their lending to the `priority sector' have not generated the intended results, since most of the banks get around this requirement by subscribing to other eligible instruments.

Further, the study also held RBI's credit planning policy responsible for the plight of rural lending.

The `service area' policy of RBI, whereby each rural bank branch is given a set of villages within which it can operate, restricts competition in rural banking.

The RBI policy not only restricts bank branches from optimising their infrastructure, but also restricts the entry of new, non-service area bank branches (including private sector bank branches) into the service area.

This is because the entry of non-service area bank branches into the service area requires a no-objection certificate from the service area branch, "which is often not easily forthcoming," the World Bank report observed.

Rural lending: World Bank blames Govt policies

Government policies lead to terrible toll in rural suicides

Indian peasants have faced greater global competition due to the deregulation of agricultural markets. In 1999, the Bharatiya Janatha Party (BJP)-led Indian federal government signed a pact with the United States to grant US producers import permission for 1,429 agricultural products that were previously prevented from entering the local market. The UPA government of Prime Minister Singh is continuing the free market restructuring of the economy. During US President George Bush's visit to India in early March, Singh signed an agreement that further opens the agriculture sector to firms such as Monsanto. These measures will further exacerbate the already intolerable conditions of Indian farmers.

Finance for the rural poor

Millions of people in the developing world's rural areas are poor not because they cannot manage money, but because they have too little of it. While studies show that rural micro-entrepreneurs produce high rates of return on the capital they invest, the problem is they lack access to sufficient funds, which means their aggregate return remains low, thus perpetuating a life in poverty.

A key objective of rural finance is to provide those people with the funds and financial services they need to multiply their earnings and build a more prosperous future. The United Nations International Year of Microcredit 2005 has provided an opportunity for dialogue among financial institutions, development banks, governments and donors on the role and potentials of rural finance - what it can do, who it can reach and why it has still not reached many of the rural poor.

New focus

In the past, "rural finance" and "agricultural credit" were used interchangeably. Today the focus has broadened: the future of rural poverty alleviation is investment in all aspects of rural development, not only agriculture. More business in rural areas generates the economic incentive to improve infrastructure, which boosts the competitiveness of production. But development can only occur when a rural area is able to attract and sustain rural investment, through a conducive operating environment, suitable financial products and services, and attractive returns.

Efforts to make financial services accessible to poor rural households must overcome several key constraints. First, rural incomes are highly susceptible to systemic risks, such as bad weather and disease, and cyclical and seasonal fluctuations in prices of agricultural commodities. Any loss of expected income has significant impact, and reduces savings and borrowing capacity.

For providers of financial services, the rural sector is particularly risky. Returns on investment capital are low and profit margins are often very low. Operating costs are high in isolated areas and, since collateral is often unavailable, lenders face greater risks from loan defaults. The low level of skills reduces the capacity for adopting new technologies, affecting both productivity and competitiveness in the marketplace. Social exclusion also limits constrains production and marketing efficiencies.

Finally, there are political and regulatory obstacles. These range from political and social interference - loans can be forgiven, savings withheld, interest rates capped, repayments suspended by decree - to land tenure, banking laws, exchange rate manipulation and tax regulations that destabilize or hinder the viability of business and financial operations in rural areas.

Despite these constraints, micro-finance institutions (MFIs) have introduced innovations - mainly in urban areas but also in the rural sector - that are realizing the potentials of microfinance in many countries. Small working capital loans for petty trade, artisanal production and microbusiness are a growing part of MFI portfolios, while rural savings products have also filled an important need. Microfinance has been instrumental in recognizing the multiplicity of both household finance needs - not only for production credit, but equally so for school fees, health costs and housing, and for services such as remittances, accessible savings outlets and insurance.

Microfinance has often led the way in addressing social, gender and ethnic equity issues which hold families in poverty. In countries where subsistence agriculture predominates, improving women's access to rural finance has favoured empowerment, equality and better lives for those women and their families.

A vision for the future.

The importance of rural finance in poverty alleviation and achievement of the Millennium Development Goals means that it will remain a high priority for governments, donors and, of course, rural households. Based on current trends, we can expect major changes in provision of products and services over the next decade.

In countries where microfinance and retail finance institutions have been operating for a long time, there will be increasing consolidation in the sector, and a marked tendency toward full service provision: single loan products and the credit-only services of agricultural banks will be replaced by savings options, remittances and insurance. Since very few providers can offer efficiently a full set of services, institutions will need to link up with specialized companies (for insurance, leasing, venture capital, etc.) and with "niche" organizations such as NGOs and self-help groups that facilitate their outreach in rural areas. Effective use of financial services will also require stronger ties to training, technology, marketing and business services.

Donor capital for lending will become relatively insignificant. Retail finance institutions will be funded largely by client savings, with investment funds, securitization and bonds also growing in importance. Subsidized finance will mostly disappear. Increased vertical integration of production and marketing, coupled with improved information systems and better regulation, will mean greater inclusion and understanding of trade-linked finance. The use of contract farming, inventory credit, forward contracting and leasing can be expected to grow. Risk management will remain a major issue, but it will also improve, through portfolio and client diversification, and improved analysis and information tracking. The use of insurance products will make the systemic and unique risks of rural finance less hazardous.

What will these changes mean for the main players in today's rural finance? Credit-focused agricultural and rural development banks are in steady decline, although in some countries they may continue to play an important role. Many NGOs will cease to have a direct role in rural finance provision and will focus instead on capacity building and social issues. For donors, the emerging shape of rural finance heralds a shift from provision of loan capital toward rural financial system development and capacity building. Government participation in rural financing will decrease but its role in regulation and supervision will become more important as the industry evolves. The end result for clients, including the rural poor, will be greater access to an array of financial and complementary services, at lower cost.


The Year of Microcredit has helped dispel the notion that the poor are "irresponsible with money". Indeed, it has confirmed that they are not only "bankable" clients, but a very important and largely untapped financial market. Despite their lack of traditional sources of collateral, micro-entrepreneurs demonstrate that "peer group pressure", as well as self-interest in a lasting source of funds, are usually sufficient to ensure very high repayment rates.


FAO and other development partners stand behind rural and microfinance organizations that wish to make a difference in poverty alleviation, economic growth and social empowerment. Such partnership requires transparency and accountability, standardization in reporting and shared learning. The vision for the future is one of hope - rural finance and the other tools that make a difference exist and are continually being refined and improved. Together we can make the vision become reality.


1. Food and Agriculture Organization of the United Nations helping to build a world without hunger

N. Kavitha
MBA, M.PhiL, (Ph.D)
Lecturer-MBA Department
SSM College of Engineering
Komarapalayam-638 183, Namakkal-Dist.
Dr. A. Ramachandran, M.Phil, Grad CWA, Ph.D
Reader in Commerce
SNR Sons College

Source: E-mail April 11, 2007


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