Formal sector credit in india

1. 1. FORMAL SECTOR CREDIT IN INDIA Charmi Doshi 10 A

2. 2. Various types of loans: Formal Sector Loans Informal Sector Loans
3. 3. Sources of credit for rural households in India, 2003 Among the formal sector are
loans from banks and cooperatives. The informal lenders include moneylenders, traders,
employers, relatives and friends, etc. In Graph you can see the various sources of credit to
rural households in India.
4. 4. FORMAL SECTOR LOANS The RBI sees that the banks give loans not just to profit-
making businesses and traders but also to small cultivators, small scale industries, to
small borrowers etc. Periodically, banks have to submit information to the RBI on how
much they are lending, to whom, at what interest rate, etc.
5. 5. FORMAL SECTOR LOANS • The Reserve Bank of India supervises the functioning
of formal sources of loans. • For instance, we have seen that the banks maintain a
minimum cash balance out of the deposits they receive. The RBI monitors that the banks
actually maintain the cash balance.
6. 6. Informal Sector There is no organisation which supervises the credit activities of
lenders in the informal sector. They can lend at whatever interest rate they choose. There
is no one to stop them from using unfair means to get their money back. Formal Sector
Compared to the formal lenders, most of the informal lenders charge a much higher
interest on loans. Thus, the cost to the borrower of informal loans is much higher.
7. 7. INFORMAL SECTOR LOANS Higher cost of borrowing means a larger part of the
earnings of the borrowers is used to repay the loan. Hence, borrowers have less income
left for themselves. In certain cases, the high interest rate of borrowing can mean that the
amount to be repaid is greater than the income of the borrower. This could lead to
increasing debt and debt trap. Also, people who might wish to start an enterprise by
borrowing may not do so because of the high cost of borrowing.
8. 8. FORMAL SECTOR LOANS • For these reasons, banks and cooperative societies need
to lend more. • This would lead to higher incomes and many people could then borrow
cheaply for a variety of needs. • They could grow crops, do business, set up small-scale
industries etc. They could set up new industries or trade in goods. • Cheap and affordable
credit is crucial for the country’s development.
9. 9. Of all the loans taken by urban households in 2003
10. 10. FORMAL & INFORMAL CREDIT • The graph shows the importance of formal and
informal sources of credit for people in urban areas. The people are divided into four
groups, from poor to rich, as shown in the figure. • You can see that 85 per cent of the
loans taken by poor households in the urban areas are from informal sources. Only 10 per
cent of their loans are from informal sources, while 90 per cent are from formal sources. •
A similar pattern is also found in rural areas. The rich households are availing cheap
credit from formal lenders whereas the poor households have to pay a heavy price for
borrowing.
11. 11. INFERENCE • First, the formal sector still meets only about half of the total credit
needs of the rural people. The remaining credit needs are met from informal sources. •
Most loans from informal lenders carry a very high interest rate and do little to increase
the income of the borrowers. • Thus, it is necessary that banks and cooperatives increase
 their lending particularly in the rural areas, so that the dependence on informal sources of
credit reduces.
12. 12. INFERENCE • Secondly, while formal sector loans need to expand, it is also
necessary that everyone receives these loans. • At present, it is the richer households who
receive formal credit whereas the poor have to depend on the informal sources. • It is
important that the formal credit is distributed more equally so that the poor can benefit
from the cheaper loans.

13. The effect of bank loans and credit

standards on output
14. Lorenzo Cappiello, Marco Protopapa, Christoffer Sørensen, Arjan Kadareja 03
March 2010
15. How important is credit availability to the real economy? This column examines evidence
from the Eurozone and suggests that a change in loan availability has a positive and
statistically significant effect on GDP. This provides support for the policies taken by
central banks to alleviate pressures on the banking system.
16. 6

17. a
18. A
19. The global financial crisis has caused substantial damage to Eurozone banks’ balance
sheets and their access to funding, raising concerns about the knock-on effects on
households and firms. Because Eurzone banks are central to both the financial system and
the provision of funds to the real economy, a reduction in credit offered by banks could
have severe ramifications for the real economy.
20. To put the importance of the banking sector in the Eurozone into perspective, by the end
of 2007 bank loans to the private sector made up 145% of Eurozone GDP, compared with
63% in the US (ECB 2009a). Furthermore, bank-dependent firms should normally be
found among the small- and medium-sized enterprises (SME) that are not able to raise
funds in the capital markets. Sixty-seven percent of employed people are in the SME
sector in the Eurozone, which is substantially larger than the 43% in the US.1 For these
reasons, the large drop in the growth of bank loans to non-financial corporations observed
in recent months (see Figure 1) deserves close monitoring by policymakers. Although the
decline in overall lending to non-financial corporations at the Eurozone level appears to
be mostly linked to demand factors, it cannot be ruled out that developments are to a
certain extent also driven by supply-side constraints in the banking sector (ECB 2009b).
21. Figure 1. Real annual growth rates of GDP and loans to non-financial corporations in the
Eurozone (%)
22.
23. Source: ECB and Eurostat.

24. New insight on the effect of credit supply in the Eurozone

25. In a recent paper (Cappiello et al. 2010), we evaluate the effects of changes in credit
supply on output for the Eurozone. Our analysis is carried out from the perspective of the
bank lending channel of monetary policy transmission, thereby addressing two related
questions: first, whether a change in banks’ financing cost has an effect on loan supply
and, second, whether changes in banks’ loans have an impact on output. The answer to
these questions is based on two assumptions. The first one concerns the “special” status
of deposits in the liability structure of banks, in that deposits cannot be perfectly
substituted with other forms of funding; a particularly realistic hypothesis at the current
juncture. The second assumption regards the peculiarity of loans for firms, in the sense
that companies cannot perfectly substitute loans with other sources of finance – this is
likely to hold true given the large population of Eurozone SMEs.
26. Evaluating the effect of credit growth on output raises a number of issues. One of the
most pertinent is concerning endogeneity, or reverse causality, since it is not possible to
perfectly distinguish whether loan supply affects output or if the demand for (and supply
of) loans is determined by future expected output. Following Driscoll (2004), our paper
addresses this issue by considering the Eurozone countries as a group of small open
economies under a fixed exchange rate regime with nationally segmented retail banking
markets. Therefore, country-specific shocks to money demand will lead to country-
specific variations in the supply of loans. For instance, suppose that, for a given level of
output and interest rate, there is a positive money demand shock in any one of the
Eurozone member states. If households and firms desire to hold more money, deposits
will increase. As a consequence, since exchange rates are irrevocably fixed, real balances
should go up in the country which has experienced the money demand shock and slightly
decrease everywhere else. If the lending channel plays a role, the deposit growth should
lead to an increase in the supply of loans due to the additional source of financing for
 banks. Therefore, output should also increase assuming the imperfect substitutability
between bank loans and other sources of financing for firms and households.
27. Our results provide empirical evidence for the existence of a bank lending channel of
monetary policy transmission in the Eurozone. In addition, and in contrast to recent
findings for the US (Driscoll 2004), it is found that in the Eurozone changes in the supply
of credit, both in terms of volumes and in terms of credit standards applied on loans to
enterprises, have significant effects on real economic activity. In other words, a change in
loan availability has a positive and statistically significant effect on GDP.
28. These findings point to the potential negative repercussions on real economic growth
arising from the effect of the financial crisis on Eurozone banks’ balance sheet. That
being said, the rebound in debt securities financing by Eurozone non-financial
corporations observed in the past year may have somewhat mitigated the otherwise
adverse macroeconomic implications from the slowdown in bank lending. Finally, the
results also provide support for the different policy measures taken by the major central
banks to mitigate the real economic effects of the financial crisis; with those of the
Eurosystem focusing in particular on alleviating the pressures on the banking system,
whereas policy measures in the US have focused more on supporting market-based
financing.
29. Disclaimer: The views expressed are those of the authors and do not necessarily
represent those of the European Central Bank, the Eurosystem, the Bank of Albania, the
European University of Tirana or the University of New York at Tirana (Albania).

30. Footnotes
31. 1 According to figures from the European Commission (for the year 2008) and the US
Census Bureau (for the year 2004).

32. References
33. Cappiello, Lorenzo, Arjan Kadareja, Christoffer Kok Sørensen, and Marco Protopapa
(2010), “Do bank loans and credit standards have an effect on output? A panel approach
for the euro area”, ECB Working Paper 1150, January.
34. Driscoll, John C (2004), “Does bank lending affect output? Evidence from the US
States”, Journal of Monetary Economics, (51):451-77.