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Types of Loans in India: Analyzing Formal and Informal Credit Impact on Households

December 5, 2023 1636 0

Rural Credit in India: Formal vs. Informal Loans –

The various types of loans in India can be conveniently grouped as formal sector loans and informal sector loans. As shown in the figure,  you can see the various sources of credit to rural households in India.                  

Understanding Formal Sector Loans: The spectrum of types of loans in India

  • These are loans from banks and cooperatives. The 
  • Oversight and Regulatory Role: Safeguarding Financial Stability in India
    • Reserve Bank of India (RBI) oversees the functioning of formal loan sources, ensuring banks maintain a minimum cash balance from their received deposits. 
  • RBI’s Inclusive Lending Mandate: Empowering Small Sectors: Apart from loan to  profit-making businesses and traders, RBI sees that banks must give loans to small cultivators, small-scale industries, to small borrowers etc. 
  • Banking Accountability: Transparency in Lending to RBI: Banks are required to provide regular information to the RBI regarding their lending amounts, recipients, and interest rates.

Sources of credit per Rs 1000 of Rural Households in India in 2012

Sources of credit per Rs 1000 of Rural Households in India in 2012

Exploring Informal Sector Loans: Understanding the various types of loans in India 

Sources: Types of loans in India can be categorized in the form of moneylenders, traders, employers, relatives and friends, etc. 

Characteristics of Informal Sectors Loan:

  • Lack of Regulatory Oversight and Supervision: There is no organization which supervises the credit activities of lenders in the informal sector. 
    • They have the freedom to lend at any interest rate and are not impeded from using unfair methods to recover their money. 
  • Informal Lenders: High Rates, Higher Costs: Informal lenders often charge higher interest rates than formal lenders, resulting in higher borrower costs.
  • Escaping the Grip of Debt Traps: It results in borrowers using more of their earnings to repay loans, reducing income and potentially leading to debt traps.
  • Discouraging Entrepreneurship: This can also discourage individuals from starting businesses due to the high cost of borrowing. 

For these reasons, banks and cooperative societies need to lend more.

  • Cheap and affordable credit is crucial for the country’s development. 
  • It 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.

Formal and Informal Credit: The Array of types of loans in India

  • Figure 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.
  • Poor Urban households: 85 per cent of the loans taken by poor households in the urban areas are from informal sources.
  • 90% of Rich Urban Households Choose Formal Loans: Among rich urban households only 10 per cent of their loans are from informal sources, while 90 per cent are from formal sources.
  • Disparities in Rural Credit: 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 large amount for borrowing. 
  • The formal sector meets only about half of the total credit needs of the rural people.

Urban Households Formal/Informal Loans

Urban Households Formal/Informal Loans

  • High-Interest Rate: A Roadblock to Financial Empowerment: Most loans from informal lenders carry a very high-interest rate and do little to increase the income of the borrowers.
  • Promoting Formal Lending in Rural Areas: It is necessary that banks and cooperatives increase their lending, particularly in the rural areas, so that the dependence on informal sources of credit is reduced.
  • Inclusive Lending: Bridging Gaps for Economic Equality: While formal sector loans need to expand, it is also necessary that everyone receives these loans.
    • It is important that the formal credit is distributed more equally so that the poor can benefit from the cheaper loans. 

Self-Help Groups in Rural India: Empowering the poor

Definition: SHGs are organized groups of rural poor, particularly women, who themselves manage these groups by pooling their resources. 

The vital role of SHGs: Addressing the need for diverse types of loans in India

  • Banking Challenges in Rural India: Banks are not present in every part of rural India, and even when they are present, obtaining a loan from a bank is more challenging than from informal sources.
  • Collateral Struggle: Poor Access to Bank Loans: It is one of the major reasons which prevents the poor from getting bank loans.
  • Collateral-Free Loans by Informal Sector: Lenders provide collateral-free loans by exploiting the borrowers at a high rate of interest.
  • SHGs play a major role in tackling these issues by empowering members through better lending facilities.

Grameen Bank of Bangladesh

Bank of Bangladesh is one of the biggest success stories in reaching the poor to meet their credit needs at reasonable rates. Started in the 1970s as a small project, Grameen Bank in 2018 had over 9 million members in about 81,600 villages spread across Bangladesh. Almost all of the borrowers are women and belong to poorest sections of the society.

Understanding the Nature of Self-Help Groups and their roles in Diverse types of Loans in India

  • Composition: A typical SHGs has 15-20 members, usually belonging to one neighborhood, who meet and save regularly. 
  • Small Saving: Diverse Member Contributions: Saving per member varies from Rs 25 to Rs 100 or more, depending on the ability of the people to save. 
  • Small Loans: Fulfilling Member Needs: Members can take small loans from the group itself to meet their needs. 
  • Empowering Communities: Path to Lower Interest Rate: The group charges interest on these loans but this is still less than what the moneylender charges. 
    • After a year or two, if the group is regular in savings, it becomes eligible for availing loan from the bank.
  • Empowering Women through Group-Based Lending: Loan is sanctioned in the name of the group and is meant to create self-employment opportunities for the members. It is the group which is responsible for the repayment of the loan.
    • Any case of non-repayment of a loan by any one member is followed up seriously by other members of the group. 
    • Because of this feature, banks are willing to lend to the poor women when organized in SHGs, even though they have no collateral as such.
  • Collateral-Free and Timely Loans through Self-Help Groups: SHGs help borrowers overcome the problem of lack of collateral  and they can get timely loans as well. 
  • SHGs are the building blocks of the organization of the rural poor.

Demonetization in India: Effects on Economy, Taxes, and State Action

  • In November 2016, India implemented demonetization to combat corruption, black money, terrorism, and fake currency circulation.
    • Old currency notes of Rs 500 and Rs 1000 were replaced with new Rs 500 and Rs 2000 notes. 
    • Public advised to deposit old notes in bank accounts until 31 December 2016 without declaration or with RBI declaration until 31 March 2017. 
    • Exchange of old currency was allowed per person and day. Old currency notes were still acceptable until 12 December 2016.
  • Demonetization’s Dual Impact: Short-Term Struggles and Long-Term Gains: The demonetization of currency led to long queues and a shortage of currency, negatively impacting economic activities. 
    • However, it improved tax compliance, channeling individual savings into the formal financial system and allowing banks to provide loans at lower interest rates. 
  • Curbing Black Money through States Action: This move demonstrates the state’s decision to curb black money, reducing tax evasion and corruption.
  • Tax Administration Benefits of Demonetization: Demonetization also helps tax administration by shifting transactions from the cash economy to the formal payment system, as households and firms transition from cash to electronic payment technologies.

 

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UDAAN PRELIMS WALLAH
Comprehensive coverage with a concise format
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