Reducing default rate in rural credit: How effective is enhanced supervision approach for formal financial institutions?

Abstract

Formal financial institutions viz. commercial banks are gradually shifting their priorities from rural credit due to many practical reasons. High default rate and non-viability of rural credit, and increasing pressure on these formal financial institutions, to be more profitable, are few of the basic reasons. This paper focuses on one probable approach of default mitigation, that is, enhanced supervision, which is one of the potential reasons for high default rate in rural sector. The paper models a specific type of interaction between the regulatory and the institution and concludes that in a regulated competitive environment the institutions will not tend to increase supervision for higher recovery of delivered credit unless the regulatory intervenes and directs the institutions to do so. Even after such intervention from the regulatory, the institutions will find it optimal to invest less in additional supervision in rural sector if rate of return is higher or the default rate is lower in alternative sectors of investment.