Credit and Commercial Banking

CREDIT: MEANING AND FUNCTIONS

• Credit arises when one party lends money to another, creating a financial claim for the lender and an obligation (debt) for the borrower.

• Every credit transaction involves future repayment of the principal plus interest, making it a special form of exchange based on deferred payment.

• Lending and borrowing began with the invention of money and led to the development of organised financial institutions.

• Credit is provided by many institutions such as moneylenders, indigenous bankers, cooperative societies, commercial banks, industrial finance institutions, insurance bodies, and export finance agencies.

• These institutions together form the financial system, with commercial banks being only one important segment.

• Credit institutions differ by purpose: some finance agriculture, others industry, trade, or exports.

• They also differ by duration of loans: short-term, medium-term, and long-term credit.

• The study of credit often focuses on commercial banks, as they play a central role in money supply and lending activities.

Functions of Credit

• Credit relaxes balanced budget constraints by enabling investors, traders, and firms to spend more than their own savings to finance trade and investment.

• It transfers surplus funds from savers to deficit spenders, promoting savings, investment, and better allocation of financial resources for economic growth.

• Efficient credit systems, managed by banks and financial institutions, support productive use of funds and expansion of business activity.

• Poorly managed credit can cause inflation, deflation, recession, unemployment, and misallocation of resources, hindering growth.

• Mismanagement may also concentrate economic power, exploit weaker sections, and obstruct social justice.

Purpose or End-Uses of Credit

• Credit is needed across all sectors, so proper allocation among uses and sectors is essential to achieve economic growth and social justice.

• Productive credit finances working capital needs and fixed investment in machinery and capital equipment across agriculture, industry, construction, and domestic & foreign trade.

• Allocation within sectors is crucial, e.g., credit distribution between large landowners and small farmers, and between large-scale and small-scale industries, affects equity and development.

• India’s credit policy prioritises priority sectors such as agriculture, small industries, exports, and weaker sections including marginal farmers and young entrepreneurs.

Origin and Evolution of Commercial Banking

• A commercial bank is a profit-oriented institution that borrows money as deposits from the public and lends it at a higher interest rate, earning profit from the interest margin.

• Unlike a money lender who lends only his own funds, a bank performs both borrowing and lending, mobilising deposits and financing business activities.

• Banks pay lower interest to depositors and charge higher interest to borrowers, and this interest spread forms the basis of their earnings.

• Modern banking originated from 17th-century English goldsmiths who stored valuables like gold and silver for wealthy individuals and issued deposit receipts.

• These receipts began to function as a medium of exchange, as debts could be settled by transferring or endorsing the receipts without moving the actual gold.

• The practice evolved into issuing written instructions to transfer deposits, leading to the development of the cheque system.

• Goldsmiths observed that much deposited gold remained idle, so they issued more receipts than actual reserves and charged interest, marking the beginning of credit creation by banks.