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Understanding Credit in Banking

Updated on September 7, 2009

The Role of Credit

The banking business has been defined as dealing in money and instruments of credit. Credit is sometimes described merely as "a promise to pay money", or as "permission to use the capital of another person". Abstractly it is referred to as "the power which one person has to induce another to put economic goods at his disposal for a time on promise of future payment". The time element is often stressed as the essential feature of credit.

Commercial loans constitute a major outlet for bank credit. In the typical commercial credit operation, funds are advanced to manufacturers or merchants on their own promissory notes, or drafts drawn on customers are discounted. The bank thus substitutes its own credit for that of the borrower or his customers. The credit of the bank is transferable and is generally accepted as a means of payment A bank loan is thus equivalent to transforming the credit of the borrower into money.

The extension of credit does not of itself imply an increase in wealth. But the process of gathering together the community's capital and putting it to use, which is effected largely through credit and credit instruments, has the net result of creating new wealth.

Credit and the Economy

The main function of credit is to facilitate the exchange of goods. Every extension of credit involves an advance of funds, goods, or services. Credit, like money, finds its main function in the field of production. Through its services in facilitating the exchange of goods, credit has helped make possible modern large-scale production and the widespread division of labor.

Credit renders still another important service: it promotes a fuller utilization of individual capacity and enterprise. Through credit advances, fixed forms of property may be converted into a purchasing medium. Also, capital temporarily advanced to others may be released in whole or in part. A merchant, for example, may be carrying many of his customers' purchases on open-book account. Pending the payment of these accounts, his resources are diminished and his activities curtailed. But if he can get credit, either from his suppliers or his bank, his tied-up capital is virtually released to him, and his productive operation is not restricted by lack of working capital. Quite frequently, credit puts capital into the hands of capable businessmen beyond the value of their individual possessions. Few businessmen could operate on a large scale if they had to depend on their own capital accumulation.

Classes of Credit

Credit may be classified under two general headings: (1) as to the recipient, and (2) as to time. Under the first heading, credit is either public or private.

'Public credit' is credit used by the people as a whole through their government—national, state, and local. It is evidenced by the issuance of interest-bearing bonds, notes, or bills, or by the issue of paper money.

'Private credit' is the credit used by industrial or mercantile concerns, by individuals, and by banks. It embraces all forms of credit that relate to private enterprise. A concern may issue bonds to assist in building a plant or to finance the carrying of current assets. A concern may give notes to a bank to provide funds with which to purchase goods, meet payrolls, or discount bills.

Bank credit relates to the credit which banks enjoy by reason of their capital structure and deposits as well as to the credit they obtain from other sources. A bank may obtain credit from its correspondent banks, from the central bank, from government agencies, or from the open market through the sale of acceptances.

Under the second, or time, heading, credit may be classified as to the length of time for which it is granted, which corresponds in general to the uses to which it is put. Accordingly the subdivisions are (1) investment (long-term, or fixed capital) credit; (2) commercial (short-term) credit; and (3) intermediate credit, covering borderline cases between the other two. Commercial credit may be further divided into producer and consumer credit.

'Investment credit' consists of funds borrowed for a long period of time. They are usually invested in fixed capital goods, such as railroads, land, buildings, and machinery. Long-term credit is usually obtained through the sale of bonds, mortgages, or debentures in the securities market.

'Commercial credit' is granted for only a short period. When used in the conversion of goods from the raw to the finished product, in the distribution of goods, or in the financing of service organizations, it is called producer credit. Generally speaking, credit so employed is kept as liquid as possible by investing it in current assets that in the normal course of business will be converted into cash and used to retire the obligation.

'Consumer or installment credit', which is also classified as short-term credit, consists of credit obtained by individuals from merchants, commercial banks, loan companies, credit unions, finance companies, and other private lenders. Sometimes called retail credit, it is normally liquidated from earnings.

'Intermediate credit' comprises loans that are used jointly for short-term needs and for fixed capital purposes such as plant improvements. The loans are generally of a long-term character, even though the funds may be partially invested in current assets that are constantly changing— from merchandise, to receivables, to cash.

Foundations of Credit

The granting of credit is based on the creditor's confidence in the debtor's willingness and ability to discharge his obligation in accordance with the terms of the agreement. The willingness of the debtor is entirely a matter of character and integrity. Ability to pay involves impersonal as well as personal factors. The personal factor may be described as the business capacity of the debtor. The impersonal factor is the marketability of the debtor's product. The primary factors of credit granting are the three C's: character, capacity, and capital. There is another important factor - conditions - which may be termed a fourth C. This has to do with conditions in the particular industry in which the company is engaged and also with general business conditions.

Character

This is the basic element in the extension of credit. While character does not of itself determine the amount of credit to be granted, it is a basic factor in both large and small grants of credit. The applicant's character as a moral risk is tested by his background, habits, associates, style of living, record for honest dealing, and reputation for paying bills— in fact everything that has a bearing on the applicant's willingness to discharge his obligation properly.

Capacity

A man may be honest in every sense of the word, but if he is deficient in ability or capacity, his desire to pay may be of no avail. The credit grantor takes into consideration the applicant's business experience, general education, inclination toward caution or the contrary, and his ability to operate his business profitably. The grantor determines whether the applicant has been tested for operating under adverse conditions, and whether he can make really advantageous use of the credit requested.

Capital

To meet the keen competition to which he is subjected, a businessman must have sufficient funds at his disposal. He must be able to equip his plant at least as adequately as his competitors. He must be prepared to meet any reasonable credit terms on a fully competitive basis. He must be able to discount his bills, and meet his payrolls. These are just a few of the things for which he will require sufficient permanent capital if he is to operate effectively.

In certain cases the credit applicant's capital, if inadequate, may be supplemented by outside capital, or collateral. Similarly, when capacity is not proved, collateral may be required. Endorsement by a responsible person, or a pledge of collateral by some outside source, may make it possible for a bank to grant credit.

Conditions

The alert credit grantor never overlooks general business conditions in the particular industry in which the applicant's company is engaged. The stage in the business cycle, and trends and developments in the local and surrounding areas are important factors to be considered.

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