Credit, in commerce and finance, term used to denote transactions involving the transfer of money or other property on promise of repayment, usually at a fixed future date. The transferor thereby becomes a creditor, and the transferee, a debtor; hence “credit” and “debt“ are simply terms describing the same operation viewed from opposite standpoints.
II. TYPES OF CREDIT
The principal classes of credit are as follows: (1) commercial credit, which merchants extend to one another to finance production and distribution of goods; (2) investment credit, used by business firms to finance the acquisition of plant and equipment and represented by corporate bonds, long-term notes, and other proofs of indebtedness; (3) bank credit, consisting of the deposits, loans, and discounts of depository institutions; (4) consumer or personal credit, which comprises advances made to individuals to enable them to meet expenses or to purchase, on a deferred-payment basis, goods or services for personal consumption; (5) mortgage credit, when a loan is secured by property; (6) public or government credit, represented by the bond issues of national, state, and municipal governments; (7) international credit, which is extended to particular governments by other governments, by the nationals of foreign countries, or by international banking institutions, such as the International Bank for Reconstruction and Development (the World Bank).
III. FUNCTION OF CREDIT
The principal function of credit is to transfer money or other assets from those who own them to those who wish to use them, as in the granting of loans by banks to individuals who plan to initiate or expand a business venture. The transfer is temporary and is made for a price, known as interest, which varies with the risk involved and also with the demand for, and supply of, credit.
Credit is indispensable to the modern world economy. It allows businesses to borrow money to invest in schemes that generate more than enough to cover the cost of the credit they have obtained; while it gives those with money to spare extra options to make their savings work for them. In short, credit enables the use of assets that would otherwise lie idle, allowing fuller use of economic resources. In poor countries, however, where financial and commercial systems are less developed, credit is much harder to come by, and those who have savings are likely just to hoard them, for cultural reasons and because of a lack of investment opportunities. As a result, economic growth and improvements in the standard of living are impeded.
The use of credit also makes many everyday business and personal transactions much easier than if real money had to change hands. For example, if a cheque is accepted in payment, the receiver is giving credit, as they will not receive any actual money until the cheque is cleared through the banking system. Other documents of credit, known as credit instruments, include bills of exchange, money orders, bank drafts, and promissory notes. These are usually negotiable instruments; they may legally be transferred by the recipient to someone else in the same way as money, unless they have “non-negotiable” written on them.
IV. ISSUE OF CREDIT
Creditors sometimes require no other assurance of repayment than the debtor’s credit standing—that is, one’s record of honesty in fulfilling financial obligations and one’s current ability to fulfil similar obligations. In some countries, notably the United States, individuals build up personal credit ratings that those granting credit can check via computer. Sometimes a creditor will require a guarantee by a third party to pay the credit bill if the debtor fails to do so. Or the debtor may be obliged to provide security by assigning to the creditor, in the event of default on the debt, the rights to assets that are at least equal in value to the loan. Bonds placed on sale by a corporation are often secured by a mortgage on the corporation’s property or some part of it. Government borrowing, as by the issue of government bonds or stock, is usually unsecured, resting on the purchaser’s confidence in the good faith, taxing power, and political stability of the government. When goods are sold on a deferred-payment or hire-purchase plan, the seller may either retain legal ownership of the goods or hold a mortgage on the goods until the final payment is made. The depositing of funds in a bank may also be regarded as a form of credit to the bank, as such funds are used for loan and investment purposes, and the bank is legally bound to repay them as an ordinary debtor.
V. CREDIT CONTROL
The first credit institutions were medieval banking houses such as the Medici. Today, however, there are a range of institutions involved in the business of credit, including commercial banks, savings banks, and specialist credit corporations.
Rates of interest charged by banks are influenced by the rate, known as the discount rate, which the banks have to pay on loans from central banks such as the Bank of England, the US Federal Reserve System, or the German Bundesbank. The discount rate is one tool that a central bank can use to control the volume of bank credit; when it wants to cut demand for credit, it will raise the rate, thus making credit more expensive to obtain. Governments may employ numerous direct forms of credit control, such as minimum deposits and maximum repayment periods on consumer credit transactions.
VI. CREDIT AND THE ECONOMY
The credit position within a country at any given moment is a useful indicator of the state of the economy: expanding credit generally reflects a period of business prosperity, whereas contracting credit usually reflects a period of declining economic activity or depression. Fluctuations in the supply of credit can also have a bearing on inflation; an increase in credit means that there is more money in the system, which may tempt businesses to increase their prices.
The importance of credit has grown dramatically in recent years as fewer and fewer transactions have been conducted in cash. Advances in technology have enabled individuals to make much greater use of credit and debit cards, and have allowed companies and financial institutions to be much more sophisticated in their dealings, now that credit can be moved electronically around the world with great ease. However, all of this has made the important task of controlling credit much more complex for national authorities.
VII. INTERNATIONAL CREDIT
The provision of international credit was transformed after World War II. In 1944, as part of the Bretton Woods Conference agreement on world post-war currency and credit stabilization, the International Bank for Reconstruction and Development was established to furnish loans for war-devastated countries to help rebuild their infrastructures and economies. In more recent years, it and its sister organization the International Monetary Fund, also established at Bretton Woods with the initial role of overseeing world interest rates, have been concerned with, among other things, the provision of long-term loans to developing countries, though usually on condition that economic restructuring and reform are carried out.
Today, government debt is taken much more seriously, largely as a result of a series of debt crises which arose in the 1970s and early 1980s when steep rises in the price of oil forced many nations to borrow heavily. Overambitious development plans that required massive loan financing were another factor in leaving a large number of nations with a heavy debt burden, which then became insupportable when interest rates rose and the prices of the commodities on which so many of the indebted countries were dependent fell.