Credit is created when one party (a person, a firm) lends money to another party, the borrower. In general, credit mean the finance provided to others at a certain (mostly fixed) rate of interest. The process of lending and borrowing creates both credit and debt.
Debt means the obligation to pay the borrowed finances.
Credit means the claim to receive money payments from the other party.
The act of lending and borrowing creates credit which is used for special type of exchange transaction that involves future payment of the principal sum borrowed as well as the rate of interest on it.
The lending and borrowing of money and the institution of money lending came into existence with the invention of money. The concept of credit is as old as money.
The bank credit is just one form of credit out of many. Money lenders, credit cooperative societies, commercial and cooperative bank, industrial financial institutions etc. are all credit institutions which do the business of lending and borrowing money. Different institutions lend money for different purposes and collectively called the Financial System.
Credit institutions can be categorized according to the type and purpose of credit they provide. Some institutions provide credit only to agriculture, some to only industries and some to finance exports only.
Credit institutions can also be differentiated according to the duration of period for which they lend money to their clients. Some provides credit for short period, some for medium term and some for long term.
Functions of Credit –
The main function of credit is to meet the financial requirements of investors who have to spend more on trade and investment than their own savings.
With the help of credit surplus funds with some individuals and institutions made available to the deficit spenders (those who are required to spend more than their resources).
Credit transfers the surplus funds of some to meet the spending by the businessmen and investors to ensure better allocation of financial resources and thereby to encourage economic growth in the economy.
But, for credit to perform its functions properly, it needs to be properly managed and controlled. Lack of efficient management can cause inflation or deflation, recession and unemployment in the economy.
The mismanagement of credit can lead to misallocation of invisible resources and decrease economic growth.
It can also can concentration of economic power in the hands of few which leads to the exploitation of the weaker sections, which slows economic growth and causes social injustice.
Purposes or End-Uses of Credit –
Credit is required by all sectors of the economy for different purposes. So, there is need for proper allocation of credit between different sectors and uses if the society is to achieve its objectives.
Mostly when credit is demanded, it may be used to finance the needs of working capital or for fixed investment (e.g. capital equipment, machinery). The broad categories for which the credit is demanded are Agriculture, Industry, Construction and Trade, for both domestic and foreign productive economic activities. The allocation of credit between different categories and users is of very Importance for the economic growth and social justice.
For example, the agricultural allocation of credit between large land owners and small farmers, the allocation of credit between large scale industries and small scale industries.
Credit policy in India in recent years has given certain importance to sectors such as agriculture, small scale industries, export and weaker sections of society such as small farmers etc.