Source guide

Money, Credit, and Banking Systems

Briefing Document: Money and Credit
This briefing document summarises key themes and facts from the provided source on "Money
and Credit," highlighting the evolution of money, the role of banking systems, the dual nature of
credit, and the challenges of access to credit in developing economies.
I. The Nature and Evolution of Money
**1. Money as a Medium of Exchange:**The fundamental purpose of money is to facilitate
transactions by acting as a "medium of exchange." This eliminates the need for a "double
coincidence of wants," which is an essential and often difficult feature of a barter system.
• "A person holding money can easily exchange it for any commodity or service that he or she
might want."
• In a barter system, "both parties have to agree to sell and buy each others commodities. This is
known as double coincidence of wants." Money "by providing the crucial intermediate step
eliminates the need for double coincidence of wants."
**2. Historical Forms of Money:**Historically, various objects served as money, evolving from
practical commodities to precious metals.
• "Before the introduction of coins, a variety of objects was used as money. For example, since
the very early ages, Indians used grains and cattle as money. Thereafter came the use of
metallic coins — gold, silver, copper coins — a phase which continued well into the last century."
**3. Modern Forms of Money (Currency and Deposits):**Modern money, unlike earlier forms,
lacks intrinsic value but is accepted due to government authorisation and linkage to the banking
system.
• Currency: Consists of "paper notes and coins." Modern currency "is without any use of its
own." Its acceptance stems from being "authorised by the government of the country." In India,
the "Reserve Bank of India issues currency notes on behalf of the central government," and the
"law legalises the use of rupee as a medium of payment that cannot be refused in settling
transactions in India."
• Demand Deposits: These are funds held in bank accounts that can be withdrawn "on
demand." They are considered money because "the facility of cheques against demand deposits
makes it possible to directly settle payments without the use of cash."
• The source explicitly links modern money forms to the banking system: "The modern forms of
money — currency and deposits — are closely linked to the working of the modern banking
system."
**4. Demonetisation:**Governments can declare certain currency notes invalid to be replaced by
new ones, a process known as demonetisation. This can be used to promote digital transactions
and control corruption.
• "In India, during November 2016, currency notes in the denomination of Rs. 500 and Rs. 1,000
were declared invalid. People were asked to surrender these notes to the bank by a specific
period and receive new Rs. 500, Rs. 2,000 or other currency notes. This is known as
‘demonetisation’."
• Post-demonetisation, "people were also encouraged to use their bank deposits rather than cash
for transactions. Hence, digital transactions started... This is promoted to reduce the requirement
of cash for transactions and also control corruption."
II. The Banking System and Loan Activities
**1. Role of Banks:**Banks act as intermediaries between those with surplus funds (depositors)
and those in need of funds (borrowers). They accept deposits, pay interest, and extend loans.
• Banks "mediate between those who have surplus funds (the depositors) and those who are in
need of these funds (the borrowers)."
• Banks keep "only a small proportion of their deposits as cash" to manage withdrawals, typically
around 5% in India. The "major portion of the deposits" is used "to extend loans."
• Banks' primary income source is the "difference between what is charged from borrowers and
what is paid to depositors."
III. Understanding Credit (Loans)
**1. Definition of Credit:**Credit (loan) is an agreement where a lender provides money, goods,
or services in exchange for a promise of future payment.
• "Credit (loan) refers to an agreement in which the lender supplies the borrower with money,
goods or services in return for the promise of future payment."
**2. Dual Nature of Credit (Positive vs. Debt Trap):**Credit can play a vital and positive role in
economic activity, enabling production and increasing earnings. However, it also carries risks,
potentially leading to a "debt-trap" if repayment becomes impossible.
• Positive Impact (e.g., Salim the shoe manufacturer): Credit can help meet "working capital
needs of production," allowing timely completion and increased earnings. "Credit therefore plays
a vital and positive role in this situation."
• Negative Impact/Debt-Trap (e.g., Swapna the farmer): Crop failure or other unforeseen
circumstances can make loan repayment impossible, forcing borrowers to sell assets or take new
loans, pushing them into a "situation from which recovery is very painful."
• "Whether credit would be useful or not, therefore, depends on the risks in the situation and
whether there is some support, in case of loss."
**3. Terms of Credit:**Every loan agreement includes specific terms that define the conditions of
the loan.
• Interest Rate: The amount the borrower must pay to the lender in addition to the principal.
• Collateral (Security): "An asset that the borrower owns... and uses this as a guarantee to a
lender until the loan is repaid." If the loan is not repaid, the lender has the right to sell the
collateral. Common examples include "land, building, vehicle, livestocks, deposits with banks."
• Documentation Requirement: Papers or records needed for the loan application.
• Mode of Repayment: How the loan will be paid back (e.g., monthly instalments).
• These elements "together comprise what is called the terms of credit," which "vary substantially
from one credit arrangement to another."
IV. Formal and Informal Sources of Credit
**1. Classification of Lenders:**Credit sources are broadly categorised into formal and informal
sectors.
• Formal Sector: Includes "loans from banks and cooperatives." The Reserve Bank of India
(RBI) supervises these.
• Informal Sector: Includes "moneylenders, traders, employers, relatives and friends, etc." There
is "no organisation which supervises the credit activities of lenders in the informal sector."
2. Key Differences between Formal and Informal Credit:
**3. Disparity in Access to Credit:**There is a significant imbalance in who accesses formal vs.
informal credit, with poorer households relying more on informal sources.
• "The rich households are availing cheap credit from formal lenders whereas the poor
households have to pay a large amount for borrowing."
• In urban areas, "54 per cent of the loans taken by poor households... are from informal
sources," compared to only "17 per cent" for rich households.
• Reasons for Poor Households' Reliance on Informal Credit:
◦ Banks are not universally present in rural areas.
 ◦ Bank loans require "proper documents and collateral," which the poor often lack. "Absence of
collateral is one of the major reasons which prevents the poor from getting bank loans."
◦ Informal lenders "know the borrowers personally and hence are often willing to give a loan
without collateral." They might also lend even if previous loans are not repaid.
V. Self-Help Groups (SHGs) and Microfinance
**1. Concept of SHGs:**SHGs are small groups, typically of poor rural women, who "pool their
savings" and lend to members.
• A "typical SHG has 15-20 members... who meet and save regularly."
• Members can take "small loans from the group itself" at lower interest rates than moneylenders.
**2. SHGs and Bank Loans:**After a period of regular savings, SHGs become eligible for bank
loans, which are sanctioned in the group's name.
• "After a year or two, if the group is regular in savings, it becomes eligible for availing loan from
the bank."
• This addresses the collateral problem: "banks are willing to lend to the poor women when
organised in SHGs, even though they have no collateral as such."
• The group itself is responsible for loan repayment, ensuring accountability.
**3. Benefits of SHGs:**SHGs offer timely credit at reasonable rates and serve as platforms for
social empowerment.
• They "help borrowers overcome the problem of lack of collateral."
• They provide a "platform to discuss and act on a variety of social issues such as health,
nutrition, domestic violence, etc."
**4. Grameen Bank of Bangladesh:**A significant success story in providing affordable credit to
the poor, particularly women, demonstrating their reliability as borrowers.
• Founded by "Professor Muhammad Yunus, the founder of Grameen Bank, and recipient of
2006 Nobel Prize for Peace."
• Its success proves "that not only are poor women reliable borrowers, but that they can start and
run a variety of small income-generating activities successfully."
VI. The Importance of Formal Credit for Development
**1. Necessity for Expansion:**Expanding formal sector credit is crucial for economic
development, especially for rural populations.
• "Banks and cooperative societies need to lend more."
• "Cheap and affordable credit is crucial for the country’s development."
**2. Equitable Distribution:**It is essential that formal credit reaches all sections of society,
particularly the poor, to reduce their dependence on expensive informal sources.
• "It is important that the formal credit is distributed more equally so that the poor can benefit from
the cheaper loans."
• "The poor should get a much greater share of formal loans from banks, cooperative societies
etc. Both these steps are important for development."