CREDIT
Origin of the terms debit and
credit
 The terms Debit and Credit have Latin roots. Debit
comes from debere, which means "to owe". The Latin
debitum means "debt".
 Credit comes from the Latin word credere, which
means "to believe" or "to entrust".
 It is more common to use the plural terms "Debits"
and "Credits".
Why we use Cr for Credit and Dr for Debit
 There are a few possible explanations. One theory
asserts that the DR and CR come from the Latin words
of debitum and creditum which are "debere" and
"credere", respectively.
 Another theory is that DR stands for "debit record" and
CR stands for "credit record".
 Finally, some believe that DR notation is short for
"debtor" and CR is short for "creditor".
What is Credit?
 The word ‘Credit’ is derived from the Latin word ‘credere’.
The word ‘credere’ means “I TRUST YOU”.
 Credit is defined by Gide as “An exchange which is
complete after the expiry of a certain period of time after
payment”.
 Credit is explained as the sale of goods and services and
money that claims in the present in return for a promise to
pay in the future.
 The promise usually based on the confidence and on the
belief that the debtor whether a person, a business firm or a
government unit will be able and willing to pay on demand
or at some future time.
What is Credit?
 “Credit is the right to receive payment” or the obligation to
make payment on demand or at some future time on
account of an immediate transfer of goods”.
 The first phrase ‘right to receive payment’ is used from the
point of view of Creditors as he is to exchange present
goods for the right to receive payment in future.
 The second ‘An obligation to make payment on demand’ is
the phrase from debtor’s point of view. The debtor has an
obligation to pay in the future for the goods required.
 Credit and Debit are thus two sides of the same shield.
Functions of Credit
 To give credit is to finance directly or indirectly the
expenditure of others against future repayment.
 Credit is the foundation upon which the economic
structure of the countries both developed and
developing is strengthening.
 The main functions which arises from the use of
credit are summarized below:
Functions of Credit
Economy in the use of metal
 Provision of working capital
 Sales of bonds
 Case of young firm
 Large scale production
 Shifting of capital to productive hands
 Entrance of new entrepreneur
 Purchase of goods
 International payments
 State revenue
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Functions of Credit
 Economy in the use of metal:
 Credit instruments are used as medium of exchange
in place of metallic coins.
 There is thus a saving of precious metals which we
were using in shape of coins.
Functions of Credit
 Provision of working capital:
 If an industrialist is short of spending power when
the production is going on, he can finance the
industry by obtaining of credit from the banks.
 He needs not sell the plant or other fixed assets
just for the purchase of raw material, paying wages
to the labors, insurance charges, electricity bills etc
Functions of Credit
 Sales of bonds:
 If the prospects of invested capital are bright and
the profits are being earned easily, the firm can
obtain possession of funds even by selling bonds.
 The firm can repay the interest as well as principal
amount easily at the specified date out of profit
earned during the course of production.
Functions of Credit
 Case of young firm:
 Credit enable the entrepreneur of a young firm to
develop its resources at a rapid speed which
otherwise would not have been possible.
Functions of Credit
 Large scale production:
 The institutions of credit have provided a ready
flow of money to the industrialists. When they
receive the large sum of capital the production is
increased on large scale.
 The cost of production of commodities is reduced.
The quality of product also improve with greater
technological research carried on in the big firms.
Functions of Credit
 Shifting of capital to productive
hands:
 There are people who have surplus money with
themselves, instead of keeping the money idle in
their safe deposits, they lend it to the financial
institutions.
 Credit thus makes possible the shifting of money to
those people who can use it productively.
Functions of Credit
 Entrance of new entrepreneur:
 Credit makes possible the entrance of new talent in
the business enterprise.
 If a person has less capital of his own but has all
the qualities of a good entrepreneur, he can setup
new firms and develop modern techniques of
production, and thus the resources of the country
are effectively utilized.
Functions of Credit
 Purchase of goods:
 Credit makes it easy and convenient to the consumer to
purchase or hire goods.
 A consumer can acquire flour, cloth, telephone, radio, car,
house, washing machine etc from the dealer with an
obligations to pay in future either by installment or in lump
sum.
 The credit thus provides an opportunity to the consumer to
use and enjoy more goods which otherwise would not have
been possible if the payment is to be paid in cash.
Functions of Credit
 International payments:
 International payments especially through the bills
of exchange, have been greatly facilitated.
 In some cases when you don’t have money so the
bank pay you on your behalf in an L/C.
 The credit card is also an example of international
payment, as even from the international market, you
can purchased the products and you will pay to your
bank later on.
Functions of Credit
 State Revenue:
 If the government expenditure is more than of its
current revenue. It can meet the deficit by the sales
of bonds.
 Thus the timely needs of the state are satisfactorily
met through credit.
Dangers of credit
 We have given a very rosy picture of the functions
of credit above.
 There is not an iota of doubt that credit is a great
boon to the business community, but it has also
some dangerous potentialities.
 If the delicate weapon of credit is not properly
regulated and controlled, it has its inherent
dangers too. They in brief are:
(i) Over issue of credit:
 The expansion of credit beyond safe limits usually results in
over investment, over production and the rise in prices.
(ii) Bad Debts:
 If an individual consumer, a businessman or a nation is not
careful in the use of borrowed money and they waist the
amount, the loans will not be paid to credit institutions
which will create panic in the monetary circles and the
superstructure of credit will collapse.
(iii). Inefficient business concerns:
 Another inherent danger of credit is that money may
accumulate in the hands of those entrepreneurs who
are financially weak and are running uneconomic
concerns.
 In case they are pushed into bankruptcy, all the firms
which had trade relations with them will suffer.
 It will also cause panic in the business circles.
(iv). Monopolistic Exploitation:
 If large amount of money is placed at the disposal of individuals
or companies, then there is danger of combines and monopolistic
exploitation.
 The monopolist can adopt unfair methods in business dealings.
(v). Borrowing by government:
 A government may spend borrowed money excessively more
than the requirement and then the citizens will lose confidence in
the credibility of the state.
What is Cash Reserve?
 Cash reserve is the liquid form of asset. It is to be kept by a
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bank in vaults and with the central bank of the country in
order to meet the demands of the customers.
Cash reserve of the bank includes three items
(i) Cash in hand
(ii) Cash kept with the central bank of the country and
(iii) Cash kept with other banks.
Cash reserve is regarded as the bank’s first line of defense
to ward off bankruptcy.
Factors which govern cash reserve
 In reality it is not possible to lay down fixed
principles regarding the fixation of cash reserves to
liabilities of the bank.
 It varies from time to time. However the main factors
governing cash reserve in brief are as under:
(i) Legal requirements:
 It is legal requirement from the central bank to the
commercial banks that they will keep a certain amount of
deposits in the form of cash reserve for the demand of the
depositors.
 The object of legal cash requirements is two fold, firstly, it
safeguard the deposits of the people and secondly, it is the
credit control weapon with the central bank.
(ii) Nature and size of deposits:
 If the clients of the banks are industrialists, businessmen
and brokers the banks will have to keep large reserve to
meet their daily demands for cash.
 The size of deposits kept by the customers also affects the
cash reserve.
 In case the banks have a few large deposits of the
customers, then a large cash reserve has to be
maintained.
 In case the number of depositors of small amount is
large, then lesser amount of cash reserve is to be held by
the bank.
(iii). Nature of advances and
Investments:
 In case a bank uses major portion of its
deposits in discounting bills, the cash reserve
ratio will be low.
 If the large portion of the funds is used in
advances and loans which cannot be liquidated
easily, larger cash reserve would be required by
the bank.
(v) Facilities of clearing house:
 If clearing house facility is available in a locality, then the
smaller amount of cash reserve will be required as the bank
will have to pay the difference of the checks drawn upon
them and drawn upon other banks held by it.
 In the absence of clearing housing, every transaction will be
made in cash. So a large amount of cash reserve is to be
maintained.
(vi) Banking facilities:
 If the banking system is well established in the
country, there will be large inflow and outflow of
funds mostly through checks.
 The banks therefore will keep a smaller portion of
cash reserve.
 In case, the banking system is infancy, then
adequate cash reserve is to be maintained by the
bank.
(vii) Area of Operation:
 The ratio of cash reserve also depends upon the area
where the bank is situated.
 A bank situated in a city will keep more cash reserve
than a bank situated in rural area where the demand
for cash is low.
(viii) Political conditions:
 If there is political stability leading to economic
stability in the country, the bank will keep lesser cash
reserves.
 The bank will keep higher reserves in case of
economic instability.
Do Banks Create Credit?
 Creation of credit means that the commercial
banks by taking in deposits and making loans
expand the money supply.
 Creation of credit is one of the important
functions of commercial banks.
 Credit creation is the multiple expansion of
banks demand deposits.
 It is an open secret that banks advance a major portion of
their deposits to the borrowers and keep smaller part of
them for the payment to the customers on demand.
 Even then the customers of the banks have full confidence
that their deposits lying in the banks are quit safe and can
be withdrawn on demand.
 The banks exploit this trust of the customers and expand
loans several times than the amount of demand deposits
possessed by them.
 “This tendency on the part of the commercial banks
to make loans several times of the excess cash
reserves kept by the bank is called creation of credit”.
Process of Credit Creation
 A single bank cannot create loan the banking
system as a whole can make loans.
 The process of credit creation is now explained
with the help of an example.
 Let us assume that there are more than one
banks in the country. It is further assume that
the required reserve ratio is 20%.
 Some body deposits $1000 in bank A. For simplicity
sake, we will show new changes in assets and
liabilities only.
 The balance sheet of bank A now appears as under.
Bank A Balance Sheet
Assets
Liabilities
Cash received = $ 1000
Demand Deposits = $1000
 We assume now that Mr. X approaches the bank A for a
loan. The bank set aside 20% or $200 as required
reserve and the balance of $800 is loaned out to Mr. X
 The Balance sheet of Bank A after giving loan would
appear as under.
Bank A Balance Sheet
Assets
Liabilities
Cash received = $ 200
Loan to Mr. X = 800
Total
= $1000
Demand Deposits = $1000
_________
Total
= $1000
 Now We assume that the borrower Mr. X makes a
payment of $800 by check to Mr. Y to pay his debt.
 Mr. Y has account in Bank B and he deposits this
amount in his account.
 The Bank B receives $800 as deposits and its
balance sheet now appear as under.
Bank B Balance Sheet
Assets
Liabilities
Cash received = $ 800
Demand Deposits = $800
 We further assume that Mr. N approaches the bank B
for a loan. The bank set aside 20% or $160 as required
reserve and the balance of $640 is loaned out to Mr. N.
 The Balance sheet of Bank B after giving loan would
appear as under.
Bank B Balance Sheet
Assets
Liabilities
Cash received = $ 160
Loan to Mr. N = 640
Total
= $800
Demand Deposits = $800
_________
Total
= $800
 Now We assume that the borrower Mr. N makes a
payment of $640 by check to Mr. M to pay his debt.
 Mr. M has account in Bank C and he deposits this
amount in his account.
 The Balance Sheet of bank C increases by $640.The
Bank C also keep 20% as required reserve ($128)
and give excess reserve of $512 as loan to Mr. Z.
 The amount loaned out to Mr. Z becomes a new deposits at
another bank K.
 If the process of creating secondary deposits is continued,
then at each stage in this sequence the amount of new loan
gets smaller and smaller.
 The initial or primary deposit of $1000 with Bank A leads
to the secondary deposits of $800 in the first round , $640
in the second round and $512 in third round and so on.
 The total increase in deposits from the initial $1000 is
$5000.
 The increase is five fold, the reciprocal of the reserve
requirement which is shown in the table below.
Example of credit creation by banking system
Banks
Primary
Deposits
Cash reserve at
20%
Credit Creation
A
B
C
D
E
F
G
H
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N
1000
800
640
512
409
327
262
209
200
160
128
102
81
65
54
41
800
640
512
409
327
262
209
167
TOTAL
5000
1000
4000
 The table shows the following points
 (i) If the cash reserve ratio is 20%and
 (ii) the initial deposit is $1000
 The banks creates newly created money of $4000.
 The total demand deposits are $5000 (initial deposit $1000
+ credit creation $4000 = $5000).
Contraction of credit
 Just as deposits create loans and loans create deposits,
similarly the withdrawal of deposits contracts credit.
 For example, If cash reserve ratio is 20%, the initial
reduction of $1000 in bank A, will lead to a reduction of
deposits of $800 in bank B, Of $640 in bank C and so on.
 If this process of credit contraction is continued, the total
deposits in the banking system is reduced by $5000.
Credit multiplier
 The credit expansion in the banking system is
influenced by the credit multiplier.
 “The credit multiplier is the reciprocal of the
required reserve ratio”.
 Credit multiplier = 1/required reserve ratio
 If reserve ratio is 20%
 Then credit multiplier = 1/0.20 = 5
 The formula for change in deposits in the banking system
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is
D = (1/r)(E)
D represent the change in the banking system as a whole
“r” is the required reserve ratio
E is the primary deposit
If initial deposit is $1000 and required reserve ratio is
20% then change in deposits in the banking system as
whole will be
D = (1/0.2)(1000)
= $5000
Limits to credit creation
 The capacity of the bank to create credit is subject to
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certain limitations which are given below.
(i). Cash Drain
(ii). Transfer of deposit to non bank financial
institution
(iii). Willingness to borrow
(iv). Different types of loan
(i). Cash Drain:
 In the chain process of multiple expansion/contraction of credit,
it is assumed that all payments are made by check and not in
cash.
 In case, some borrowers withdraw a part or all of the amount
loaned to them in cash, banks will not be able to create the credit
to the desired extent.
 An outflow of cash from the reserves of the banks will reduced
their ability to expand deposits and vise versa.
(ii). Transfer of deposits to non bank
financial institutions:
 The transfer of funds to non bank financial institutions can
also limit the credit creation ability of the banks.
(iii). Willingness to borrow:
 The bank may not be able to take full advantage of credit
expansion if they are unable to find sufficient qualified
borrowers willing to apply for loan.
(iv) Different types of loans:
 It is assumed that all the deposits in the banks are in
the form current deposits only.
 The fact is otherwise, the banks keep a fairly large
deposits in the form saving and time deposits.
Conclusion
 The multiple deposit creation model seems to indicate that
the central bank of the country has complete control over
the level of current deposits by setting the required reserve
ratio.
 The fact is that all the four players i-e the central bank,
commercial banks, depositors and borrowers are important
in the determination of credit expansion.