What Is Formal and Informal Sources of Credit

• Credit creation: One of the main functions of commercial banking is credit creation. It is the banks that create loans for producers to invest in the economy. Banks provide the loan by accepting the people`s deposit. Investors` investment improves the economy and investments are provided by the bank. 2. Why should a balance be available to everyone on reasonable terms? The loan from the informal source receives loans from institutions that do not fall under the jurisdiction of a legal person. Credit from these sources money lenders, friends, relatives, traders, employers. etc. can be described as informal sources of credit. Compared to formal lenders, most informal lenders charge much higher interest rates on loans. Thus, the cost to the borrower of informal loans is much higher.

Formal sources of credit are always preferred to informal sources because: What does all this indicate? First, the formal sector still covers only about half of the total credit needs of the rural population. Other credit needs are covered by informal sources. We have seen in the examples above that people get loans from different sources. The different types of loans can be grouped into loans from the formal sector and loans to the informal sector. The former include loans from banks and cooperatives. Informal lenders include lenders, traders, employers, relatives and friends, etc. Figure 1 shows the different sources of credit for rural households in India. Does more credit come from the formal sector or the informal sector? 3. Should there be a regulator like the Reserve Bank of India that deals with the lending activities of informal lenders? Why should his task be difficult enough? What are the differences between formal and informal sources of credit? • Unfair blackmail: Informal sources do not have a code of conduct and lenders can easily exploit borrowers. They can use any illegal means to recover their loans. They can use their muscle power to recover loans.

On the other hand, formal sources use only legal means in their actions. Figure 2: What percentage of all loans taken out by urban households were formal and what percentage were informal? Second, while credit to the formal sector needs to be expanded, it is also necessary for everyone to receive these loans. Currently, it is the richest households that receive formal loans, while the poor depend on informal sources. It is important that formal credit be distributed more evenly so that the poor can benefit from cheaper loans. There is no organization that oversees lenders` loans in the informal sector. They can lend at any interest rate they choose. No one is stopping them from using unfair means to get their money back. • Promote economic growth: the potential for savings and the increase in the existing capital stock allow economic development. The expansion of credit through the process of credit creation of commercial banks also allows the economic growth of the country.

The formal source of credit includes all sources of borrowing from institutions that operate under RBI guidelines or are carried out under certain rules. They are more reliable than informal sources. Banks and cooperatives are the main sources of formal credit. Loans are the most important element needed to enable the country`s economic development. The availability of cheap and affordable credit is crucial to promote the economic development of any country. The fundamental importance of money and credit in the economy can be summarized as follows: Figure 2 shows the importance of formal and informal sources of credit for people living in urban areas. People are divided into four groups, from the rich to the poor, as shown in the figure. You can see that 85% of loans taken out by poor households in urban areas come from informal sources.

Compare that to wealthy urban households. What do you think? Only 10% of their loans come from informal sources, while 90% come from formal sources. A similar trend can also be observed in rural areas. Rich households take out cheap loans from formal lenders, while poor households have to pay a large amount to borrow. 4. Why do you think the share of loans in the formal sector is higher for the richest households than for the poorest households? • A high interest rate: Informal sources such as lenders charge any interest rate that results in huge costs that borrowers have to repay, and lenders can easily exploit borrowers. On the other hand, formal sources have a fixed interest rate on different types of loans. The Reserve Bank of India oversees the operation of formal sources of credit. For example, we have seen banks maintain a minimum cash balance from the deposits they receive. The RBI supervises the banks in the effective maintenance of the cash balance. Similarly, the RBI finds that banks lend not only to profitable businesses and traders, but also to small producers, small industries, small borrowers, etc. At regular intervals, banks must provide the RBI with information about how much they lend, to whom, at what interest rate, etc.

• Less savings: Informal sources such as lenders charge each interest rate, resulting in huge costs that borrowers have to repay, and lenders can easily exploit borrowers. Thus, they would have less income after the repayment of their loans. Thus, the savings made with them would be minimal. • Encourages investment: From a development perspective, another important role of money is to make the level of investment regardless of the current level of savings. The greater the current savings, the greater the investment. The credit that households, businesses and government save is part of investment and further promotes economic development. (a) Loans granted by banks and cooperative institutions are referred to as the formal credit sector. Most loans from informal lenders have a very high interest rate and do little to increase borrowers` income. It is therefore necessary for banks and cooperatives to increase their lending, especially in rural areas, in order to reduce dependence on informal sources of credit.

For these reasons, banks and cooperatives need to lend more. This would lead to higher incomes and many people would then be able to borrow money at a lower cost for a variety of needs. They could cultivate, do business, build small industries, etc. They could build new industries or trade goods. Cheap and affordable loans are crucial for the country`s development. . b) They are not supervised by the Reserve Bank of India – RBI. . . .

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