33. Credit market: functions, participants, instruments, indicators.

Credit is a contractual agreement, in which a borrower receives something of value now, with the agreement to repay the lender at some date in the future.

Without credit facilities many firms would not be in existence today. Such money sought by business is used to invest in its future prosperity by purchasing assets, such as plant, machinery, etc. In addition to its capital it also requires short-term finance and this usually obtained from suppliers.

The ultimate purpose of a commercial enterprise must therefore, be to make profits, and as the business world revolves around credit, achieving this objective not only maintains the equilibrium by enabling an enterprise to meet its commitments, it also encourages expansion, providing of course nothing untoward happens to upset the market.

The credit function providing a continuing supply of credit for businesses, consumers, and governments to support both consumption and investment spending in the economy. Business, government, and the consumer depend upon credit. Business uses short-term credit to finance inventories and long-term credit to expand its plants and equipment. For the consumer and the government, credit is also indispensable.

Forms of loans

Credit may also be classified as to whether it is extended on the basis of formal documents called credit instruments. Credit instruments are formal documents drawn up as evidence of credit. They are two types: promises to pay and orders to pay. Commercial banks and other financial institutions create credit, sometimes as creditors sometimes as debtors. Their principal assets are credit instruments, which they buy and sell. By using one type of credit instrument (checks), the public continuously changes the ownership of the credit liabilities of the commercial banks (demand deposits).

There are two kinds of promises to pay; notes, which are concerned with short-term credit, and bonds, which usually involve long-term credit.

A mortgage is a document pledging some specified property to a creditor as security for the payment of debt.

Instead of being in the form of a promise to pay, a credit instrument may be an order to pay. Orders to pay are called drafts.

Types of Loans

• Secured

A secured loan is a loan in which the borrower pledges some asset (e.g. a car or property) as collateral for the loan.

A mortgage loan is a very common type of debt instrument, used by many individuals to purchase housing. In this arrangement, the money is used to purchase the property. The financial institution, however, is given security — a lien on the title to the house — until the mortgage is paid off in full. If the borrower defaults on the loan, the bank would have the legal right to repossess the house and sell it, to recover sums owing to it.

• Unsecured

Unsecured loans are monetary loans that are not secured against the borrowers assets. These may be available from financial institutions under many different guises or marketing packages:

• credit card debt

• personal loans

One of the forms of credit is personal loans. The purpose of this credit is to grant the money or the goods to the people with agreement to pay them back in some particular period of time. The borrowers are physical people (физические лица), and the lenders are credit organizations. The personal lending can be given in money form as well as in goods. In countries with market economy, personal lending is both convenient and profitable form of serving the population; and it plays an important role in the economy.

• bank overdrafts

• credit facilities or lines of credit

• corporate bonds

Loans

The principal business of commercial hanks is to make loans to qualified borrowers. Loans are among the highest yielding assets a bank can add to its portfolio, and they pro­vide the largest portion of operating revenue.

Banks make loans of reserves to oilier banks through the federal funds market and to securities dealers through repurchase agreements. Far more important in dollar volume, however, are direct loans to businesses and individuals. These loans arise from negotia­tion between the bank and its customer and result in a written agreement designed to meet the specific credit needs of the customer and the requirements of the bank for ade­quate security and income.

A substantial portion of bank credit (nearly 20 percent of all bank assets) is extended to commercial and industrial customers in the form of direct loans. Historically, commercial banks have preferred to make short-term loans to busi­nesses, principally to support purchases of inventory. In recent years, however, banks have lengthened the maturity of their business loans to include term loans (which have maturities over one year) to finance the purchase of buildings, machinery, and equip­ment. Because these longer-term loans carry greater risk due to unexpected changes in interest rates, banks have also required a much greater proportion of new loans to carry variable interest rates that can be changed with shifting market conditions.

Moreover, longer-term loans to business firms have been supplanted to some extent in recent years by equipment leasing plans available from larger banks and the sub­sidiaries of bank holding companies. These leases are the functional equivalent of a loan: the customer not only makes the required lease payments for using the equipment but also is responsible for repairs and maintenance and for any taxes due. Lease financing carries not only significant cost and tax advantages for the customer but also substantial tax advantages for a bank because it can depreciate leased equipment.

Commercial banks are also important lenders in the real estate field, supporting the construction of residential and commercial structures. Major types of loans in the real estate category include farm real estate credit, conventional government-guaranteed (FHA and VA) single-family residential loans, conventional and government-guaranteed loans on multifamily residences (such as apartments), and mortgage loans on nonfarm commercial properties. Indeed, commercial banks are the most important source of con­struction financing in the economy.

Probably the most dynamic area in bank lending today is the making of installment loans to individuals and families, particularly loans secured by a property owner's equity in his or her home, so-called home equity loans, whose interest costs are tax deductible to the home owner and borrower. Home equity loans can be used to finance a college edu­cation or to pay down other debts, or they can be used for a variety of needs not related to housing. The number of new households has expanded rapidly in recent years, and commercial banks have moved to answer this need by offering longer maturities on installment loans and new types of credit arrangements, especially credit-card loans. Banks finance the purchase of automobiles, home furnishings, and appliances and pro­vide funds to modernize homes and oilier properties and to pay for education and travel. There is growing concern today that consumer loans, particularly of the credit-card variety, are becoming more risky for banks due to an upsurge in default rates on credit-card loans. Unemployment and a slowly growing economy account for part of this trend, but probably as important is growing competition from nonbank lenders, such as American Telephone and Telegraph Co. (AT&T), which announced its own credit-card program as the 1990s began. This intense competition has encouraged many banks to give credit cards to customers who may have little or no credit history, some of whom turn out to be poor credit risks.

Source 2:

Loans. Loans are the principal income-producer for commercial banks. There are several categories of bank loans. The most important quantitatively is loans to commerce and industry—i.e., business loans. Banks regard such loans as high-priority items. More than half of all demand deposits in commercial banks are held by firms, and individual bankers feel a strong compulsion to accommodate business borrowers in order to avoid alienation and possible loss of important deposit accounts. The interest rate charged to major business borrowers with excellent credit ratings is known as the "prime rate," and is a widely publicized interest rate.

Other types of loans which are quite important quantitatively include real estate loans and loans to individuals. Real estate loans consist of long-term mortgages on residential properties, farms, and business properties. Also included in this group are short-term loans to building contractors, generally paid off when the property is completed and sold. Banks employ several arrangements to grant loans to individuals, commonly known as consumer loans. Banks may lend directly to consumers, or purchase paper (lOU's) issued by finance companies which use the proceeds obtained to make consumer loans. Rapidly growing factors in the consumer credit area are the use of bank credit cards and overdraft arrangements, sometimes known as "instant credit" privileges. These items, ushered in by the record-keeping efficiency of the computer, are essentially methods of providing automatic credit access. Customers to whom banks issue credit cards, such as Master Charge and Bankamericard, obtain a line of credit from any business which belongs to the plan. Such customers may also obtain cash advances from any of thousands of banks which belong to the plan. Customers who have been granted "instant credit" or overdraft privileges may obtain automatic credit by writing checks in excess of demand deposit balances.

Other types of loans granted by banks include loans to financial institutions, loans to dealers, brokers, and individuals to purchase and/or carry securities, loans to farmers, and federal funds sold. Federal funds sold refers to commercial bank deposits at the Federal Reserve which have been loaned to other banks. Its counterpart, federal funds bought (i.e., borrowed), is a major component of the "borrowings" item on the liability side of the bank balance sheet.