Let us take the story of banks further. What do the banks do with the deposits which they accept from the public? There is an interesting mechanism at work here.
Banks keep only a small proportion of their deposits as cash with themselves. For example, banks in India these days hold about 15 percent of their deposits as cash. This is kept as a provision to pay the depositors who might come to withdraw money from the bank on any given day.
Since, on any particular day, only some of its many depositors come to withdraw cash, the bank is able to manage with this cash. Banks use the major portion of the deposits to extend loans. There is a huge demand for loans for various economic activities. We shall read more about this in the following sections.
Banks make use of the deposits to meet the loan requirements of the people. In this way, banks mediate between those who have surplus funds (the depositors) and those who are in need of these funds (the borrowers). Banks charge a higher interest rate on loans than what they offer on deposits. The difference between what is charged from borrowers and what is paid to depositors is their main source of income.
A large number of transactions in our day-to-day activities involve credit in some form or the other. 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. Let us see how credit works through the following two examples.
It is festival season two months from now and the shoe manufacturer, Salim, has received an order from a large trader in town for 3,000 pairs of shoes to be delivered in a month time. To complete production on time, Salim has to hire a few more workers for stitching and pasting work. He has to purchase the raw materials. To meet these expenses, Salim obtains loans from two sources.
First, he asks the leather supplier to supply leather now and promises to pay him later. Second, he obtains a loan in cash from the large trader as an advance payment for 1000 pairs of shoes with a promise to deliver the whole order by the end of the month. At the end of the month, Salim is able to deliver the order, make a good profit, and repay the money that he had borrowed.
In this case, Salim obtains credit to meet the working capital needs of production. The credit helps him to meet the ongoing expenses of production, complete production on time, and thereby increase his earnings. Credit, therefore, plays a vital and positive role in this situation.
Mohan, a small farmer, grows groundnut on her three acres of land. he takes a loan from the moneylender to meet the expenses of cultivation, hoping that her harvest would help repay the loan. Midway through the season, the crop is hit by pests and the crop fails.
Though Mohan sprays her crops with expensive pesticides, it makes little difference. he is unable to repay the moneylender and the debt grows over the year into a large amount. Next year, Mohan takes a fresh loan for cultivation. It is a normal crop this year. But the earnings are not enough to cover the old loan. he is caught in debt. he has to sell a part of the land to pay off the debt.
In rural areas, the main demand for credit is for crop production. Crop production involves considerable costs on seeds, fertilizers, pesticides, water, electricity, repair of equipment, etc. There is a minimum stretch of three to four months between the time when the farmers buy these inputs and when they sell the crop. Farmers usually take crop loans at the beginning of the season and repay the loan after harvest. Repayment of the loan is crucially dependent on the income from farming.
In Mohan’s case, the failure of the crop made loan repayment impossible. He had to sell part of the land to repay the loan. Credit, instead of helping Mohan improve her earnings, left her worse off. This is an example of what is commonly called a debt trap. Credit in this case pushes the borrower into a situation from which recovery is very painful. In one situation credit helps to increase earnings and therefore the person is better off than before.
In another situation, because of the crop failure, credit pushes the person into a debt trap. To repay her loan she has to sell a portion of her land. he is clearly much worse off than before. 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.