Synopsis: This article discusses how lending works, its role in an economy, and how it contributes to the overall growth and development of the economy.
Lending, also known as financing, occurs when someone allows another person to borrow money, property, or any other valuable asset. This concept is by no means new. In fact, its genesis can be traced as far back as ancient Mesopotamia, when agricultural communities borrowed seeds and money with the promise of repayment post-harvesting crops.
Today, lending occurs whenever you swipe a credit card to pay for your meal, take out a student loan to attend a university, or apply for a business loan to launch a start-up.
How Does Lending Work?
Lending encapsulates varied kinds of transactions, with the final outcome being the repayment of debt. Lending is undertaken by financial institutions, including banks, that have historically accounted for most of the lending that occurs in our economy.
These institutions source surplus funds from savers in the form of deposits and lend them to borrowers for consumption, production, and investment purposes. This, in turn, leads to money creation. This credit expansion eventually leads to an increase in overall demand which further stimulates the production of goods, thus ushering in further growth and development of the economy.
To illustrate, assume a customer deposits Rs. 10 lakhs in a bank account. The bank then apportions, say 20%, i.e., Rs. 2 lakhs as reserves, that it is supposed to maintain as per central bank’s guidelines, and lends out the remaining Rs. 8 lakhs to a borrower. Further, assume that the money has been borrowed for buying a car and that the dealer will deposit this Rs. 8 lakhs into the bank. The bank, then again, apportions 20% of this as reserves and lends out the remaining 80%.
In this way, a bank can end up creating up to Rs 50 lakhs, also known as the multiplier effect. This final amount ends up assisting consumers or business owners in meeting their financing needs.
Banks play an important role in credit intermediation, as they not only lend the money directly to the end user but also lend indirectly through refinancing and by lending to other financial lending institutions. Banks facilitate commerce and extend various kinds of loans, namely wholesale, retail, consumer, industrial, etc.
How Does Lending Add Value to the Economy?
As Hahn (1920) puts it, “Capital formation is not the result of saving but of the granting of credit.” But the real value add happens when the borrower uses the loan money constructively.
A loan taken out for the creation of assets or for business expansion will add to the productive capital of the economy. A government taking out loans to fund social sector expenditure and building infrastructure will also generate wealth for the economy.
However, taking out loans for meeting regular expenses that go beyond sustenance needs is likely to create a debt burden instead.
To substantiate, Consumer Finance is provided to enable individuals to meet their needs, including funding education or meeting medical expenses. This leads to human capital formation and can even sow the seeds for entrepreneurship. Such loans end up expanding choices and opportunities for poor families, thus ensuring greater social mobility and an eventual leveling out of some of the endemic inequalities.
In addition to personal consumption, consumers may also take out mortgages for building homes, which further urbanizes the economy and results in asset creation. Interestingly, some of the home loan books in countries such as China and Vietnam are made up of loans for small vans and motorbikes instead. This implies such home credit can also be used by people to run their businesses.
At the business end, loans can be taken out for launching start-ups or for expanding existing businesses. Such capacity expansion enhances innovation and productivity, thus fueling the growth of the economy.
Banks additionally loan out amounts to other financial institutions such as NBFCs, HFCs, Microfinance institutions, and SHGs. These lenders ensure last-mile connectivity and strive to support consumers by providing them with short-term, small-ticket loans. Banks also arrange financing for leveraged investors, including hedge funds. These investors rely on their ability to borrow funds at low costs against securities to support their investments. These, along with venture capital and alternative investment funds, are responsible for funding new ideas and supporting the growth of new-age companies.
Credit also fuels economic activity by allowing governments to smooth out their spending by mitigating the cyclical pattern of tax revenues that plays out in tandem with business cycles. Additionally, governments issue bonds to fund infrastructure investment. They also provide guarantees for loans advanced to vulnerable sections of society, including SC/ST/women entrepreneurs. Credit is also extended to agriculturists, MSMEs, and other priority sector-based businesses, which are credit-starved but socially significant. Lately, loans are also being raised for meeting green and sustainable finance requirements.
Are Borrowing Needs Being Met?
In India, the bank credit to GDP (Gross Domestic Product) ratio has ranged from 51.9% in 2011-12 to 56% in 2020-21. This is unlike the case in advanced economies like the USA and China, where domestic credit to the real economy has gone up to nearly 200% of GDP. The US has a very active corporate market to finance credit needs-something that India has been struggling to develop. As a result, the Indian credit delivery mechanism has been lagging, thus dragging down both GFCF (Gross Fixed Capital Formation) and GDP growth.
However, things are beginning to look up in part due to the FinTech revolution. FinTech companies have been broadening their loan product offerings by tailoring them to customers’ needs. They are also collaborating and co-lending with other financial institutions to provide financial services efficiently at affordable costs.
India has the highest FinTech adoption rate globally (87%) and our FinTech industry is projected to reach US$ 150 billion by 2025. Alternate options also include crowdfunding and peer-to-peer (P2P) lending, which allows individuals to borrow from each other directly over RBI-regulated platforms. Decentralized finance (DeFi), which involves offering blockchain-based financial services, has also been expanding recently.
Bottom Line – Apply for a loan at Protium today!
Lending is pivotal to an economy’s growth, as loans can be utilized for financing expenditures on infrastructure development, developing new technologies, human capital formation, and meeting contingency needs. These loan repayments further instill a habit of saving among the masses, thus kick-starting a virtuous cycle of saving-loaning-investing in the economy.
Are you looking for loans to finance your business, education, or discretionary needs? Apply at Protium to avail of loans at attractive interest rates with minimal documentation. Call 8828827800 to find out more!