NCERT · Class 10 · Social Science · Economics: Money and CreditExplain the two major sources of formal and informal credit in India. What are the major differences between them and why is it important for the poor to get more credit from formal sources?

Introduction to Credit Sources\nCredit (loan) refers to an agreement in which the lender supplies the borrower with money, goods, or services in return for the promise of future repayment. In India, credit sources are broadly classified into two categories: formal sources and informal sources.

1. Formal Sources of Credit

• Definition: Formal sources of credit include loans from banks and cooperatives.
• Supervision: The Reserve Bank of India (RBI) supervises the functioning of formal sources. RBI monitors the banks to maintain a minimum cash balance and ensures they give loans not just to profit-making businesses but also to small cultivators, small-scale industries, and borrowers.
• Interest Rates: They generally charge a lower rate of interest compared to informal sources.
• Collateral: They require collateral (security against loans) and proper documentation.

2. Informal Sources of Credit

• Definition: Informal sources include moneylenders, traders, employers, relatives, and friends.
• Supervision: There is no organization that supervises the credit activities of lenders in the informal sector. They can lend at whatever rate they choose.
• Interest Rates: They charge very high rates of interest, which does not benefit the borrower.
• Collateral: Terms of credit are often flexible, and sometimes loans are given without formal collateral, but the exploitation is high.

Why Poor Need More Formal Credit

• Debt Trap: Informal lenders charge very high interest rates, leading to a situation called a debt trap. The high cost of borrowing means a larger part of the earnings is used to repay the loan, leaving little for livelihood.
• Income Growth: Cheap and affordable credit from formal sources is crucial for the country's development and for enabling poor households to increase their incomes by starting small businesses or farming without the fear of exploitation.
• Reduction of Dependence: Expanding formal credit reduces the dependence on traditional moneylenders who often exploit vulnerable sections of society.