Credit

Credit is the trust which allows one party to provide money or resources to another party where that second party does not reimburse the first party immediately generating a debt, but instead promises either to repay or return those resources (or other materials of equal value) at a later date. In other words, credit is a method of making reciprocity formal, legally enforceable, and extensible to a large group of unrelated people.

The resources provided may be financial, examples, granting a loan, or they may consist of goods or services. Credit is extended by a creditor, also known as a lender, to a debtor, also known as a borrower.

Credit does not necessarily require money. The credit concept can be applied in barter economies as well, based on the direct exchange of goods and services. However, in modern societies, credit is usually denominated by a unit of account.

When a bank creates credit, it effectively owes the money to itself. If a bank issues too much bad credit (those debtors who are unable to pay it back), the bank will become insolvent; having more liabilities than assets. That the bank never had the money to lend in the first place is immaterial - the banking license affords banks to create credit - what matters is that a bank’s total assets are greater than its total liabilities, and that it is holding sufficient liquid assets - such as cash - to meet its obligations to its debtors. If it fails to do this it risks bankruptcy.

There are two main forms of private credit created by banks; unsecured (non-collateralized) credit such as consumer credit cards and small unsecured loans, and secured (collateralized) credit, typically secured against the item being purchased with the money (house, boat, car, etc.). To reduce their exposure to the risk of not getting their money back (credit default), banks will tend to issue large credit sums to those deemed credit-worthy, and also to require collateral; something of equivalent value to the loan, which will be passed to the bank should the debtor fail to meet the repayment terms of the loan. In this instance, the bank uses sale of the collateral to reduce its liabilities. Examples of secured credit include consumer mortgages used to buy houses, boats etc., and PCP (personal contract plan) credit agreements for automobile purchases.