The Credit Market

Introduction to the credit market

The credit market is a broad financial market where borrowers and lenders engage in the exchange of funds, typically in the form of loans, bonds, or credit instruments. It plays a critical role in the economy by facilitating the flow of capital from entities with surplus funds (lenders) to those in need of funds (borrowers). The credit market can be divided into several segments, each with its own characteristics, participants, and instruments. Financial institutions are the backbone of the credit market, providing the necessary infrastructure for lending and borrowing, managing credit risk, and ensuring the flow of capital in the economy. Each type of institution plays a specific role in supporting different segments of the market, from individual consumers to large corporations and governments.

Participants in the Credit Market

• Borrowers: These are entities that seek to obtain funds to finance various needs. Borrowers can be individuals, corporations, governments, or other institutions. They issue debt instruments like bonds or take out loans from financial institutions.
  • Individuals/Consumers: Typically borrow through credit cards, personal loans, mortgages, auto loans, and student loans.
  • Corporations: Borrow through bank loans, corporate bonds, commercial paper, and lines of credit to finance operations, expansions, or acquisitions.
  • Governments: Borrow through government bonds, treasury bills, and notes to finance public spending and infrastructure projects.
• Lenders: These are entities that provide the funds to borrowers. Lenders can be banks, financial institutions, insurance companies, investment funds, or individual investors.
  • Banks and Financial Institutions: Provide various forms of loans and credit to consumers, businesses, and governments.
  • Investors: Purchase debt instruments like bonds, providing funds to borrowers in exchange for periodic interest payments and the return of principal at maturity.
  • Pension Funds, Insurance Companies, Mutual Funds: Often invest in bonds and other credit instruments as part of their investment portfolios.

Segments of the Credit Market

• Consumer Credit Market:
  • Involves lending to individuals for personal use. The primary instruments include credit cards, personal loans, auto loans, and mortgages. This market is heavily influenced by factors such as interest rates, consumer confidence, and employment levels.
• Corporate Credit Market:
  • Involves lending to businesses and corporations. Companies access credit through bank loans, corporate bonds, commercial paper, and revolving credit facilities. The health of the corporate credit market is closely tied to economic conditions, corporate earnings, and market interest rates.
• Government Credit Market:
  • Governments borrow funds to finance their spending and investment programs. This market includes instruments like government bonds, treasury bills, and municipal bonds. Government borrowing is influenced by fiscal policies, economic conditions, and central bank policies.
• Mortgage Market:
  • A significant segment of the credit market, where individuals borrow to finance the purchase of real estate. The mortgage market includes various loan products, such as fixed-rate mortgages, adjustable-rate mortgages, and home equity loans. This market is heavily influenced by interest rates, housing market conditions, and regulatory policies.
• Syndicated Loan Market:
  • Involves large loans provided by a group of lenders (a syndicate) to a single borrower, typically a corporation or government. These loans are used for significant capital projects, mergers, or acquisitions.

Credit Instruments in the Market

• Loans:
  • Direct lending agreements between a lender and a borrower, typically provided by banks or financial institutions. Loans can be secured (backed by collateral) or unsecured, with varying terms and interest rates.
• Bonds:
  • Debt securities issued by corporations, governments, or other entities. Bondholders are lenders who receive periodic interest payments (coupon payments) and the return of the principal at maturity. Bonds can be categorized as corporate bonds, government bonds, municipal bonds, and junk bonds, among others.
• Commercial Paper:
  • A short-term, unsecured promissory note issued by corporations to finance their short-term liabilities. Commercial paper typically has a maturity of less than 270 days and is a cheaper alternative to bank loans for large companies.
• Credit Derivatives:
  • Financial instruments used to manage or transfer credit risk between parties. Examples include credit default swaps (CDS), which provide protection against the default of a borrower.
• Securitized Debt Instruments:
  • Debt instruments that pool various types of loans, such as mortgages or auto loans, and sell them as securities to investors. Examples include mortgage-backed securities (MBS) and asset-backed securities (ABS).

Factors Influencing the Credit Market

• Interest Rates:
  • The level of interest rates set by central banks and prevailing in the market heavily influences borrowing and lending activities. Higher rates typically reduce borrowing demand, while lower rates encourage it.
• Credit Risk:
  • The perceived risk of default by borrowers impacts the terms of credit, including interest rates and credit limits. Higher risk leads to higher interest rates or stricter borrowing terms.
• Economic Conditions:
  • The overall health of the economy, including factors such as GDP growth, inflation, and employment, affects both the supply and demand for credit.
• Regulation:
  • Government regulations and policies, such as capital requirements for banks or consumer protection laws, can impact the functioning and accessibility of the credit market.

Banks and Financial Institutions

1. Banks

Banks tailor their loan facilities/products to meet the needs of the customers. Most of Bank products are grouped into two broad categories which are Fund-Based and Non-fund Based. The facilities are further classified as Term Loan (project financing) and working Capital facilities.

The Term loans are sanctioned for both productive purposes to business and non-productive purposes e.g. personal loans, consumer loans, house loans, vehicle loans. Productive purposes include plant and machinery, furniture and fixtures etc. all for the purpose of capital investment to help the borrower meet the day today expenditure required for production of goods for sale. Working capital is based on operating cycle of a business.

In a loan account the entire amount is disbursed to the borrower in a single amount and an interest is charged either as a fixed interest or a floating rate. Fixed interest rate means that the same rate will be charged through the life of the facility while in a floating rate case, the interest rate is bound to change from time to time.

Categories of Bank Products

Fund-based facility implies that the banks funds are directly involved. Funds are either credited in the borrowers current account or paid to the parties from whom services were procured or assets. Examples are demand loans, term loans, overdrafts, cash credit, packing credit, bills purchased/discounted.

Non-Fund Based Facility is contingent in nature meaning the liability will arise at a future date on happening of an event. E.g. LC, bank guarantees.

Fund Based Facilities

1.   Demand Loan

It is an advance for a fixed amount repayable on demand.

2.   Term Loan/Hire Purchase

It is a loan advanced for acquisition of assets and equipment. It can be drawn in lump sum or in installments and is granted for a period in excess of 6 months and not exceeding seven years.

3.   Overdrafts

It’s a current account on which drawing limits have been sanctioned against security or without security. It is granted on short periods and is subject to a stipulated repayment programme.

Non-fund Based Facility

1. Letter of Credit

The Bank gives an undertaking on behalf of its customers to honor bills drawn under the letter of credit. They are referred to as a guarantee given to a seller by the bank on behalf of the buyer that on a given due date the seller will be paid the amount due. It is common in export credit. It’s a facility known as documents against acceptance. Payment is paid at a future date

2.   Bank Guarantees

It is a contract by the bank to perform the promise or discharge the liability of a third person in case of default. The bank is the guarantor or the surety customer is the principal debtor and the person to who guarantee is issued is called the beneficiary. Types of Guarantees are;

Types of Guarantees

1. Financial guarantee

A financial guarantee is a legal commitment made by a guarantor (often a bank, insurance company, or other financial institution) to assume responsibility for a borrower’s debt or obligations if the borrower fails to meet their payment obligations. In essence, it is a promise to cover the debt or financial liability of a borrower in the event of default.

1.   Performance guarantee

They are guarantees in respect of performance of a contract or obligation. In the event of non-performance the bank will make good the loss that will arise as a result of non-performance e.g. for non-supply, or short supply.

1.   Deferred payment guarantee

Bank guarantees repayment of an installment of loan/debt on behalf of its customer. They are issued by banks in favour of importers who import raw materials from foreign countries and the payment made by importers are normally in installment. If the installment is defaulted the guarantee is invoked. The bank guarantees payment of each installment as and when due.

Characteristics of Loan Products

1. Maturity
2.   Commitment specification- loan agreement
3.   Collateral requirement- security
4.   Purpose
5.   Repayment source- business/salary
6.   Repayment characteristics- fixed interest rate/floating interest rate Covenant requirement