Q. 163.7( 3 Votes )

Why are formal so

Answer :

Formal source of credit includes all the sources for raising the credit from the institutions which are functioning under the guidelines of RBI or which are performed with specific rules. They are more reliable than informal sources. Banks and cooperatives are the main formal sources of credit.

The credit from the informal source is getting loans from institutions that do not come under the purview of any legal entity. Credit from these sources moneylenders, friends, relatives, traders, employers…etc. can be said as informal sources of credit.

Formal sources of credit are always preferred over informal sources because:

A high rate of interest: The informal sources like moneylenders will charge any rate of interest which will lead to huge cost the borrowers to repay and lenders can easily exploit the borrowers. On the other hand, the formal sources have a fixed rate of interest for different types of loans.

Fewer savings: The informal sources like moneylenders will charge any rate of interest which will lead to huge cost the borrowers to repay and lenders can easily exploit the borrowers. Thus only less income would be left with them after paying their loans back. Thus the savings with them would be minimal.

Unfair means of extortion: The informal sources will not have any code of conduct and lenders can easily exploit the borrowers. They can use any illegal means to get their loans back. They may use their muscle power for the collection of loans. On the other hand, formal sources use only legal means in their dealings.


Credit is the most significant component required for enabling economic development in the country. The availability of cheap and affordable credit is crucial for promoting the economic development of any country. The basic importance of money and credit in the economy can be summarised as:

• Promotes investment: From the viewpoint of development, another important role of money lies in making the magnitude of investment independent of the current level of savings. The greater the current savings, the greater the investment. The credit that the households, firms and government saves become pat part of the investment and further promoted economic development.

Credit creation: One of the main functions of the commercial bank is credit creation. It is the banks that create credit for the producers to invest in the economy. The banks make the credit available by accepting the deposit from the people. The investment of the investors makes the economy better off and investment is made available by the bank.

Promote economic growth: The saving potential and the addition to the existing stock of capital enables economic development. The expansion of credit through the credit creation process of the commercial banks also enables the economic growth in the country.

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