Understanding credit

Credit is the most important part of the economy. Ray Dalio, founder of the investment firm Bridgewater Associates, describes it as a transaction between a lender and a borrower, in which the borrower promises to pay back the money in the future along with interest.

Credit leads to an increase in spending, thus increasing income levels in the economy. This in turn leads to higher GDP (gross domestic product) and thereby faster productivity growth. If credit is used to purchase productive resources, it helps in economic growth and adds to income. Credit further leads to the creation of debt cycles.

Understanding the Role of Credit In The Economy

Impact on US banks

Banks are majorly impacted by credit growth in an economy. This is because their primary business is to provide loans to customers in return for interest payments. As an economic environment improves and customers are more willing to spend, demand for credit grows. This is advantageous for banks, as it leads to more loans being provided and an increase to interest incomes.

In the last few quarters, US banks have been direct beneficiaries of rising credit demand backed by historically low interest rates. Year-over-year, consumer credit has grown 7.02% in 2Q15. Since 2013, it has been growing at an average rate of 6.67%.

Banks like Wells Fargo (WFC), JPMorgan Chase (JPM), Bank of America (BAC), and Citigroup (C) stand to benefit from rising credit demand. Investors looking for diversified exposure to banks could invest in the Financial Select Sector SPDR ETF (XLF).

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