Key differences between Internal and External Credit

Internal credit refers to the credit facilities or borrowing arrangements provided within an organization, institution, or system without involving external financial intermediaries such as banks or lending agencies. It is essentially a mechanism where credit is extended through internal resources, reserves, or inter-departmental arrangements to meet operational, financial, or developmental needs. For example, cooperatives, large corporations, and government bodies often maintain internal credit systems to support their members, employees, or subsidiaries. The purpose of internal credit is to ensure liquidity, smooth cash flow, and financial flexibility while reducing dependency on external borrowings. It also allows for quicker approvals, lower transaction costs, and more trust-based lending. Internal credit strengthens organizational stability, ensures timely support, and promotes self-reliance in managing financial obligations.

Functions of Internal Credit:

• Credit Assessment and Underwriting

The primary function is to conduct a thorough, independent evaluation of a borrower’s creditworthiness. This involves analyzing financial statements, cash flow projections, industry position, and management competence to determine the Probability of Default (PD). The internal credit team uses this analysis to structure the facility—setting the amount, tenor, pricing, and covenants—ensuring the terms align with the perceived risk. This rigorous underwriting process is the first line of defense, aiming to make sound lending decisions that balance risk and reward before any funds are disbursed, thereby protecting the institution’s capital from the outset.

• Risk Rating and Pricing

A critical function is assigning an internal risk rating to each borrower. This rating, based on quantitative and qualitative factors, categorizes the risk level and directly influences the loan’s pricing. Higher-risk borrowers are assigned a higher rating, which translates to a higher interest rate to compensate for the increased risk. This systematic process ensures pricing is objective, risk-based, and consistent across the institution. It is fundamental to calculating the required return on economic capital and ensuring that the price charged adequately covers the loan’s expected loss and contributes to the institution’s profitability.

• Portfolio Monitoring and Management

Internal credit is responsible for the ongoing surveillance of the existing loan portfolio. This involves tracking borrowers’ financial health, monitoring compliance with covenants, and reviewing the adequacy of collateral. The team identifies early warning signs of deterioration and conducts periodic reviews to update risk ratings. This proactive monitoring allows for timely intervention, such as restructuring a stressed account before it defaults. By managing the portfolio’s overall health and concentration risks, this function aims to minimize credit losses and ensure the long-term stability and quality of the institution’s assets.

• Policy Development and Compliance

The internal credit department establishes the institution’s credit policy, defining its risk appetite, underwriting standards, and approval authorities. This framework ensures all lending activities are consistent, prudent, and aligned with strategic goals. The function also involves ensuring compliance with these internal policies as well as external regulatory requirements (like those from the RBI). By setting clear rules and monitoring adherence, this function maintains lending discipline, controls risk-taking behavior, and protects the institution from losses due to unstructured or non-compliant credit decisions, thereby upholding the integrity of the credit process.

• Stress Testing and Provisioning

This forward-looking function involves assessing the portfolio’s resilience under adverse economic scenarios. Internal credit teams run stress tests to estimate potential losses if unemployment rises, GDP falls, or interest rates increase. The results inform strategic decisions about capital buffers and risk appetite. Furthermore, based on the risk ratings and expected loss models, the team calculates and recommends provisions for potential loan losses. This ensures the institution’s financial statements accurately reflect the risk in its portfolio and that it sets aside sufficient capital to absorb future losses, a key requirement of accounting standards like Ind AS 109 or IFRS 9.

External Credit:

External credit refers to funding obtained by a borrower from outside sources, distinct from internal generation or retained earnings. This includes loans from banks, debt instruments like bonds issued to public or private investors, and commercial paper. It encompasses both fund-based facilities (direct cash infusions) and non-fund-based facilities (like guarantees). The cost and terms are determined by the lender’s assessment of the borrower’s creditworthiness. External credit is essential for financing growth, investments, and working capital, but it increases leverage and creates a legal obligation for repayment, introducing financial risk to the borrower’s balance sheet.

Functions of External Credit:

• Capital Formation and Business Growth

External credit’s primary function is to provide the capital necessary for businesses to invest and expand beyond their internal cash generation limits. It funds critical activities like purchasing new machinery, expanding facilities, entering new markets, and financing large-scale projects. This injection of capital enables companies to pursue growth opportunities they could not afford with equity or retained earnings alone. By bridging the gap between business ambition and available resources, external credit acts as a catalyst for economic development, job creation, and innovation. It allows firms to achieve scale and competitiveness, driving both corporate and national economic growth by mobilizing savings into productive investments.

• Working Capital Management

A vital function is financing the operating cycle—the gap between paying for raw materials and receiving cash from customers. External credit facilities like cash credit, overdrafts, and bill discounting provide the essential liquidity for day-to-day operations. They fund inventory holding, cover accounts payable, and bridge temporary cash flow shortfalls. This ensures business continuity, prevents operational disruptions, and allows companies to take advantage of supplier discounts or meet sudden spikes in demand. Effective working capital financing through external credit is crucial for maintaining solvency and operational efficiency, enabling smooth business functioning irrespective of cash flow timing mismatches.

• Leverage and Return on Equity Enhancement

External credit allows business owners to use leverage to amplify their returns. By using debt financing, a company can undertake a larger volume of business than its equity base would permit. If the return generated from the borrowed funds exceeds the cost of debt, the surplus accrues to the equity shareholders, thereby increasing the Return on Equity (ROE). This function of “trading on equity” is a powerful tool for wealth creation, optimizing the capital structure. It enables promoters to retain control without diluting ownership while potentially achieving higher profitability, making it a key strategic financial management tool.

• Risk Mitigation for Creditors (Credit Enhancement)

External credit functions within a structured framework designed to protect the lender. This includes rigorous credit appraisal, stipulation of covenants, and obtaining collateral. Covenants act as early warning systems, allowing lenders to intervene if the borrower’s financial health deteriorates. Collateral provides a recovery avenue in case of default. These risk mitigation tools enable lenders to extend credit to a wider range of borrowers by securing their interests. This function is essential for the stability of the financial system, as it allows for the prudent distribution of credit while managing the inherent risk of default.

• Economic Stability and Monetary Policy Transmission

On a macro level, external credit is a key channel for transmitting central bank monetary policy. When a central bank adjusts interest rates, it influences the cost and availability of external credit from commercial banks. This, in turn, stimulates or restrains investment and consumption spending in the economy. Furthermore, a well-functioning external credit market ensures the efficient flow of funds from savers to borrowers, promoting economic stability and growth. It allows for consumption smoothing over time for individuals and facilitates capital allocation to its most productive uses across the economy, underpinning overall financial stability.

Key differences between Internal Credit and External Credit