FORMS OF CREDIT: AN OVERDRAFT FACILITY (1)

Study Unit FORMS OF CREDIT: AN OVERDRAFT FACILITY (1)

(A) WHAT IS AN OVERDRAFT? An overdraft is a form of borrowing from a bank that is available to private individuals and to businesses. An overdraft varies from a loan in several important ways. When a bank allows a customer an overdraft facility, the bank gives that customer permission to withdraw more money from his or her current account than he or she has in it. This means that the customer’s bank balance goes below zero. This is known formally as the account being ‘overdrawn’ and informally as the account being ‘in the red’. If the balance of the bank account is positive, it is known formally as being ‘in credit’ and informally as being ‘in the black’. This kind of debt can be described as an authorised overdraft where there is a pre-existing arrangement with the bank, or possibly as an unauthorised overdraft, as UK banks allow customers to run up unauthorised debt in some circumstances.

An overdraft from a retail bank, meaning a bank that offers banking services to individuals and small businesses, is usually just to tide someone over a short period of financial difficulty and it is typically for a comparatively small sum, for example, an overdraft with a limit of £2,000 for a term of one year. During this period of time the account holder is not bound by any restrictions or obligations concerning withdrawals and can dip into the overdraft as and when required. Unlike a loan, 100% of the debt is repayable at the end of the term rather than requiring repayment by regular instalments over a fixed term. This gives the borrower more flexibility but can lead to him or her having to find the total amount of the debt in a lump sum at the end of the term if the overdraft facility is not renewed by the lender. The other major drawback of an overdraft is that the lender can call in the full amount of the debt at any time.

(B) THE WORLD’S FIRST OVERDRAFT The information below is about a historical document. It concerns the origins of the concept of the overdraft. The first overdraft in the world was granted by The Royal Bank of Scotland in 1728. The information is about the historical book that recorded the event and the effect that the creation of the overdraft had on the economy of Scotland at the time.

“This book, the first volume of directors’ minutes of The Royal Bank of Scotland, records how in May 1728 Edinburgh merchant William Hog and his bank came up with a new way to stabilise his working capital, by agreeing in advance that whenever he needed to do so, Hog could temporarily take more money from his account than he held in it. William Hog thus became the world’s first recipient of a cash credit, the forerunner of the modern overdraft.

Like many merchants, both before him and since, Hog found that he had a problem; his business finances were made up of payments received and payments made, but these two sides of the deal did not always happen in the most convenient order. Often, he would be required to pay bills before his own bills had been paid, leaving him out of pocket. In 1728, The Royal Bank of Scotland was uniquely well-placed to begin offering this new facility. Unlike its older rival Bank of Scotland, it was only a year old, and therefore held in its coffers large quantities of shareholder money that it had not yet had a chance to invest. Cash credits were a good way to get that money out into the community, helping customers while earning interest for the bank.

The new service was helpful for existing businessmen, but indispensable for those wishing to start up new enterprises. Conventional loans had to be backed by some kind of security, but the new cash credits required only the bond of the applicant and two or more men who were prepared to vouch for him. In the small business community of 1720s Edinburgh, it was easy enough for the bank to know who it was dealing with, and the risk of the applicant and his guarantors all letting down the bank was fairly small. Many new businesses came into being thanks to the cash credit. Their success in turn made a huge contribution to the economic growth of Edinburgh and the whole of Scotland. Even the philosopher David Hume (1711-76), who was in general no fan of banking, appreciated the benefits the cash credit had brought to Scotland, describing it as ‘one of the most ingenious ideas that has been executed in commerce’. ”