Template:M intro pb lending and financing

A distinction we make less of than we might in the capital markets in the one between lending — the outright extension of credit — and financing — providing money against rights to an asset of greater value.

We tend to treat asset financing as a special case of lending — a sort of safer lending, with recourse to the asset should the borrower fail — and as a fundamentally different thing to outright investment in return for a share of profits.

Lending and financing is debt; investment is equity. This is a fundamental divide.

We draw this distinction because we are accustomed to think of capital deployment in terms of return. The expected returns at maturity — that is, without considering the risk the borrower will fail in the mean time — from lending and financing are similar and are calculated by reference to an independent index that has nothing to do with the borrower: an interest rate.

This can be either a fixed or interest-rate dependent. (Being term arrangements, any interim market moves not explained by interest rates are credit questions and therefore present value assessments of risk and not return).

An equity investment has no term and pays variable return. A decline in share price is a measure of the return of the instrument and not, properly regarded, a reflection of the risk of default (though it may be correlated with it). Since it does not have a term, there is no par value for a share. It's value on sale is a reflection of its return with one exception, where the issuer is outright bankrupt. A company’s failure to meet a target share price or analysts expectations is not in any sense a default on the contractual obligation represented by a share until the company is actually bankrupt.

You could — and herein JC does — make an argument that outright lending and owning are more closely aligned, and they are different from asset financing, which includes much capital markets activity we do not usually think of as lending of any kind.

Lending is an outright allocation of capital, apropos nothing, against an expectation of a return. A lender assumes the borrower’s bare credit risk.

Financing involves the outright assumption of market risk against an asset. As long as that asset holds up, the borrower’s prospects don’t come into it.

To be sure, in a financing there is always a “second-loss” risk exposure to the borrower if the asset does collapse in value between margin calls — so there is residual credit risk — but it remains fully contingent on that asset failure, and is in turn a failure of the financier’s market risk management rather than credit risk management per se.

We can distinguish between financing, as a bilateral transformation of asset values between parties on the one hand — I give you cash in return for an asset you give me, with the expectation that we will reverse this exchange at a later date — and investment, as an outright transfer of capital on the other — I give you cash in return for your payment of a return on my investment, which may be interest and an agreement to repay principal at a later date (if debt) or a proportional share the return on your business (if equity). While they are different in some regards, these are both outright investments of capital: where they sit in the borrower’s capital structure is a second-order distinction which, at the limit, breaks down: in an insolvent/distressed credit, shareholders are wiped out so the bondholders are effectively in the same position as shareholders — hence the concept of the debt-for-equity swap.)

Characteristics

The key difference between financing and lending arrangements is collateral: a financing arrangement involves the upfront exchange of money for goods of equal or even greater value and thereafter margin adjustments to take account of fluctuations in the value of the asset exchanged. Under a securities financing, for example, there will be a margin flow each day reflecting the move in the value of the financed assets. Done

Originally, swap transactions were something of a hybrid in that there was an initial exchange albeit synthetic but there was not necessarily any margining arrangement thereafter. Therefore a financing arrangement could morph into a lending arrangement if the underlying asset appreciated or depreciated enough in value.

It was not long before collateralisation was introduced to the ISDA — credit support annexes were published a couple of ears after the 1992 ISDA in the mid 1990s and while these were optional arrangements, often structured as one-way margining obligations in favour of the swap dealer, after the global financial crisis of 2008 bilateral variation margining became a regulatory requirement. Most swaos these days are fully margined both ways. This is not always a good thing.

Examples of lending

• Deposit taking
• Traditional lending
• Uncovered bond investments
• Equity investments

Examples of financing

• Repo
• Securities lending
• Swaps
• Securitisation
• Prime brokerage
• Project finance

On this view most capital markets activity (repos, securities lending, derivatives, securitisation and structured financing) is fundamentally financing — while the traditional banking book (corporate lending, consumer credit) represents true capital allocation. Notably initial public offerings — also a form of capital injection — tend to be managed and underwritten by banks, but placed into the market.

Note that bonds and stocks themselves, as they are “securitised” can in turn be financed. This is what the prime broker does.