Template:M intro pb lending and financing: Difference between revisions

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


We draw this distinction in part because of a linguistic looseness around the word “borrow”, and in part because we are accustomed to think of capital investment chiefly in terms of its ''return'', and the return of an equity investment and return of a debt investment a very different.
We draw this distinction in part because of a linguistic looseness around the word “borrow”, and in part because we are accustomed to thinking of capital investment chiefly in terms of its ''return'' and not ''risk''. The return of an equity investment is very different to the return of a loan.
 
But their ''risk'' profiles of a loan and a share are similar, and closely correlated. And, from a [[legal eagle]]’s perspective, it is the ''risk'' of a investment that will cause us trouble, not its ''return''.
 
First, some terminology:
 
In an outright, unsecured ''loan'', the lender allocates capital to the borrower, ''apropos'' nothing, against an expectation of a payment by the borrower of a return. A lender assumes the borrower’s bare [[credit risk]].
 
In a ''financing'', the financier provide assumes the [[market risk]] of a third-party asset, against the payment of a financing rate. If the financed asset declines in value, the loan value is adjusted by means of a margin mechanism. As long as the asset doesn’t suddenly collapse, the borrower’s prospects don’t come into the risk assessment of a financing arrangement.


=====Linguistics looseness about borrowing=====
=====Linguistics looseness about borrowing=====
{{Drop|B|ankers use the}} word “borrow” in a strange way. In ordinary usage, it implies a transfer of possession but not ownership:  
{{Drop|B|ankers use the}} word “borrow” in a strange way. In ordinary usage, “borrowing” implies ''possession'' but not ''ownership'':  
{{Quote|
{{Quote|
“May I borrow your car for the weekend?”<br>
“May I borrow your car for the weekend?”<br>
“I have borrowed this book from the library.” }}
“I have borrowed this book from the library.”}}
We have possession and control of what we borrow against the rest of the world, but — by definition — not the lender. The lender owns it, always. If we did something strange like buy the car for the weekend and sell it back, we would not consider that a borrowing.
We have possession of what we borrow but the lender always ''owns'' it.


Things are different when it comes to banking. Firstly, because of its unique nature as an anti asset, you cannot borrow, in this ordinary sense, money. As long as you hold onto it, any money you borrow is yours absolutely. No one, including the lender, has a better claim to that money than you. If this was anything other than money, we would not call this a “borrowing”.
Borrowing is different when it comes to banking. Firstly, because money is an unownable [[anti-asset]], you cannot “borrow” it in this ordinary sense.  


Why do I mention this now? Because it rubs out one of the fundamental distinctions between a loan and a share investment. I am not “lending” you “my” money, with the expectation you will return it. Instead, I am investing money with you on terms that you will pay an equal amount of money (a bit more, actually) back.
Cash is special: as long as you hold it, no one, including the person who “lent” it to you, has any proprietary claim on that money. This follows because money cannot be ''owned'', only held. To “lend” money is to give it away absolutely against an enforceable promise from the recipient to pay not the ''same'' money, but an “[[equivalent]]” amount of ''any'' [[fungible]] money, back.  


That is, when I advance you a loan, I am not, in the ordinary sense, “lending” you my money. I am ''giving'' you my money for you to use in your business. In your hands the money I give you has no difference in quality from money and equity investor gives you in return for shares. The only difference is the return I agree to pay you.
If we were talking about anything other than money, ''we would not call this “borrowing”''.
=====Return metrics=====
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. We calculate them by reference to an independent index that has nothing to do with the borrower: an [[Interest|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).
Why mention this now? Because it rubs out one of the fundamental differences between a “loan” and an “investment”: the lender does not “lend” “her” money to the borrower, the same way she might lend her car. Rather, she ''gives'' money to the borrower on terms that the borrower will later pay back an equal sum, plus interest.


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.  
====Return metrics====
{{drop|T|he expected returns}} ''at maturity''<ref>Without considering the ''risk'' the borrower will not be able to repay</ref> from lending and financing are similar. We calculate them by reference to an independent index that has nothing to do with the borrower: an [[Interest|interest rate]].  


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.
By contrast an [[common equity|equity]] investment has no [[term]], no “par value” and pays a variable return. The rising or falling share price measures how the market values the business: that is the share’s “return metric”. A failure to beat a benchmark, reach a target or meet analyst’s expectations is still a return, just a disappointing one. It is correlated with the risk of business failure but is still not a “risk metric”. It is not a “default” on the contractual obligation the share represents. Only the company’s bankruptcy would be that and — well — too late.  


Lending is an outright allocation of capital, apropos nothing, against an expectation of a return. A lender assumes the borrower’s bare [[credit risk]].
You could — and I do — make an argument that ''outright lending'' and ''owning'' are more like to each other, and less like asset financing. Asset financing is more like the kind of capital market activity we do not usually think of as ''lending'' — [[prime brokerage]], [[swap]] trading, [[securities financing]] and [[futures]] trading.
 
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.


====Interlude: isn’t all lending a subcategory of financing?====
====Interlude: isn’t all lending a subcategory of financing?====
{{Drop|B|ut, JC, by}} your own logic, therefore, ''every'' loan is extended against delivery of an asset: the legal debt claim against the borrower, whether that takes the shape of an abstract contractual claim having no physical form, but provable in court all the same, or a tangible instrument representing indebtedness, freely transferable on its own terms. In each case A lender can, more or less easily, raise money against the asset represented by its loan. Indeed, in the broadest sense, that is all banks do.  
{{Drop|B|ut, JC, by}} your own logic, therefore, ''every'' loan is extended against delivery of an asset: the legal debt claim against the borrower. It does not matter whether it takes the shape of an abstract contractual claim visible only to the law and provable only in court, or a tangible instrument representing indebtedness, freely transferable on its own terms. In each case the lender can, more or less easily, raise money against the asset represented by its loan. Indeed, in the broadest sense, that is all banks do.  


Does this not prompt a warping of swaptime: does it not, instead, say that rather than financing being a subspecies alone, alone is a subspecies of a financing?  
Does this not prompt a warping of swaptime: does it not, instead, say that rather than financing being a subspecies alone, alone is a subspecies of a financing?  


In one sense, yes; in another, no. The key difference is the measure of performance: in one case, the borrower provides a legal claim only against itself; in the other, it provides a ''margined'' claim against an unrelated asset. Unless there is a sudden extreme crash,  the lender’s risk is only to the present value of the asset,  and the borrower keeps all the risk of the asset. To be sure, in both cases there is, usually, credit risk;<ref>not always: a securitisation of [[EUA|carbon credits]], for example, involves no credit risk to the asset, as it has none.</ref> but in the case of a pure margin financing, it only arises in an extreme crash scenario. That is plainly not the case where the borrower remains the outright credit of the loan.
In one sense, yes; in another, no. The key difference is the measure of performance: in one case, the borrower provides a legal claim only against itself; in the other, it provides a ''margined'' claim against an unrelated asset. Buy the margin mechanism it adjusts the size of its claim to the prevailing size of the asset. Unless there is a sudden extreme crash,  the lender’s claim is only to the present value of the asset. The borrower keeps all the risk of the asset. It's ultimate sanction is to sell it and return the proceeds to the lender.  
 
Where the “asset” is only the legal obligation to repay of the borrower, the lender cannot defray its credit risk unless it sells the instrument absolutely, in which case it is no longer financier or lender at all.


To be sure, in a [[financing]] there is always a [[Second-loss|“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''.  
To be sure, in a [[financing]] there is always a [[Second-loss|“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''.  
====Financing as asset transformation====
{{Drop|W|e 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: this is an exchange of equivalent values — and ''investment'', as an outright transfer of capital on the other — I give you cash in return for your promise to pay me 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).


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]].)
Oil>uWhile 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====
====Characteristics====

Latest revision as of 22:01, 3 November 2024

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 in part because of a linguistic looseness around the word “borrow”, and in part because we are accustomed to thinking of capital investment chiefly in terms of its return and not risk. The return of an equity investment is very different to the return of a loan.

But their risk profiles of a loan and a share are similar, and closely correlated. And, from a legal eagle’s perspective, it is the risk of a investment that will cause us trouble, not its return.

First, some terminology:

In an outright, unsecured loan, the lender allocates capital to the borrower, apropos nothing, against an expectation of a payment by the borrower of a return. A lender assumes the borrower’s bare credit risk.

In a financing, the financier provide assumes the market risk of a third-party asset, against the payment of a financing rate. If the financed asset declines in value, the loan value is adjusted by means of a margin mechanism. As long as the asset doesn’t suddenly collapse, the borrower’s prospects don’t come into the risk assessment of a financing arrangement.

Linguistics looseness about borrowing

Bankers use the word “borrow” in a strange way. In ordinary usage, “borrowing” implies possession but not ownership:

“May I borrow your car for the weekend?”
“I have borrowed this book from the library.”

We have possession of what we borrow but the lender always owns it.

Borrowing is different when it comes to banking. Firstly, because money is an unownable anti-asset, you cannot “borrow” it in this ordinary sense.

Cash is special: as long as you hold it, no one, including the person who “lent” it to you, has any proprietary claim on that money. This follows because money cannot be owned, only held. To “lend” money is to give it away absolutely against an enforceable promise from the recipient to pay not the same money, but an “equivalent” amount of any fungible money, back.

If we were talking about anything other than money, we would not call this “borrowing”.

Why mention this now? Because it rubs out one of the fundamental differences between a “loan” and an “investment”: the lender does not “lend” “her” money to the borrower, the same way she might lend her car. Rather, she gives money to the borrower on terms that the borrower will later pay back an equal sum, plus interest.

Return metrics

The expected returns at maturity[1] from lending and financing are similar. We calculate them by reference to an independent index that has nothing to do with the borrower: an interest rate.

By contrast an equity investment has no term, no “par value” and pays a variable return. The rising or falling share price measures how the market values the business: that is the share’s “return metric”. A failure to beat a benchmark, reach a target or meet analyst’s expectations is still a return, just a disappointing one. It is correlated with the risk of business failure but is still not a “risk metric”. It is not a “default” on the contractual obligation the share represents. Only the company’s bankruptcy would be that and — well — too late.

You could — and I do — make an argument that outright lending and owning are more like to each other, and less like asset financing. Asset financing is more like the kind of capital market activity we do not usually think of as lendingprime brokerage, swap trading, securities financing and futures trading.

Interlude: isn’t all lending a subcategory of financing?

But, JC, by your own logic, therefore, every loan is extended against delivery of an asset: the legal debt claim against the borrower. It does not matter whether it takes the shape of an abstract contractual claim visible only to the law and provable only in court, or a tangible instrument representing indebtedness, freely transferable on its own terms. In each case the lender can, more or less easily, raise money against the asset represented by its loan. Indeed, in the broadest sense, that is all banks do.

Does this not prompt a warping of swaptime: does it not, instead, say that rather than financing being a subspecies alone, alone is a subspecies of a financing?

In one sense, yes; in another, no. The key difference is the measure of performance: in one case, the borrower provides a legal claim only against itself; in the other, it provides a margined claim against an unrelated asset. Buy the margin mechanism it adjusts the size of its claim to the prevailing size of the asset. Unless there is a sudden extreme crash, the lender’s claim is only to the present value of the asset. The borrower keeps all the risk of the asset. It's ultimate sanction is to sell it and return the proceeds to the lender.

Where the “asset” is only the legal obligation to repay of the borrower, the lender cannot defray its credit risk unless it sells the instrument absolutely, in which case it is no longer financier or lender at all.

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.

Financing as asset transformation

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: this is an exchange of equivalent values — and investment, as an outright transfer of capital on the other — I give you cash in return for your promise to pay me 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).

Oil>uWhile 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.

  1. Without considering the risk the borrower will not be able to repay