Lending versus financing

A fundamental distinction in the capital markets between lending and financing: Lending involves the outright assumption of credit risk against a borrower; financing involves the outright assumption of market risk against an asset.

In a financing there is always a second loss risk exposure to the borrower — so residual credit risk — but this remains fully contingent on asset failure, and that in turn is a failure of market risk management rather than lending per se.

I would draw a distinction between bilateral transformations of asset values between parties on one hand — I give you cash in return for an asset, with the expectation that we will reverse this exchange at a later date — and outright transfers of capital on the other: outright investments, whether that be via debt or equity capital injection.

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.

See also

• Financing
• A swap as a loan
• Bilaterality<Credit risk
• Market risk