Template:M intro pb lending and financing

A fundamental distinction we make less of than we might in the capital markets in the one between between lending and financing: We tend to treat financing as a special case of financing, and to be differentiated from, for example, ownership.

You could — and herein JC does — make an argument that in fact lending and owning are more closely aligned, and they are different from 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 lender’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 — 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 draw a distinction between bilateral transformations 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 outright transfers 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.)

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.