1.3 Lenders and borrowers

We shall look at the markets for securities in Chapters 5 and 6 and see that

their behaviour departs in various ways from that suggested by conventional market

analysis.

1.3Lenders and borrowers

In this section, we want to discuss people’s reasons for lending and borrowing and

the differing needs of lenders and borrowers that nancial intermediaries have to

try to meet. In modern economies, where savers make their surplus available to

borrowers via nancial intermediaries, it is sometimes useful to refer to the savers and

borrowers as ultimate lendersand ultimate borrowers. This enables us to distinguish

their behaviour from that of the intermediaries themselves who are also ‘lending’

(to ultimate borrowers) and ‘borrowing’ (from ultimate lenders) and frequently lend-

ing and borrowing between themselves. It is ultimate lenders and borrowers that we

are concerned with here.

Ultimate lenders:Agents whose excess of income over expenditure creates a nancial

surplus which they are willing to lend.

Ultimate borrowers:Agents whose excess of expenditure over income creates a

nancial decit which they wish to meet by borrowing.

1.3.1Saving and lending

In any developed economy there will be people and organisations whose incomes are

greater than they need to nance their current consumption. The difference between

current income and consumption we call saving. The saving could be used to buy ‘real’

assets, that is to say machinery, industrial premises and equipment, for example,

in which case as well as saving they would be investing. However, many people will

be saving at a level which exceeds their spending on physical investment. Indeed,

in the personal sector there will be people who save but undertake no physical

investment at all. The difference between saving and physical investment is their

nancial surplus. It is this surplus that is available for lending.

What conditions have to be met to induce those with a surplus to lend? We can say

that in their choice of asset, lenders will be seeking to minimise risk (often expressed

as maximising liquidity) and to maximise return. We know from section 1.1.3 that

risk comes in a number of forms. We distinguished, for example, between ‘capital’

and ‘income’ risk and said that both might arise from someone else’s default or

simply from market conditions. One situation which both borrowers and lenders

have to anticipate is the risk of needing early repayment (for lenders) and the risk

of being called to make early repayment (for borrowers). For lenders this poses a

particular form of capital risk and explains why lenders are generally prepared to

trade liquidity for return. A lender who needs to dispose of an asset unexpectedly

wishes to do so quickly, cheaply and in the knowledge that the proceeds of the

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Chapter 1 • Introduction: the nancial system

sale are fairly certain. These are the joint characteristics of liquidity. In the absence

of these characteristics, a lender requiring unexpected repayment faces capital risk

since any asset – even a house – can be sold quickly if the seller is prepared to face a

sufciently large capital loss. If we express our objective in liquidity terms, therefore,

liquidity and its component characteristics are thus one feature that lenders will

wish to maximise, ceteris paribus. Alternatively, we can express the same objective as

a minimisation of risk.

The second characteristic which lenders will look at, again with a view to maxim-

isation, is return. The return on a nancial asset may take a number of forms. It may

take the form of an interest payment at discrete intervals. This interest payment

may be xed at the outset of the loan or it may vary, but, xed or variable, it will be

paid to the lender for so long as the loan is outstanding. Notice, because it will be

important later, that if an asset pays a xed rate of interest, as do government bonds,

for example, then movements in market interest rates will make that asset more or

less attractive. If market rates rise above the level paid on a xed-interest asset, that

asset will be less attractive than current alternatives and its price will fall. If market

rates fall, it will become more attractive and its price will rise.

Another form which yield may take is the dividend. Unlike a rate of interest which

has to be paid for as long as the loan is outstanding, a dividend payment normally

reects the ability of the borrower to pay. Thus in a good year, the borrower may

pay the lender a large dividend, but in a poor year the dividend may be small or

even non-existent. Entitlement to a dividend, therefore, normally indicates that the

lender is sharing in the risk of the borrower’s business.

A third source of yield, which may be less obvious than either of these, is the

yield that comes from an appreciation in the capital value of the asset. Clearly,

many people hold company shares not just for the dividends paid out annually but

because they expect the value of the shares to rise over time. Government stock

which bears a xed rate of interest also has a xed date and a xed value at which

it will be redeemed. If market interest rates have forced the market value of a stock

below its redemption value, buying the stock and holding it to redemption will

produce a guaranteed capital gain which can be expressed as an annual rate of return

over the rest of its life. Some assets, treasury bills for example, have no interest paid

on them but are sold ‘at a discount’ to their redemption value. In this case the yield

consists entirely of capital gain.

Thirdly, lenders will wish to minimise transaction costs. There is little point in

nding a lending opportunity which seems to offer a superior rate of return if the

charges for entering into the commitment absorb the margin over the next best

rate of return. This is a problem that confronts many small lenders in particular.

The commissions charged for buying stocks and shares, for example, often have a

minimum threshold which makes the commission a large fraction of a small purchase

of shares. Many personal pension plans sold in the 1980s allowed pension funds to

levy charges for setting up the contract, which meant that many savers would have

earned a better overall (‘net’) rate of return by making their own contributions into

a mutual fund.

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