1.3.3Lending, borrowing and wealth

So far, we have discussed owsof lending and borrowing. While ows are very

important, we need to remember that ows cause changes in stocksand that there

are times when stocks matter. For example, a person with a (net) current nancial

surplus is adding to his or her stock of nancial wealth. A person or rm with a (net)

current decit has either to increase their stock of nancial liabilities (by borrowing)

or to sell some existing nancial assets. In either event a nancial decit leads to a

reduction in net nancial wealth.

Notice that we talk here, as we did with the ows of lending and borrowing, of

‘net’ positions. People will hold simultaneous debtor and creditor positions. People

with mortgages will also have building society deposits. A rm may have a very

substantial long-term debt as a result of recent expansion and at the same time be

holding a considerable sum in a high-interest bank account.

Why is this the case? Remember that one of the ways in which nancial inter-

mediaries make a prot is by charging a rate of interest to borrowers which exceeds

that which they pay to lenders. At rst glance, therefore, it seems strange that

people should have a large outstanding debt with an institution at the same time

that they hold assets with that institution. Surely, one would think, they would be

better off using the assets to pay off at least part of the debt. Suppose that a borrower

has savings in the building society equal to half his outstanding mortgage. The

interest received on this obviously goes some way to subsidising or reducing the cost

of the interest paid to the society on the mortgage. But since the rate of interest

26
	..	..

FINM_C01.qxd 1/18/07 11:18 AM Page 27

1.4 Summary

received from the savings is less than the rate of interest paid on the mortgage, there

would seem to be a benet in using the savings to pay off half the mortgage debt.

However, this overlooks the fact that while the house-buyer has savings with the

society, he has access to ‘ready money’, or at least to ‘liquidity’. If he uses the savings

to pay off half the mortgage, he is sacricing the convenience or benet that liquidity

confers. Thus, if we were to persist with the calculation of cost and benets, we

should have to say that paying off half the mortgage would certainly bring a benet

in the saving of interest (equal to the difference in the two rates being paid) but at

the same time it would cause a loss of benet in the access to ready funds. Provided

our house-buyer values liquidity more highly than the interest rate saving, then

maintaining both the mortgage and the savings simultaneously is entirely rational.

Notice that the interest saving is a differential or ‘spread’ between the rate charged

on mortgage lending and the rate paid on building society deposits. We are familiar

in other spheres of economics with the idea that people base their allocation decisions

upon relativeprices. We should not therefore be surprised that the same holds true

when people make decisions about nancial allocations. We shall see later that the

behaviour of spreads is very important.

The point which emerges from this discussion is that in making decisions to

borrow and to lend, that is to say making decisions to acquire nancial liabilities and

assets, people are faced with a complex choice. The choice is not just about whether

to be either a borrower or a lender but about the amount of both borrowing and

lending they should undertake. It also involves a decision about the best mix of types

of liability and asset for their particular circumstances. Economists are referring to this

decision when they say that people are exercising their portfoliochoice. As we have

just seen, exercising portfolio choice involves arranging the portfolio, the mixture

of liabilities and assets, in such a way that, for a given cost, the benet derived from

each asset or liability is equal at the margin. When this is the case people are said

to be in portfolio equilibrium. The study of the principles underlying portfolio choice

is known as portfolio theory. There is more on portfolio equilibrium and portfolio

theory in Appendix I.