Longer term financing and its tradability

Mehdi Rahman | Published: October 30, 2019 20:11:17

Business entities, established with capital injected by owners, are of different types - sole proprietorship, partnership, joint stock and so on. Whatever name is given, a business entity belongs to its owner/s. Its day-to-day operations are run generally by paid staff. Owners are also found working as paid staff as do some CEOs, COOs and CFOs and provide services accordingly.

The capital injected into the business entity is meant for its operations. A portion of the capital is used to purchase capital goods and the remainder as working capital. Capital invested by owners may be inadequate with upward trend in activities and the entity needs more funds. It is loan which works as sources of such capital needs.

Loan fund is of two types - working capital loan and term loan. Working capital loan meets requirements of procurement of goods and services of regular business operations. This is offset with sales revenue generated thereon. Term loan is used to procure capital goods like machinery and equipment required for production of outputs. The expenses to procure fixed goods are not offset with sales revenue; only a portion as depreciation is adjusted with sales revenue to recover the cost of capital goods.

Loan, both as working capital and long-term financing, is taken from informal sources and formal sources like banks and financial institutes. In Bangladesh context, banks are the main source of such financing. Banks depend on deposits for their lending activities. They collect short-term deposits. Such short-term raw materials -- loan money derived from deposits -- cannot be used for capital goods.

In such a scenario, we can cite example of export trade. Exporters are facilitated with letters of credit and pre-shipment financing to procure input contents with maximum tenure of six (6) months against their export sales of four (4) months tenure. Such facilities help exporters wash out loan/import liabilities with export payments.

Banks' financing for procurements on a short-term basis do not face problems since the period of their raw materials' (deposits') sourcing matches with loan recovery period. But such loan cannot be used by borrowers to manufacture, for example, aeroplane which takes huge production time. As such, short-term working capital is not workable for production of goods requiring longer time. Term loan extended by banks in the name of project finance leads to the same scenario if it depends on short-term deposits.

There are three types of financing, as classified by Hyman P Minsky: (a) hedge finance, interest and principal of which is settled by income flows; (b) speculative finance, interest of which is covered from income flows; and (c) ponzi finance, where inflows are insufficient to cover interest and principals, requiring new loans to support the repayments.

In case of short-term working capital financing by banks, repayment is done with sales revenue generated from outputs. Expenses are recorded in the books of accounts as payment for inputs and relevant services. Interest expenses are also recorded. As per Minsky's classification, smooth repayment can be termed as hedge finance. Banks do not face liquidity problems to settle deposits from which they extend such loans.

Term loan extended by banks is used for procurement of fixed goods to run operations of business entities. Recording the capital goods as revenue expenses makes the output prices uncompetitive, leaving the finished goods unsold. So, only a portion of capital expenses needs to be recorded as depreciation in the books.

Sufficient profits are required, if the repayment of principal proceeds is higher, to settle the dues to banks. But profitability is not practically so adequate to use profit for settlement of principal proceeds in case of insufficient depreciation charges. New loan may be required to offset the principal proceeds. Banks also face liquidity problems if repayment is not received on maturity.

Share capital, used mainly for procurement of capital goods like machinery, equipment, is not refundable to its owners/shareholders. Owners can sell their share capital, instead, if they want to other individuals/entities. Business entities do not buy back the share capital invested therein by shareholders earlier. Term loan has the same functions as capital does. So, it is rarely repayable if the repayment size is not reasonable. Due to mismatch in such cases with regards to repayment, term loans turn defaulted, making banks' assets nonperforming. Banks become illiquid to meet the depositors' demand and eventually face problems of solvency.

Inadequate repayment from term lending entails incremental deposits or injection of capital for settlement of short-term deposits, depending on types of lending. But these options are not readily available. To overcome the situation, liquidity supports from central banks may work. But such windows are not so easily available. Interbank borrowings help in the short term to face the situation.

Banks work as intermediary to collect savings from individuals and to invest the same in the form of loans within the framework of fractional reserve mechanism. Excessive creation of money through lending in the way of so-called fractional reserve framework does not sustain smooth operations in the long run. In such a situation, sufficient deposits are required for lending operations. Short-term deposits are suitable for short-term working capital financing.

An economy operating without having sound assets market depends on banks for term finances. But such financing is not supportive through short-term deposits, resulting in the so-called balance sheet mismatch.

So term loan should be meant for longer period exceeding 10 years for the comfort of the borrowing entities. We observe that private borrowings from external sources are serviced on time, rare records are found as defaults. This is due to the time factor of longer periods. But our banks cannot extend longer term loans to business entities due to its short-term sourcing.

In our country, term lending needs to be replaced by long-term bond. However, issuance of bond needs specified instructions to be followed. The market, moreover, is not ready for bond.

Still banks are only source of term financing. But tenure of the term loan from banks is not long in the sense that they need to meet maturity of short-term deposits. Long-term assets turn into default loan due to unbearable repayment size. Hence, there needs a trade-off for term financing. Otherwise, financing like speculative or ponzi as pointed by Hyman Minsky shall continue.

Banks need to observe regulatory instructions for classifying their assets. Assets without repayment flows are classified as bad or such other terms as regulations require. This situation leads borrowing entities to be in the categories of defaulters, leading them to have no banking facilities. To clean up the books of banks, different policy supports are found from regulatory authorities. They are, however, supportive for short term. The same default situation is found later unless the loan tenure is set to be longer one. There is a tug of war between banks and borrowers -- Banks prefer medium-term lending while borrowers want financing for longer terms. Banks cannot go beyond the limit considering their inputs tenure.

In some cases, loans are found purchased by third banks, which help borrowers to avoid being defaulters. Loan selling banks feel comfortable with repayment since the assets are not tradable in the market. Longer term financing by banks is not possible since they cannot liquidate their assets when needed. Though, we know, the present system leads borrowers to be defaulters, it continues.

The country needs alternative policy tools for banks to reduce dependency of borrowers on banks. On the path of becoming a middle income country, we need longer term capital financing, from local sources in addition to borrowing in foreign currency. Policy support to facilitate banks for financing longer tenure is a grave necessity of the hour. Assets created by way of longer term lending needs to be tradable. In this case, banks can create tradable bonds backed by assets held in their balance sheets. Such lending, with tradable capacity, to business entities may work as near equivalent to capital and is a hedge finance to them, to avoid being defaulters. The same assets by way of bond sales may be recycled to pay off depositors and to extend additional loan to the economy. Authorities concerned should devise certain policy framework to support longer term loans.


Share if you like